countries with better financial institutions might also have better intellectual property rights. Since plausible correlates are too numerous to control for, any observed relationship between finance and innovation is open to alternative interpretations.

Subject to this caveat, the problem of correlated unobservable country level determinants is less of a concern in the present paper. The reason for this is that I focus on the differential effect of finance across firm size. Correlates of financial development which affect small and large firms to the same degree do not matter to the interpretation of my results. Moreover, such unobserved determinants of R&D activity are unlikely to cause both lower relative R&D spending and higher relative R&D productivity in small Another caveat that goes with this study is that the analysis essentially compares firm size and R&D activity across different industry-country cells. Unlike a panel study, it cannot distinguish between changes in the allocation of R&D to firms and in the composition of firms. The results are thus consistent with theories in which financial development affects the distribution of innovation across firms by either encouraging the entry of small innovative firms, or re-allocating finance from existing large firms to small The rest of the paper is organized as follows. Section 2 describes the data. Next, section 3 presents preliminary evidence to suggest that finance might matter to innovation by small firms. Section 4 spells out the estimated equations. I present the main probit and OLS estimation results in Section 5, robustness checks in Section 6, and then conclude in Section 7.

# 2 Data

## 2.1 Firm Data

I use firm level data from World Bank Enterprise Surveys<sup>3</sup> that were carried out between 2003 and 2006. Every survey consisted of a random sample of firms from one country, stratified by firm size and broad 2-digit industry. Enterprise Survey data from different countries are comparable because of similar sampling strategy and survey instruments. Since no country in my data set was surveyed twice during this period, I treat the data as a pooled cross-section of firms.<sup>4</sup> The focus being investment in R&D, firms from the service industry are excluded from the sample.<sup>5</sup> The full sample consists of nearly 21,000 manufacturing firms from 57 countries, of which 28 are in Eastern and Central Europe, 9 in Africa, 5 in Southeast Asia, and 15 in Latin America. Table 1 lists key summary statistics by country. While most are middle and low income countries, there are a few rich countries in the sample, notably South Korea, Portugal, Spain, Germany and Ireland. Thus, the data encompass a broad range of countries at different levels of development.

The sample size variation across countries is related to the variation in the total number of firms in these countries. All but the following four countries - Brazil, Mexico, Thailand and Egypt- contribute less than a thousand firms to the sample. In terms of

> 3See www.enterprisesurveys.org for detailed descriptions of the surveys.

> 4Note that the country-industry dummies in the estimations absorb all year dummies.

> 5This is not to say that such firms do not innovate. However, they are much less likely to take out patents, and so dropping them makes the data more comparable to those used in most other studies of innovation.

4