training investments, inadequacies in management style, or other productivity-enhancing investments that were not undertaken, or that firm managers may not even have been aware of. Another concern regarding subjective responses is that firms' perceptions may reflect differences in firm performance -- successful firms may view their business environment as less limiting.

Given these and related shortcomings of subjective indicators, this paper aims to exploit _objective_ business environment indicators to examine and quantify the intensity with which different business environment variables are correlated with productivity and innovation outcomes, rather than rely on subjective perceptions reported by managers. Objective business environment indicators reflect the actual incidence of various factors which potentially constrain business operations. These include metrics such as the share of electricity used that came from generator(s) that the establishment owns or shares, the losses from crime as a share of sales, the share of investment financed externally, the share of sales financed on credit, and internet access.

# **Hypotheses**

Our core hypothesis is that business environment factors are important determinants of variation in productivity and innovation across firms. Productivity and innovation are likely also to be explained by additional firm-specific factors such as managerial education and practices, workforce skills, and local spillovers. We test hypotheses related to each of the following major areas of the business environment in the context of productivity and innovation<sup>5</sup> : (1) incentives for productive entrepreneurship, including the extent of competition faced by the firm, enterprise regulation and corruption, and crime and security; (2) access to skills; (3) connectivity to global knowledge through trade and other channels; (4) access to finance; and (5) access to quality physical infrastructure. This section reviews findings from the empirical literature relevant to these five major areas to motivate the main hypotheses regarding the association between business environment indicators and productivity and innovation in Sri Lanka.

**_<mark>(1) Incentives for productive entrepreneurship.</mark>_** <mark>Whether entrepreneurial talent is allocated to productive entrepreneurship (wealth creation by increasing within-firm TFP through innovation), to unproductive entrepreneurship (wealth diversion via rent seeking), or to destructive entrepreneurship (wealth destruction via criminal or conflict-generation activities) depends on the relative payoffs facing individuals with entrepreneurial talent (Baumol 1990). For rapid, sustainable growth, it appears essential that the prevailing ‘rules of the game’ in the business environment allow transformational entrepreneurs to grow quickly and reap sufficiently generous rewards from innovation without fear of expropriation by public rent-seeking or private crime. We use the following business environment measures:</mark>

- **<mark>Competition.</mark>** <mark>Gorodnichenko, Svejnar and Terrell (2010) find robust evidence of a positive relationship between foreign competition and innovation using enterprise-level data similar to those employed in this paper. We hypothesize that foreign competitors not only pressure</mark>

> 5 See Trajtenberg (2009). See also Dutz (2007) for a similar broad definition of innovation and description of these four areas that provide key levers for innovation policy in addition to physical infrastructure.

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