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Firm Subsidies and Resource Misallocation

Governments in developing and advanced economies subsidize firms in a discretionary fashion. Do such policies mitigate or exacerbate the misallocation of resources across firms? I analyze a typical EU policy using novel data on applicants and recipients of capital subsidies in Greek manufacturing. In my framework, firms face existing distortions that subsidies can correct or exacerbate. The actual policy exacerbates misallocation, decreasing aggregate total factor productivity (TFP) by 0.15%. The policy's potential effects are large as reallocating subsidies among firms can increase TFP by 2% or decrease it by 3%. The actual policy's effect is small because firms facing high distortions are as likely to receive a subsidy as those facing low distortions.