31 by 94% and 36%, respectively in 2010. For the three census periods (2000, 2005, and 2010), the averages are 79% and 25%, respectively).

More crucially, our results show that there is a positive relationship between the measure of distortion (TFPR) and the measure of productivity (TFPQ). The positive relationship suggests that productive firms are systematically “taxed,” potentially resulting in larger drags on overall aggregate TFP. The decomposition of the sources of productivity shows that both the distortions in the output and capital market harm productive firms.

We simulate three different GDP growth trajectories based on different magnitudes (or speed) of the realization of hypothetical productivity gains. With modest reforms, a realization of a 10% TFP gains is expected to lift growth by 0.4ppt. This result suggests that increasing the intensity of market reforms will increase the realization of productivity gains and hence lift growth by as much as 1.3ppt per year over five years. This additional growth is especially crucial considering that the Malaysian authorities have identified TFP to be the most important source of future economic growth.

This paper provides evidence on the extent and the implications of misallocation of resources on Malaysia’s manufacturing sector and the overall economy. While we do not systematically identify the underlying sources of distortions, we provide insights that suggest that distortions in the output markets appear to matter more than distortions in the capital or labor markets. For policy makers, this may not be sufficient information for specific policy actions. One broad policy suggestion is to increase domestic competition, including lowering market barriers and reducing non-performance–based incentives. This is particularly evident for the food and beverage industry, which has received significant subsidies from the government.

Reducing barriers to labor mobility can also contribute positively to growth going forward. It is argued that Malaysia faces a shortage of skills and talent (World Bank, 2014). Thus, policies that address the misallocation of resources should also support a better use and allocation of human capital. For instance, barriers to inflows of talents into the country should be reduced. This, in turn, will strengthen learning from the global frontier.

In summary, the paper provides evidence to support the notion that productivity gains derived from a more efficient allocation of resources can be an important source of economic growth. The debates on whether the productivity gains estimates are dominated by measurement errors notwithstanding, we believe that the effects of misallocation on overall growth could be even higher than our estimates suggest because the manufacturing sector has significant linkages with other sectors in the domestic economy. Therefore, there may be potential spillovers of productivity loss into other sectors, particularly the services sector.

On the other hand, the Hsieh and Klenow framework makes simplifying assumptions such as constant elasticity of substitution (CES) aggregation and constant markup across firms in the same sector. Because of these assumptions, what we attribute to misallocation could be partly due to different markups, which in turn could be driven by differential quality and/or demand for firms’ products. In future research, we will try to disentangle improvements in physical efficiency (TFPQ) from other quality and demand factors, thanks to newly obtained data on outputs and material inputs for Malaysian manufacturing firms.