Policy Research Working Paper                 10628




  Is There Still A Role for Direct Government
  Support to Firms in Developing Countries?
                             David McKenzie




Development Economics
Development Research Group
December 2023
Policy Research Working Paper 10628


  Abstract
 Should governments in developing countries directly sup-                           for government involvement, and then lessons from a recent
 port firms with policies such as grants, subsidized loans, and                     research agenda in development economics on how to target
 training and consulting programs, or should they instead                           these programs, on whether they induce firms to undertake
 just aim to enact sensible regulatory and macroeconomic                            additional activities, on avoiding political capture, and on
 policies and not attempt to engage in industrial policy?                           how these interact with competition. This work shows that
 While industrial policy has gained renewed attention in                            these policies can deliver some of their promised benefits,
 developed economies, it faces considerable skepticism in                           but that there is still much to learn and the need for system-
 developing countries scarred by previous experiences and                           atic and serious attempts at prospective impact evaluation
 facing limited fiscal space. This paper discusses the rationale                    as new policies are launched.




 This paper is a product of the Development Research Group, Development Economics. It is part of a larger effort by the
 World Bank to provide open access to its research and make a contribution to development policy discussions around the
 world. Policy Research Working Papers are also posted on the Web at http://www.worldbank.org/prwp. The author may
 be contacted at dmckenzie@worldbank.org.




         The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development
         issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the
         names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those
         of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and
         its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent.


                                                       Produced by the Research Support Team
     Is there still a role for direct government support to firms in developing countries? #


                                                 David McKenzie,
                              Development Research Group, The World Bank




Keywords: Firm support; industrial policy; green growth agenda; impact evaluation
JEL Classification Codes: O25, O14, O32, D22, L26.




Prepared for a special issue of New Zealand Economic Papers



#
 I thank the editors Asha Sundaram and Dennis Wesselbaum for the invitation to contribute to this special issue and
for their helpful feedback, and World Bank colleagues for discussions in several seminars about these types of policies.
The findings, interpretations, and conclusions expressed in this paper are entirely those of the author. They do not
necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its
affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent.
Introduction

Industrial policy in developed countries have recently gone from being “the policy that should not
be named” to being “back in a big way” (Van Reenen, 2023). In the United States the Inflation
Reduction Act allocated $400 billion in subsidies for solar, wind, electric vehicles and other green
activities, the CHIPS Act provides $39 billion in financial incentives to the semiconductor
manufacturing industry; while a variety of programs provide small grants, subsidized loans, and
free trainings to small and medium enterprises. In Europe, between 2014 and 2020, 67 billion euros
were spent on “Smart Specialization” programs designed to explicitly support innovation and firm
development in specific sectors in which it was thought particular regions might have a
comparative advantage – with the goals of launching 15,000 new products, 140,000 new start-ups,
and generating 350,000 new jobs (Gómez Prieto et al, 2019)

Yet in my discussions with operational staff at the World Bank and policymakers in developing
countries, I often encounter a lot of skepticism about any form of direct support to firms (such as
grants, subsidized loans, training, and consulting programs, etc.) that aim to help individual firms
to grow, innovate, and be more productive. Instead they favor focusing on getting regulatory and
macro policy right to support the whole economy and benefit firms indirectly. This skepticism is
often underpinned by the historic experience with supporting infant industries and protectionism
in many Latin American and African countries, which has tainted the idea of industrial support,
linking it to an image of protected, unproductive firms, that benefit from political favoritism and
that offer high prices and/or poor services to consumers. More recently, in a post-Covid era in
which government budgets are tightening, there is also concern about public spending going to
support relatively well-off firm owners instead of alternatives such as social programs.

Why might governments want to directly support some firms?

From a normative viewpoint, discussions of whether developing country governments should try
to directly support firms are typically based on different theoretical arguments around market
failures and externalities. As Rodrik (2019) has argued, the market failures which industrial
policies target “in the markets for credit, labor, goods and knowledge have long been at the core
of what development economists study”. While fixing these markets may be the first best policy
solution, doing so can be difficult, and policies such as grants and subsidies can help firms better
cope with these market failures. A second theoretical justification comes in the form of

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externalities. Three types of externalities seem most important here. The first are the externalities
to society of good productive jobs that are key drivers of poverty reduction and the structural
transformation of developing economies. Supply-side efforts to provide training and skills to
workers will have limited success if there is a shortage of employers wishing to hire these workers
(Carranza and McKenzie, 2023). Second, externalities arising from pollution and the underpricing
of carbon cause firms to underinvest in adoption of green technologies, prompting increasing
interest in green industrial policies. Third, the types of technology adoption and innovation
undertaken by developing country firms may be quickly copied by competitors, leading to a free-
riding problem and spillovers that result in underinvestment. Finally, the strategic management
literature argues that improving skills and strengthening firm capabilities are critical for innovation
and productivity, so that the government should have a direct interest in supporting these activities
as way of increasing overall economic performance (e.g. Teece and Pisano, 1994).

