Total Factor Productivity Losses Resulting from Capital and Labour Misallocation in Sri Lanka

Aggregate productivity can largely be determined by how production factors are allocated across heterogeneous firms. Although, the existing literature documents the contribution of misallocation in capital and labour to the Aggregate Total factor Productivity (TFP), studies on the relative roles of labour and capital misallocation affecting productivity in a single economy are limited. Using annual firm-level survey data and a static model, this paper contributes to the literature by estimating the cross-firm misallocation of labour relative to capital and their impact on aggregate productivity loss for Sri Lanka during 1994-2017. The results suggest that relative to the counterfactual efficient allocation of capital and labour, misallocation of both capital and labour has been rising and entails sizable negative impacts on TFP. The misallocation of labour has steeply been rising and 2.4-fold of that for capital misallocation. The results further suggest that firms can hardly grow bigger due to firm size-dependent capital and labour misallocation. The results specifically suggest that labour misallocation can be a binding constraint for business expansion preventing Sri Lanka from moving to a more productive economy.