Investment Climate and Economic Performance: Some Firm Level Evidence from India

Based on a survey of over 1000 manufacturing establishments across a number of states in India, this paper analyzes the effect of key aspects of the investment climate on firm productivity. We find that, controlling for establishment size and industry, value added per worker is about 44 percent lower in states that entrepreneurs consider to be of relatively poor investment climate. Most of this gap is due to lower total factor productivity (TFP) of firms in these states. We then relate firm productivity to objective indicators of the investment climate. We trace about a quarter of the TFP gap to inferior power supply and poorer internet connectivity in poor-climate states. About a tenth is due to higher regulatory burden in the same states. The TFP disadvantage of poor-climate states would have been even higher if labor market rigidities were not a stronger drag on productivity in the better-climate states. Not only does this regional pattern in productivity confirm managers’ subjective ratings of investment climates, but it also matches a similar pattern in capital formation. The average rate of net fixed investment is less than 2% for firms sampled from poor-climate states against a figure of about 8% in good-climate states. This evidence suggests that local governance—working through the regulatory environment and infrastructure—plays a significant role in investment and productivity growth.