Whether or not one is convinced by these theoretical arguments, the practical reality is that most
governments are pursuing some forms of these policies. This has been the case historically in many
parts of the world. In addition to the famous use of industrial policy in East Asian countries, such
policies have been used in the U.S. and Europe. For example, Bianchi and Giorcelli (2022) show
how a World War II training program in the U.S. had positive and long-lasting effects on firm
performance and the adoption of beneficial management practices, as well as positive spillovers
on the supply chains of these trained firms. Juhász et al. (2023) document that advanced economies
remain the highest users of industrial policy interventions. But such policies are also widely used
in developing economies today, with countries using a range of business training programs,
management improvement programs, investment readiness programs, innovation adoption
subsidies and credits, partial credit guarantees, green technology initiatives, and other such
programs that assist particular firms. The key question is then not whether governments should
pursue such policies (they have decided they will), but rather what types of industrial policies they
should use, and how these policies can be done better.

What has been largely missing from this policy debate until recently has been concrete empirical
evidence on whether these programs deliver their intended results, and on whether the theoretical
concerns of critics arise in practice. An active recent research agenda in development economics
has started to provide some answers.


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Targeting and Additionality of Firm Support Policies

Once governments have decided they want to provide some support to specific firms, a key
question is then which firms they should support. It is impossible to take part in such policy
discussions for very long without hearing the common refrain that “governments can not pick
winners”, with the resulting concern that the firms that end up being supported will turn out to be
failures. It is true that it is very hard to predict which firms will grow the fastest or benefit the most
from a government program. For example, in a study of a large business plan competition in
Nigeria, I found that, conditional on getting through an initial screening, expert judges, machine
learning models, and economic models all had very low ability to predict which firms would grow
fastest over the next three years (McKenzie and Sansone, 2019). However, governments typically
do not need to identify the winners, they just need to design programs that attract high potential
firms, and screen out those with little prospect for growth. Indeed in that same Nigerian business
plan competition, using the fact that a lottery was used to decide among semi-finalists, I found that
the government support causally resulted in higher firm survival, more profits, sales, and
innovation, and higher employment over the next five years, including increases of over 20
percentage points in the likelihood of a firm having 10 or more workers (McKenzie, 2019). A
second solution can be to support firms in stages, and have information revealed along the way
that helps better determine which firms to support more extensively. The goal should not be to
avoid failures: such programs should be aiming to support firms to undertake risky activities, in
which it is likely that not all will succeed, which is part of the reason why the market can find it
hard to privately finance such activities.

The second concern raised is that even if governments do support successful firms, they may just
end up subsidizing them to undertake activities these firms were planning on doing anyway,
thereby enriching the owners of these firms with no public benefits. This is often referred to as a
lack of “additionality”, in that the funding does not induce firms to undertake additional activities.
Many recent empirical studies do show that this concern is often overblown, and that when
government programs subsidize or help firms to do something, firms indeed do more of this thing.
For example, a directed lending program in India did get targeted firms to expand borrowing and
use it to increase production (Banerjee and Duflo, 2014), a new loan product in China did get firms

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to borrow more and increase sales (Cai and Szeidl, 2022), grants for science-industry collaboration
in Poland led firms to do more collaboration on the project they applied for and to increase
patenting (Bruhn and McKenzie, 2019), and firms provided with management consulting on
Colombia use more consulting hours, improve their management practices, and increased
employment (Iacovone et al, 2022).

Political Capture

However, these benefits and additionality are not automatic, but depend on programs being
designed well and on them attracting the right firms as applicants. A concern is then whether many
developing countries lack the state capacity to implement such programs well, and in particular,
the risk of lobbying from powerful firms and politicians to use these programs to enrich themselves
or their networks.

This is certainly a concern to take seriously. In attempts to evaluate matching grant programs to
support innovation and firm upgrading in six African countries, my colleagues and I (Campos et
al, 2014) found that political economy or capture reasons were often a proximate cause of low
take-up of these programs by firms. This was often tied to red tape and bureaucracy. By making it
complicated for firms to learn about and apply to these programs, only connected firms end up
with access. For example, in one country I attempted to work in, the Chamber of Commerce ended
up effectively writing the program regulations in a way that only its members would be eligible.
There therefore needs to be a lot of effort devoted to making such programs simple and transparent
to apply to. This is where there is a role for a third party organization to help set the rules, monitor,
and oversee implementation. In the EU, the European Commission sets rules on the use of state
aid that help prevent individual countries and politicians doling them out to their favorites. Having
the World Bank or donors like FCDO/DFID hire staff for and oversee a project implementation
unit and help write the eligibility conditions for programs can help a lot here.

