(2010) and Hallward-Driemeier and Pritchett (2010) emphasize that policy implementation differs greatly across regions even though firms within a country face the same _de jure_ institutions. They show evidence that de facto enforcement of policies differ greatly at the local level within a country, and de facto business environment may matter much more than de jure business environment. Since enforcement of policies tends to be decided at the city level, we measure our environmental variables at the city level.<sup>21</sup>

# **_Results from the Baseline Specification_**

We first report the regression results from the most restricted, also the most common, baseline specification—all coefficients are assumed to be the same for the two countries, and there are no interactions among the business environment variables. This specification assumes homogeneous policy effects across the two countries. For comparison purposes, we report results when productivity is either measured by TFP or by log labor productivity. In the latter case, we also control for the interactions of industry dummies with log capital-labor ratio. Since the environmental variables are correlated with each other (Appendix table), we are concerned about the effects of multicollinearity when we include all of them in the regression. We therefore start by including them one by one in our regressions, and then include them all together to see if the results change much. Only one environmental variable, deal uncertainty, has different results between the one-by-one specification and the all-included specification. We present the results based on labor productivity in table 4, and those based on TFP in table 5.

Comparing the results in tables 4 and 5 reveals that we obtain qualitatively identical results whether we use labor productivity or TFP as the dependent variable. For this reason, our discussion below will focus on results in table 5 where we use TFP as the dependent variable. The three indicators of labor flexibility—the share of nonpermanent workers, the share of large firms, and lagged firm size—all have positive and statistically significant (or close to being so) coefficients.<sup>22</sup>

> 21 Alternatively, we can measure it at the provincial or state level. However, measuring this way suffers from two problems. First, given that recent studies find enforcement matter a great deal, it is more appropriate to measure the business environment at the more decentralized city level. Second, given the state and province tend to have some policy formulation role, provincial measures of the environment may reflect better de jure policy environment. However, recent studies have shown convincingly that what matters tend to be de facto rather than de jure regulations (Hallward-Driemeier et al. 2010; Hallward-Driemeier and Pritchett 2010). Finally, we have more variations at the city than at the province/state level, and given the number of policy variables we examine, more degrees of freedom also provide a great practical advantage.

> 22 It is important to point out, however, that some of our proxies for labor flexibility, such as firm size, may reflect other factors such as a legacy of earlier small and medium enterprise sector reservations, skills, and managerial control system.  We thank Giovanna Prennushi for pointing this out.

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