Government Aid to Firms : Cause or Cure of Misallocation?

Governments in advanced and developing economies allocate capital subsidies to firms in a discretionary fashion through industrial policy or state aid. Do such discretionary policies mitigate or exacerbate the misallocation of resources across firms? This paper analyzes a typical EU policy using novel data on applicants and recipients of capital subsidies in Greek manufacturing by extending the canonical misallocation framework to allow for subsidies to interact with existing firm-specific distortions. The actual policy worsens allocative efficiency, decreasing aggregate total factor productivity (TFP) by 0.15%, but performs better than a uniform subsidy, which would reduce TFP by 0.7%. The scope of subsidies, though, is large: reallocating the policy's budget among firms can increase TFP by 1-2% but also decrease it by 2-3%