developing and 5 high-income countries.<sup>9</sup> The study finds that micro and small firms have less access to formal finance, face significantly greater interruptions in infrastructure services, and pay more bribes as a percentage of sales than do large firms, while larger firms spend significantly more time dealing with officials and red tape. A lack of finance and poor infrastructure reduce the employment growth of medium and large firms. Business regulations affect mostly the employment growth of small firms, which apparently prefer to remain small to evade regulators. The study concludes that a weak business environment displaces activity from large, medium, and small firms to the benefit of micro ones. To the extent that large firms are more productive, this would imply substantial resource reallocation from more productive firms to less productive ones leading to important losses in aggregate productivity. This shift in economic activity would also imply higher degree of informality and lack of innovation and growth opportunities as smaller firms tend to underinvest in innovation and training given the substantial fixed costs associated with these activities.

This cross-sectional study of Aterido et al. (2011), however, suffers from the problem of establishing direction of causality. To address the problem of endogeneity, the authors aim to reconstruct the broader business environment which was faced initially by firms of different size in a given sector of a country, and then tried to examine how that affect their employment growth.<sup>10</sup> The underlying critical assumption is that there was no change in business environment faced by firms of different size and sector over the years, which arguably is a very strong assumption as WBG _Doing Business_ report portrays rapid changes in regulatory environments in different countries over a much shorter period of time. Morevoer, it is also difficult to gauge the direction of bias introduced through this assumption as changes in different dimensions of business environment in different countries could be driven by various time-

> 9 Access to finance is measured by the share of investment financed with external funds, the share of working capital financed externally, and/or the share of sales on credit, business regulatory condition is measured by the percentage of time managers devote to dealing with authorities or the days firms devote to inspections, extent of corruption is measured by if a firm paid bribe or the percentage of sales paid on bribes, and infrastructure bottleneck is measured by the number of days firms remained without power services and the share of average cargo’s value lost while in transit.

> 10 The paper constructs a measure of IC conditions faced by firm i on dimension k in country c, by averaging the responses of firms in the same country-location-sector-size cell excluding the observation for firm i in computing the average. While this measure is based on a firm’s current size and responses about the current environment, to simulate the business environment faced by the firm in its initial condition, the paper assumes that the conditions faced by the firms of a certain size at the current period are the same as the conditions facing the same-sized firm in the earlier period. More specifically, suppose that a textile firm in capital city of Chile, which was small three years ago and is now observed as medium size in the survey. Then its response is used to construct the average of Santiago-textile-medium sized firms and used as the initial condition for the medium sized firms three years ago. Similarly, observations based on the current Santiago-textile-small sized firms are used as proxy for business environment faced by the Santiago-textile-small sized firms three years ago.

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