the number of surveyed firms, about 39% the sample is from Latin America, 27% from Europe, 18% from Southeast Asia, and 16% from Africa.

Following the convention in the literature, I measure firm size by the value of total annual sales (in million US dollars), and spending on innovation by annual expenditure on research and development (in ’000 US dollars).

The surveys categorize firms into two-digit (ISIC) industry groups; there are 16 such categories in the data. Since my main estimation exploits variation in the probability of engaging in R&D within country-industry cells, I do not use cells in which either all firms report strictly positive R&D expenditure, or no firm reports R&D. This amounts to dropping about 4% of the original sample. This leaves me with 654 country-industry cells, each containing about 30 firms on average. After dropping outliers in R&D spending and sales, the data set consists of 19845 firms.

Since not all innovative activity can be classified under an exclusive category, and since some R&D consists of fixed investment in equipment and facilities, it is likely that this current R&D spending is an understatement of a firm’s expenditure on innovative activities. It is also possible that different firms report different things under R&D spending. However, there is no reason to believe that this measurement error varies systematically across firm size and financial development.

The surveyed firms were asked if their own R&D resulted in a new product, a new process and a significant upgrading of the product. For every firm, I sum up these indicators to construct an index of innovative output that ranges in value from 0 to 3. This index differs from the most commonly used measure of innovative output, which is the number of patents taken out by a firm. Since not all innovative activity results in a new patent, the index is a more exhaustive and direct measure of innovation than patenting activity.<sup>6</sup> But it shares, with patents, the limitation of being a count measure instead of a direct estimate of the monetary value of the new products or processes. Furthermore, a “new product” introduced by a typical small firm in an industry is likely to have less monetary value than a new product introduced by large firms in the same industry. However, it is reasonable to assume that this interindustry reporting bias does not vary across countries.

Table 2 shows that about 26% of the sampled firms spent a positive amount on research and development. As reported in Table 1, there is considerable cross-country variation in this figure. Only 4% of the firms surveyed in Oman report having spent on R&D, while in South Africa this percentage is 52. National income figures in Table 1 also reveal that in general, more firms do R&D in larger economies.

Among firms that do spend on R&D, the average spending on R&D is 3% of total sales. Fewer than a tenth of these firms spend more than 10% of the value of their sales on R&D. The average value of the innovation index for firms engaged in R&D is 2; nearly a quarter of these firms have an innovation index of zero.

# 2.2 Measures of Financial Development

In keeping with common usage in the literature on finance and growth, my principal measure of a country’s financial development is the ratio of private credit to GDP,<sup>7</sup> where private credit is defined as the total credit from deposit-taking institutions to

> 6Although it misses the effect of R&D on technology adoption (Griffith et al. (2004)).

> 7See studies surveyed in Levine (2005).

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