# 1 Introduction

The quality of governance affects the type of business environment a firm faces, resulting in direct and indirect effects on productivity outcomes both at the firm and aggregate levels. Firms in a weak business environment have to allocate resources away from productive to non-productive use to handle administration burdens or comply with excessive regulations. These activities reduce firm productivity.<sup>3</sup> In contrast, a strong business environment can indirectly increase firm productivity as the firm experiences competitive pressures, more flexible input markets, and knowledge spillovers when firms agglomerate in places with better functioning markets.<sup>4</sup> In aggregate, the efficiency of the market also determines how resources are allocated across firms. A growing literature following Hsieh and Klenow (2009) documents how market distortions, which prevent inputs from being allocated to the most productive firms, can have important consequences on aggregate productivity across countries. Such market distortions occur, for example, when firms face differential tax, labor or capital costs due to either de jure or de facto regulations. In turn, efficiency of the business environment is dependent on how the government and in some cases, the local bureaucrat administers and interprets regulations and policies. The actions of these bureaucrats can promote or hinder firms, affecting the levels of firm productivity.

This paper investigates the link between local governance – particularly as it relates to the local business environment – and aggregate productivity through two channels: within firm productivity levels and resource allocation across firms. We use firm-level data from Vietnam to answer this question by analyzing how variations in provincial administrative quality affect measures of (i) firms’ productivity and (ii) province-level resource misallocation. We focus on productivity because it has a straightforward interpretation of measuring the economic cost (through output distortions) of complying with business procedures in the province (Greenstone et al., 2012).

Our main results suggest that a higher quality of the local governance has a positive impact on firm productivity. This result is driven largely by the level of corruption in the provinces, measured by the degree of informal charges paid to the provincial government, and to a lesser extent, by the risks of land expropriation and time required to complete business procedures. We also find that improvements in the business environment, as measured by different aspects of local governance, have a differential effect on firms depending on their productivity levels: a better business environment positively affects high productivity firms but not low productivity firms. While lower land expropriation risks and lower informality benefit high productivity firms, better entry regulations matter for the low productivity firms. We do not find any effects of improvements in the business environment on measures of resource allocative efficiency within the provinces and sectors. This could be driven by the fact that an increase in local governance only reflects the experience of a subset of firms in the economy. If these changes do not benefit the most productive firms, then we might not observe improvements in allocative efficiency.

> 3 Greenstone et al. (2012) find that the introduction of environmental regulations decreased productivity levels of U.S. manufacturing firms. Fisman et al. (2007) and De Rosa et al. (2010) find a negative impact of corruption and bribery on firms in Uganda and Central European countries. Giordano et al. (2015) show that public sector inefficiencies reduces the labor productivity of Italian firms.

> 4 See Syverson (2011) for a comprehensive review. For individual studies that consider the effect of each factor, see Pavcnik (2002), Topalova et al. (2011) and Fernandes (2007) on trade competition, Amiti et al. (2007) on input market flexibility, Van Biesebroeck (2005) and De Loecker (2007) on learning through exporting, Greenstone et al.  (2010) on agglomeration spillovers.

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