efficiently – and without combining them with sufficient complementary knowledge-intensive intangible assets.<sup>2</sup> Insufficient increases in aggregate, economy-wide TFP reflect three complementary dynamics within the economy: (i) _sectoral_ misallocation, with a large proportion of the working population remaining in lower-productivity sectors of the economy, such as low capital-intensity and low knowledge-intensity segments of agriculture or informal jobs; (ii) _within-sector, across-firm_ misallocation, in which less productive firms account for a disproportionate demand for resources and are not forced to exit and make room for more productive existing firms or new entrants by the selection mechanisms of ‘creative destruction’; and (iii) insufficient _within-firm_ productivity upgrading or innovation, the commercialization by transformational entrepreneurs of new-to-the-firm (and in a few instances also new-to-the-world) process, product, organization and marketing technologies, literally turning ideas into higher productivity and wealth at the firm level (and also across firms, given the prevalence and social desirability of knowledge spillovers across firms).

This study explores the impact of the Sri Lankan business environment on productivityenhancing resource reallocation across firms within clusters of enterprises, on TFP at the firm level, and on productivity-upgrading innovation within firms. Our focus on business environment constraints in manufacturing is motivated by our finding that Sri Lanka has not had the same productivity benefits from sectoral resource reallocation as other South Asia economies and that there may be a need for future growth in manufacturing to come more from increases in TFP rather than be driven mainly by increases in employment shares. The paper undertakes an empirical exploration of what aspects of the business environment are associated with increases in productivity (as measured by output and value added per worker at the cluster level, and TFP at the firm level) and innovation (as reflected by indicators of within-firm improvements in product, process, organization and marketing technologies). In this context, we examine wherever possible _which_ forces constrain productivity and innovation in the manufacturing sector and _to what degree_ these constraints matter relative to each other.

For the cluster-level productivity analysis, we combine two established data sources in a novel way by importing average ‘industry-firm size-location’ cluster-level business environment variables from the World Bank Enterprise Survey (WBES) to the comprehensive Census of Industry productivity data available for similar clusters of enterprises. We use a novel empirical approach by comparing the relative importance and distance to a ‘productivity frontier’ given the potential relaxation of constraining business environment indicators. For the firm-level TFP

> 2 The importance for growth of three main classes of intangible assets has been explored recently, namely firm investment in computerized information (software and databases), innovative property (R&D spending, product development in the financial industry, architectural, engineering and other designs), and economic competencies (reputation and branding, employee training, and business process improvements). Based on the quantification of these classes of intangible assets, intangible investment is actually greater than tangible investment in the UK, US and Sweden,; and in Canada, Denmark, Finland, France, Germany and Japan, it comes close (OECD 2010). See Dutz et al. (2012a) for a recent application to another middle-income country, Brazil.

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