Resource Misallocation: Does Supporting SMEs Harm Productivity?

The Short Answer First

Yes, supporting small and medium enterprises (SMEs) can harm aggregate productivity if it is designed as permanent, general support for small firms simply because they are small, because it can keep resources — capital, labor, land, and credit — trapped inside low-productivity firms and prevent them from moving to more efficient ones. But not all SME support is harmful; it can be justified and productivity-enhancing if it addresses a specific market failure, such as credit constraints, information gaps, managerial skill gaps, technology-adoption costs, or limited market access.

What Is Meant by Resource Misallocation?

The central idea in the "resource misallocation" literature is that an economy loses productivity not only when its technology is weak, but also when resources are not allocated to the most productive firms. Under allocative efficiency, resources should flow toward the highest-productivity units until the marginal products of factors of production converge across producers within the same sector. But where taxes, subsidies, credit constraints, monopolies, size-linked regulations, or political protection favor certain firms, marginal products diverge, and capital or labor becomes "trapped" inside firms that do not deliver the highest social return.

Hsieh and Klenow show that gaps in the marginal products of capital and labor across firms within industries can reflect allocative distortions, and that moving to a US-like efficiency level could have raised manufacturing productivity by roughly 25–40% in China and 50–60% in India according to their early estimates. In their model, a distinction is drawn between TFPQ (a firm's true physical productivity — its technical ability to convert inputs into outputs) and TFPR (revenue productivity, which rises when a firm is constrained or faces a distortion preventing it from expanding). The critical insight is that more productive firms should be larger if they face no constraints; if a highly productive firm is relatively small, this may indicate it faces an implicit tax or a credit or regulatory constraint blocking its expansion.

What Does This Have to Do with SME Support?

SME support becomes problematic when it is built on the premise that "smallness" itself deserves support. From an aggregate productivity standpoint, firm size is not an end goal; what matters is: is the firm productive? Does it have growth potential? Does it face a market failure preventing it from reaching its efficient size? Here lies the paradox: many SME support programs are justified because they generate jobs, increase economic diversity, and support entrepreneurship, but if the support keeps a large number of low-productivity small firms in the market, it may raise short-term employment at the expense of long-term productivity, wages, and growth. A World Bank guidance document on SME-support interventions notes that some common tools do not improve firm efficiency and may generate misallocation that lowers aggregate productivity — while affirming, by contrast, that effective tools do exist when they target productivity, growth, and a specific market failure.

Four Mechanisms Through Which Support Harms Productivity

Supporting survival instead of growth: if support is designed to protect small firms from exiting, it may keep low-productivity firms in the market. Economic exit is not always a social failure; in many cases it is a necessary mechanism for freeing up labor and capital in favor of more productive firms. The problem arises when support becomes a tool for prolonging the life of firms that cannot grow. Following Restuccia and Rogerson's logic, distortions that make some producers face different prices for inputs or outputs can lower output and aggregate productivity by rates that, in their model, may reach 30–50%.

Size-dependent distortions: many SME support programs grant advantages to firms below a certain employee count or revenue threshold — tax exemptions, subsidized loans, lower fees, lighter regulatory requirements. These tools create an incentive for firms to stay small or legally fragment their activity to avoid losing privileges, which harms even small firms with high potential that hesitate to expand for fear of losing support. Guner, Ventura, and Xu show that size-dependent tools that reduce the average firm size by 20% can lower output by up to 8.1% and output per firm by up to 25.6%, while increasing the number of firms.

Supporting less-productive firms at the expense of more-productive ones: the more dangerous problem is not support itself, but its being inversely linked to productivity. If less-productive firms obtain easier financing or larger exemptions than more-productive ones, support becomes an implicit tax on efficiency and an implicit subsidy for inefficiency. Restuccia and Rogerson confirm that misallocation becomes highly consequential when more-productive firms are hit with constraints or implicit taxes while less-productive ones receive protection or support — meaning the danger lies not simply in random dispersion, but specifically in distortions being negatively correlated with productivity.

