Project Heterogeneity and Growth: The Impact of Selection

In the classical literature of innovation-based endogenous growth, the main engine of long run economic growth is firm entry. Nevertheless, when projects are heterogeneous, and good ideas are scarce, a mass-composition trade off is introduced into this link: larger cohorts are characterized by a lower average quality. As one of the roles of the financial system is to screen the quality of projects, the ability of financial intermediaries to detect promising projects shapes the strength of this trade-off. In order to study this relationship, we build a general equilibrium endogenous growth model with project heterogeneity and financial screening. To illustrate the relevance of the mass and composition margins we apply this framework to two important debates in the growth literature. First, we show that corporate taxation has only a weak effect in growth, but a strong effect on firm entry, both well known empirical regularities. A second illustration studies the effects of financial development in growth. A word of caution arises: for economies that are characterized by high rates of firm creation, domestic credit should not be used as a proxy of financial development, in contrast to most of the empirical literature.