Financial Development and Innovation in Small Firms

This paper uses firm level data from a cross section of 57 countries to study the effects of financial development on innovation in small firms. Prior research suggests that financial development has a disproportionately positive effect on innovation by small firms. Small firms are more likely to spend on research and development in countries at higher levels of financial development than large firms in the same industry. The study reveals that:

• In a country like Romania, which is at the 20th percentile of financial development, a decrease in firm size is associated with a decrease in research and development spending;
• This decrease is less in a country like South Africa, which is at the 80th percentile of the distribution of financial development;
• Small firms produce more innovations per unit of research and development spending than large firms;
• These patterns are stronger in industries inherently more reliant on external finance.

These empirical findings suggest that financial development can have positive growth and distributional consequences by encouraging research and development in small firms.