Do financial constraints hold back innovation and growth?

This paper provides evidence that capital-market imperfections hold back innovation and growth, and that public policy can complement capital markets. We deliver the evidence by studying the effects of government funding on the behavior of SMEs in Finland. By adapting the methodology recently proposed by Rajan and Zingales [Rajan, R.G., Zingales, L., 1998. Financial dependence and growth. American Economic Review 88, pp. 559-587] to firm-level data, we show that government funding disproportionately helps firms from industries that are dependent on external finance. We demonstrate that the result is economically significant and robust to a variety of tests.