The Capacity to Regulate – How Low State Capacity Worsens Capital Misallocation


Industrial regulation is a prominent explanation of misallocation, especially in India. But what causes misallocation: the regulation itself or its implementation? This paper finds that lower implementing capacity increases the misallocation due to a policy requiring permits for foreign investment. We utilize a policy experiment in India which decreased the capacity to approve foreign investments. We show how this leads to an overall increase in capital misallocation. In low-corruption sectors, the dispersion of wedges increases homogenously for politically connected and unconnected firms. In high-corruption sectors, the dispersion of wedges increases only for unconnected firms. The policy change causes an overall productivity loss through a decrease in total factor productivity (TFP) of 4.5%. Using extensive administrative and performance data on Indian bureaucrats, we further identify the effect of bureaucrat performance on capital misallocation.

In Progress