by internal funds, while there is no statistically significant difference by R&D status in equity financing. I also find that these patterns hold equally for both small and large firms.<sup>14</sup> Thus, R&D activity certainly seems to be associated with bank funding, while the association with equity is unclear.

Second, there is evidence in the data that small firms report stronger financial obstacles than large firms. Surveyed firms were asked to rate finance as an obstacle to growth, and on average smaller firms’ ratings were higher. Being a subjective rating, this is open to the interpretation that small firms simply complain more. Nevertheless, unless this tendency to complain varies differentially by size across countries, it is interesting to note that the higher rating by small firms is less pronounced as we move to countries at higher levels of financial development. Table 5 regresses firm rating of financial obstacles on firm size interacted with private credit/GDP. Controlling for country-industry effects, the tendency of smaller firms to complain more about access to falls as PvtCredit rises.

Next, figures 2 and 3 give graphical previews of the main finding in this paper. Figure 2 plots R&D spending against firm size separately for countries above and below the median value of the private credit/GDP ratio.<sup>15</sup> A comparison of the two panels makes it evident that in my sample of 19,845 firms, the positive association between R&D spending and firm size is stronger in countries at lower levels of private credit.

Figure 3 graphs the innovation/R&D ratio against firm size for countries above and below the median value of the private credit/GDP ratio. It shows that while the innovation/R&D ratio falls with firm size in both set of countries, the decline is sharper in countries below the median value of private credit. Thus, consistent with an explanation based on financial inefficiency, patterns in R&D returns are the reverse of those seen in R&D spending, and there is greater dispersion in returns in low PvtCredit countries. The OLS and probit estimations reported in section 5 confirm these observations.

# 4 The Empirical Specification

## 4.1 Financial Development and The Probability of Spending on Innovation

Let rijc be a dummy variable that equals one if a risk-neutral firm i in industry j and country c engages in R&D. The probability that the firm does R&D can be modeled using a latent variable approach. The size of the R&D project is fixed. Suppose yijc is the firm’s expected profit from the project, defined as the discounted stream of revenue from the R&D output minus the discounted stream of cost of R&D inputs. If the firm needs external financing for R&D, then this cost includes the cost of external funds. Firm i does R&D if the expected profit is higher than a threshold y<sup>∗</sup> . In line with the observation in Hall (2005) that R&D spending by firms has the characteristics of fixed

> 14In regressions with R&D dummy interacted with firm size as an explanatory variable, the interaction term was insignificant.

> 15The lines, drawn for ease of illustration, are non-parametric locally weighted regression estimates. The graph is drawn for firms reporting non-zero R&D expenditure.

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