Subsidized loans without productivity screening: credit support can be necessary when SMEs face genuine financing constraints due to a lack of collateral or credit history, but it becomes harmful if granted based on size, relationships, or sector without assessing productivity or growth potential. In this case, subsidized credit can lead to financial crowding: weak firms obtain cheap capital while more productive firms do not get adequate financing — raising the dispersion of the marginal product of capital and lowering aggregate productivity.

When Is Support Justified?

The misallocation literature does not call for rejecting SME support, but for redesigning it. Support is justified when it meets two conditions: the existence of a clear market failure, and a design that pushes firms toward productivity and growth rather than permanent dependence on the support itself.

The rule here: support the constraint, not the size. Don't support a firm because it is small — support it because it is productive or promising and faces a correctable constraint.

Is the Problem in SMEs, or in Support Design?

Three categories of SMEs should be distinguished, each with a different appropriate treatment:

Weak design treats these three categories as one. Good design distinguishes between social support that targets income, productivity support that targets growth, and innovation support that targets high-potential firms.

Implications for Support Design in Developing and Gulf Economies

For economies pursuing economic diversification, including Gulf economies, SME support can be an important tool for broadening the productive base and reducing reliance on rentier sectors. But the risk is that support turns into a system of permanent privileges for small firms that cannot scale. SME support design should therefore rest on the following principles:

• Shifting from size-based to productivity-based support: the eligibility criterion should not be employee count or revenue alone, but indicators such as value-added growth, productivity per worker, technology adoption, export capacity, and financial governance.
• Linking support to clear performance indicators: such as real sales growth, productive employment, wage growth, entry into new markets, or obtaining quality certifications.
• Avoiding sharp size thresholds: because they create an incentive to stay below a certain size; gradually tapering support is preferable to a sudden cutoff.
• Allowing exit and reallocation: policy should not prevent the exit of firms that cannot survive; exit mechanisms are best paired with training and re-employment programs.
• Targeting high-potential firms: not every small project is a developmental one; the largest productivity impact usually comes from firms capable of expansion and innovation.
• Evaluating impact empirically: using methods such as difference-in-differences, regression discontinuity, or randomized controlled trials where possible, to measure whether support raises productivity or merely prolongs firm survival.

A Framework for Testing Whether Support Harms Productivity

Any supporting body or researcher can test the effect of support through the following questions:

Conclusion

Supporting SMEs does not necessarily harm productivity, but it can when it turns into size-based protection or permanent support unconditioned on efficiency. The core issue is not "should we support SMEs?" but "which SMEs do we support, why, under what conditions, and over what time horizon?" The literature of Hsieh, Klenow, Restuccia, and Rogerson teaches us that aggregate productivity depends not only on the productivity of each individual firm, but on how resources are distributed among them. If capital, labor, and privileges are granted to less-productive firms, aggregate productivity falls even if this appears, on the surface, to support entrepreneurship and employment. But if support is designed to address specific constraints preventing productive firms from growing, SME support can become a tool for raising productivity rather than weakening it.

References (APA 7)

Guner, N., Ventura, G., & Xu, Y. (2008). Macroeconomic implications of size-dependent policies. Review of Economic Dynamics, 11(4), 721–744. https://doi.org/10.1016/j.red.2008.01.005

Hsieh, C.-T., & Klenow, P. J. (2009). Misallocation and manufacturing TFP in China and India. The Quarterly Journal of Economics, 124(4), 1403–1448. https://doi.org/10.1162/qjec.2009.124.4.1403

Restuccia, D., & Rogerson, R. (2008). Policy distortions and aggregate productivity with heterogeneous establishments. Review of Economic Dynamics, 11(4), 707–720. https://doi.org/10.1016/j.red.2008.05.002

Restuccia, D., & Rogerson, R. (2013). Misallocation and productivity. Review of Economic Dynamics, 16(1), 1–10. https://doi.org/10.1016/j.red.2012.11.003

Restuccia, D., & Rogerson, R. (2017). The causes and costs of misallocation. Journal of Economic Perspectives, 31(3), 151–174. https://doi.org/10.1257/jep.31.3.151

World Bank. (2021). Strengthening World Bank SME-support interventions: Operational guidance document. World Bank.