Recent empirical studies document that the level of resource misallocation in the service sector is significantly higher than in the manufacturing sector. A new IMF Working Paper quantifies the importance of this difference and studies its sources.

Conservative estimates for Portugal (2008) show that closing this gap, by reducing misallocation in the service sector to manufacturing levels, would boost aggregate gross output by around 12 percent and aggregate value added by around 31 percent. Differences in the effect and size of productivity shocks explain most of the gap in misallocation between manufacturing and services, while the remainder is explained by differences in firm productivity and age distribution. We interpret these results as stemming mainly from higher output-price rigidity, greater labor adjustment costs and more informality in the service sector.

Introduction

In the current economic environment, many advanced economies are struggling with low productivity and potential growth, coupled with high debt and limited fiscal and monetary policy space. This has led to renewed interest in the study of productivity and a search for policies to boost output. A number of theories have been put forth trying to explain the productivity slowdown as well as differences across countries. A now well-accepted result in the growth literature is that differences in the degree of allocative efficiency is one reason why countries differ in terms of aggregate total factor productivity (TFP). Most of the empirical studies linking resource misallocation to differences in TFP, however, have been based on data from the manufacturing or agricultural sectors. Only recently have estimates of misallocation in the service sector become available, despite services being the largest sector for most countries either in terms of value added or total employment.

One new result common to these economy-wide studies is that the level of estimated efficiency gains in the service sector is significantly higher than in the manufacturing sector. Estimates obtained in Dias et al. (2016) for Portugal, for the 2004-2011 period, show that resource misallocation is, on average 24 percentage points (p.p.) higher in services than in manufacturing when evaluated in terms of gross output, or around 40 p.p. higher when evaluated in terms of value added. Similarly, estimates in Garcia-Santana et al. (2015) for Spain, for the 2001-2007 period, suggest that efficiency gains are around 22 p.p. higher in services than in manufacturing, while estimates in Benkovskis (2015) for Latvia, for the 2007-2013 period, allow us to compute an average misallocation gap of around 32 p.p. between the two sectors. While not strictly comparable (methodologies and sectoral definitions vary across papers), these numbers show that the level of resource misallocation in the service sector is significantly higher than in the manufacturing sector. This raises three questions: (1) how costly is the ”excess misallocation” in the service sector?; (2) what are the drivers of ”excess misallocation”?; and (3) to what extent does this reflect structural differences between the manufacturing and service sectors?

Using the theoretical framework developed in Hsieh and Klenow (2009), with the three-factor extension presented in Dias et al. (2016), and firm-level data for the Portuguese economy, we quantify the extent of misallocation between the manufacturing and service sectors and its implications for aggregate TFP and GDP. We estimate that if the misallocation gap between services and manufacturing were closed (by making the level of misallocation in the service sector be the same as in manufacturing), aggregate gross output (our aggregate TFP) would increase by about 12 percent, while aggregate value added (GDP) would increase by about 31 percent. This result is not due to a small number of industries with abnormal levels of misallocation, but a strong regularity: the majority of manufacturing sector industries rank among the industries with the lowest misallocation.

To identify the drivers of excess misallocation in the service sector we use regression analysis. We find that structural differences between the two sectors can fully explain the higher levels of allocative inefficiency in the service sector. Idiosyncratic productivity shocks, which impact allocative efficiency in the presence of capital/labor adjustment costs and/or output-price rigidity, is the most important factor contributing to the misallocation differences between the two sectors. However, the contribution of productivity shocks stems more from different impacts than from the difference in the magnitude of the shocks between the two sectors. The sectoral firm-size structure, proxied by the skewness of the productivity distribution, is the second most important factor explaining the misallocation differences. A higher proportion of low productivity firms in the service sector makes the productivity distribution more right-skewed, contributing to a higher level of misallocation in the service sector due to the prevalence of size-dependent policies. Lastly, our empirical model suggests that the proportion of young firms also has a bearing on misallocation differences between the two sectors. Young firms emerge as facing higher rental costs of capital than older firms, which we take to be evidence of the presence of credit constraints imposed by financial institutions on young firms due to a lack of credit history or insufficient guarantees. However, the net contribution of this factor is negative, meaning that in the absence of this effect the difference in misallocation between service and manufacturing sectors would be even larger.

Our findings have important consequences for developing countries and economies undergoing structural transformation. Duarte and Restuccia (2010) demonstrate that differences in productivity in the service and agriculture sectors across countries are one of the main factors behind overall productivity differences between countries. In particular, low productivity in the service sector and lack of catch-up can explain the experiences of productivity slowdown, stagnation, and decline observed across economies. Hsieh and Klenow (2009) show that differences in misallocation in the manufacturing sector are important to understanding the differences of total factor productivity between developed and developing countries. Using data for the manufacturing sector in China and India, the authors conclude that reducing the level of misallocation in these economies to the levels observed in the U.S. economy would increase productivity by 30-50 percent in China and 40-60 percent in India. However, if a significant difference of allocative efficiency between manufacturing and the service sector, similar to that documented for Portugal, Spain or Latvia, are present in other countries, the importance of resource misallocation to explaining productivity differences between developed and developing countries may even be higher than what the empirical evidence based on data from the manufacturing sector alone would suggest.

By shedding light on the reasons behind the higher level of misallocation in the service sector relative to the manufacturing sector this paper also contributes to the understanding of the policies that may contribute to increasing productivity growth, particularly in advanced economies. Our analysis suggests that boosting competition so as to reduce output price rigidity in the service sector, avoiding size-contingent laws that may contribute to the survival of unproductive firms and reducing barriers to growth by eliminating credit constraints imposed by financial institutions on young firms, are measures that can contribute to reducing within-industry misallocation, especially in the service sector, and thus to increase aggregate TFP and aggregate value added (GDP).

The views expressed in this IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.