What drives regional productivity differentials?

In both Italy and Spain, as in many other countries, there is a large and persistent productivity gap between less and more developed regions. The underlying drivers of these gaps can reflect many different factors. This paper leverages balance-sheet microdata to identify those drivers in the case of Italy and Spain, drawing lessons applicable across the OECD. Whilst sectoral composition accounts for one-quarter of the observed gap in both countries, the remainder is attributable to a 20-30% multifactor productivity (MFP) penalty affecting firms in less developed regions (LDRs), which persists across sectors, firm sizes and age classes. There is no evidence of weaker market selection leading to an overrepresentation of low-productivity firms in LDRs, as the average gap is best explained by a parallel shift in the productivity distribution. Compared to developed regions in the same country, Italian LDRs have a larger gap in capital per employee and in average firm size than Spanish LDRs. The findings may reflect differences in centralised wage bargaining, as well as a larger gap for Italian LDRs in access to finance and in institutional quality.