The role of competition

Historically, infant industry approaches to industrial policy often aimed to protect firms from
competition through tariffs, exclusivity, and other measures. But the concern is then that these
protected firms have little incentives to improve and innovate, and never grow up. Instead, we
heard in our work on a management improvement program in Colombia (Iacovone et al, 2022)


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that it was the threat of competition from Chinese imports that put the impetus on family-run firms
to try to improve their management practices through participating in the government program.

Supporting export- and innovation-oriented firms that are doing something different also alleviates
the concern that helping some firms may just simply lead them to stealing the business of firms
not supported, with no growth in the overall market. This is what happened with a subsidized loan
program in China (Cai and Szeidl, 2022), with firms that got loans using them to take market share
from those in the same industries that did not. In contrast, business training in Kenya helped firms
to figure out new products to sell, and sales in the market as a whole expanded, with untrained
women not being hurt by having others in their market receive training (McKenzie and Puerto,
2021). Supporting many firms so that they have to compete, rather than just protecting one firm,
can help ensure these benefits arise. In a study of private schools in Pakistan, when only one school
in a village received a grant, it increased capacity (taking students from other schools), but not
quality, whereas when all schools got grants, they competed on quality and children’s test scores
improved (Andrabi et al, 2020). Supporting groups of firms can also generate additional benefits
if they can learn from one another and form new network connections. In Colombia, providing
consulting to small groups of firms that were not directly competing with one another delivered
lasting improvements in management at one-third the cost of providing individual consulting
(Iacovone et al, 2022).

Finally, another concern of policymakers is that subsidies for firms to use training or business
consulting can end up undercutting the market for business service provision. However,
empirically this often may not be the case, due to the presence of substantial information frictions
in the market for business service provision. In a study in Nigeria, we found that most small and
medium enterprises did not know of the existence of most service providers, found it hard to tell
good from bad providers, and did not trust them (Anderson and McKenzie, 2022). A program
which subsidized firms to try using HR consultants, accounting firms, and marketing firms not
only improved management practices and firm growth, but also led to firms being more likely to
go back to the market and use their own funds to buy more of these services. That is, government
support, rather than undermining competition in business service provision, can be used to build
market demand.




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Coordination with Regulation and Taxation

The role and effectiveness of direct support to firms will also depend on the regulatory and tax
environments. Regulations which protect incumbents and make entry and exit difficult, as well as
those that make it hard for productive firms to expand, will likely limit the effectiveness of
industrial policies. But regulatory efforts alone may do little to spur growth and innovation if firms
are not able to take advantage of new opportunities because of the market failures and externalities
that direct firm support is intended to help overcome. Governments should therefore aim to
coordinate their direct and indirect efforts to support innovation and growth. Juhász et al. (2023)
argue for an iterative process here, with coordination also with the private sector to understand
where blockages and obstacles to productivity arise and how to best resolve these.

Acemoglu et al. (2018) raise the concern that some types of research and development (R&D)
subsidies for innovation can be counterproductive, because they can help less innovative firms to
survive longer, slowing down the process of reallocation to more innovative firm types. In contrast,
they argue that taxing the operations of all firms can free up resources for R&D by encouraging
the exit of low productivity firms. However, even in the United States there is empirical debate
about how much of growth and innovation comes from reallocation (e.g. Hsieh and Klenow, 2017),
and this process can be even less selective in developing countries. The principles discussed above
for targeting direct support programs in a way that supports firms to do something different and
avoiding political capture can help in mitigating this concern. Juhász et al. (2023) also argue that
spending on customized public inputs such as customized job training and manufacturing
extension services can be more cost-effective than general tax credits.

I do see a tax on firm profits as part of a way to sustainability finance direct support programs,
since the government will collect more tax revenue if it succeeds in spurring firm growth. In
addition, governments can benefit from paying lower social benefits if these firms hire additional
workers, and may also consider giving innovation grants under a royalty model, in which firms
that are successful pay a time-limited royalty back to the government that can also help finance
the next set of projects. Israel’s R&D Fund employs such a model, where firms that receive grants
make royalty payments if their projects reach commercialization.




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Support, but Evaluate

Despite well-founded skepticism about direct government support to firms, the above examples
show that these programs can deliver benefits in terms of higher productivity, more innovation,
and job creation. There are many design issues needed to ensure that these firms are targeted to
the types of firms that have the potential to benefit from these programs, that the policy instruments
do help firms overcome market failures and externalities, and that risks of political capture are
minimized. Often these choices are based on copying what has been used elsewhere, or on ex-ante
assessments involving considerable guesswork. But the innovation process is complex and risky,
and obtaining proper counterfactuals of what would have happened without the policy is difficult.
Building rigorous prospective impact evaluations alongside these projects to enable better
measurement of impacts and adjustments along the way is needed. This is especially the case as
new areas of government support such as the green agenda take hold.




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References
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