An obvious policy implication of these findings is that government policies that we refer collectively as the business environment have a strong bearing on the spatial distribution of economic activities. We use the term business environment as just another name for what Dollar et al (2004) call investment climate. We define it as something broadly synonymous with institutions in the growth literature (Knack and Keefer 1995), or with what Hall and Jones (2000) call social infrastructure.<sup>3</sup> Our focus on only two items of a possibly long list of elements of business environment is dictated by the prominence that labor deregulation and problems of the power sector have in the current policy reform literature in India. At the same time they seem to be relatively easy to measure, and show significant variation across sub national regions.<sup>4</sup> Our broader result that differences in business environment are a major source of regional gaps in productivity is consistent with Dollar et al (2004) who report similar findings for international gaps in manufacturing productivity based on the World Bank’s Investment Climate Surveys and the same methodology.<sup>5</sup> Our findings on labor regulation are consistent with a recent paper by Besley and Burgess (2004), which also shows that regional differences in labor regulation are part of the reason why some of India’s states have lagged behind others in industrial development.<sup>6</sup> This finding is confirmed by Aghion et al (2004) with data disaggregated to the three-digit ISIC level 3 Accordingly we would include under it government activities relating to regulation of trade and industry and the provision of public goods that affect the cost or scale of production at the firm level by influencing factor productivity, prices or both. Apart from labor market regulations, pertinent regulatory activities include those aimed at financial markets/institutions, environmental externalities and zoning, industrial licensing, bankruptcy laws, the regulation of utilities including power, telecom or transport companies, law and contract enforcement institutions, customs regulation, and domestic and foreign trade taxes.

4 Many other aspects are either far more difficult to observe (e.g. the quality of law or contract enforcement institutions), or do not seem to vary a great deal sub nationally (e.g. industrial licensing and the regulation of financial markets). Besley and Burgess (2004) make the latter point with respect to labor regulation. 5 Our finding of association between business environment and spatial productivity gaps is also consistent with Escribano and Guasch (2004), Latin American data, Eifert et al (2005) for a number of African economies, and Haltiwanger and Schweiger (2005) on a much larger set of developing economies. Each of these papers analyzes international productivity gaps based on the World Bank Investment Climate Surveys but from perspectives slightly different from Dollar et al (2004). Dollar et al (2002) and HallwardDriemeier et al (2003) link in country variation in productivity to business environment using the World Bank survey data for India and China respectively.

6 Based on an analysis of time series of aggregate (state level) data, Besley and Burgess conclude that labor law reforms that some states carried out over the period 1958-1992 to reduce compliance costs led to faster growth in manufacturing employment and productivity than in states that, either did not amend the labor law at all, or did so, but in ways that increased the cost of regulation to businesses.

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