Economics Letters 173 (2018) 30–34

Contents lists available at ScienceDirect

Economics Letters
journal homepage: www.elsevier.com/locate/ecolet

Testing the effect of investments in IT and R&D on labour

productivity: New method and evidence for Indian firms
∗
Rupika Khanna, Chandan Sharma
Indian Institute of Management Lucknow, India

highlights

• Do technological investments in IT and R&D contribute to labour productivity growth?

• We test this hypothesis using micro-level manufacturing data from a developing economy.
• The results are robust to transmission bias in production function set up.
• IT and R&D. have a complementary effect on labour productivity.

article info a b s t r a c t

Article history: Utilizing a micro-level dataset of 900 firms for the period 2000–2016 from Indian manufacturing, this
Received 4 July 2018 paper explores the effects of technological investments on labour productivity performance of firms
Received in revised form 21 August 2018 by looking at investments in Information Technology (IT) and Research & Development (R&D). The
Accepted 7 September 2018
present study is the first to assess the role of IT and R&D jointly for Indian manufacturing. To control for
Available online xxxx
transmission bias in production function estimation, a GMM-based one step control function estimator is
JEL classification: applied. We find large effects of both IT and R&D across various sub-samples. Further, our results imply
C33 that there is a complementarity between IT and R&D in generating labour productivity growth.
D24 © 2018 Elsevier B.V. All rights reserved.
O3
Keywords:
Information technology
Research & development
Production function estimation
Labour productivity

1. Introduction
Technological advancement is considered to be one of the most
crucial factors affecting economic growth. In the growth theo-
ries, generation of new knowledge through research and develop-
ment (R&D) and information technology (IT) leveraged innovations
are strongly identified as the major sources of technical progress
(Romer, 1990), hence growth.
Empirically, innovative activities, typically proxied by R&D in-
vestments, have long been found to boost productivity perfor-
mance of a firm (Griliches, 1979; Hall et al., 2013). Since the mid-
1990s, growth research has also focused on IT as a factor affecting
productivity growth (Brynjolfsson and Hitt, 2003; Erumban and
Das, 2016). However, a feature of the previous literature is that
the role of IT and R&D has been examined singularly, ignoring
∗ Correspondence to: Indian Institute of Management Lucknow, Noida
Campus, Sector 62, Noida 201 307, India.
E-mail addresses: fpm15013@iiml.ac.in (R. Khanna), csharma@iiml.ac.in
(C. Sharma).
the possible correlations between the two investments. Given that
both IT and R&D are considered as innovational inputs and may
be correlated,1 Brynjolfsson and Hitt (2003) suggest that omitting
the role of unmeasured complementary investments may have
seriously biased the effect of IT in the previous literature. A few
scholars have already highlighted the complementarities between
firm’s IT capital and intangible, innovational activities such as,
R&D, new architecture, new product development and engineering
design (see, Corrado et al., 2017). Specifically, evidence on the joint
role of IT and R&D has appeared in Hall et al. (2013), Chen et al.
(2016) and Cerquera and Klein (2008). A few studies have also
assessed whether these assets are complementary or substitutes
in the production process, however these have produced a mixed
evidence. For instance, Chen et al. (2016) find a complementary
effect of IT with respect to R&D effort in 10 European countries.
On the other hand, Cerquera and Klein (2008) note that intensive
use of IT leads to reduced R&D effort in German firms.
1 See for example, Hall et al. (2013).

https://doi.org/10.1016/j.econlet.2018.09.003
0165-1765/© 2018 Elsevier B.V. All rights reserved.
 R. Khanna, C. Sharma / Economics Letters 173 (2018) 30–34
Polák (2017) notes that lack of good quality data is a major
reason why much of the literature has ignored the possible inter-
play between these investments. The purpose of this study is to fill
this gap. To this effect, we assess the joint effects of technological
investments in IT and R&D on labour productivity in a production
function framework. This is achieved by analysing micro-level data
on Indian manufacturing firms.
Our paper contributes to the literature in the following ways.
First, the existing literature examines separately the effects of IT
and R&D on labour productivity, which may lead to potentially
biased estimates and policy conclusions. We implement a joint
framework to assess these investments as well as the related com-
plementarities. Second, most of the studies use traditional estima-
tors to compute production function elasticities which sometimes
fail to control for transmission bias or simultaneity associated with
input choice. We control for this simultaneity in input choice by
employing Wooldridge (2009), a recently developed GMM-based
semi-parametric control function estimator. This is the first work
employing this method to assess the problem at hand. Lastly,
this paper contributes hugely to the growth literature on India
by providing evidence on the role of IT in Indian manufacturing
firms, which has been a less explored question mainly because
of data limitations. To the best of our knowledge, this is also
the first attempt to evaluate the effects of IT and R&D jointly for
Indian manufacturing. In the relatively new literature on the joint
assessment of these investments, the previous literature evidence
is available for Italian firms (Hall et al., 2013), Norwegian firms
(Rybalka, 2015), European economies (Chen et al., 2016), OECD
countries (Pieri et al., 2017).
Broadly, our findings suggest significant effects of IT and R&D on
labour productivity in the sample firms. We also find these inputs
to be complementary to each other in the production process.
2. Empirical setting
2.1. The labour productivity equation
We assume the following specification for firm i in year t:
( ) ( ′′ ) ( ′′ )
Q KIT KO
ln = ln ω + α ln + β ln
L it L it L it
( ′′ )
KRD
+ δ ln + θ ln (L)it + εit
L it
where α, β , γ and δ represent the output elasticities of IT capital
assets (KIT ′′ ), non-IT/ ordinary capital assets (KO ′′ ), accumulated
R&D capital assets (KRD ′′ ) and labour (L). Q is the firm’s output
defined in value-added terms. θ = α + β + γ + δ − 1 is a measure
of scale economies, whereby the values of θ > 0, θ < 0 or θ = 0
respectively indicate increasing, decreasing and constant returns
to scale. ωi,t is a parameter measuring total factor productivity. It
is assumed to evolve as a first-order Markov process:
ωi,t = E(ωi,t |ωi,t −1 ) + ui,t
where ui,t is a random shock component assumed to be uncorre-
lated with the technical efficiency, the state variables in KO ′′i,t and
the lagged free variables ωi,t −1 .
2.2. Production function estimation
As per the paradigm of theory of producer behaviour (Berndt
and Khaled, 1979), there is a simultaneity between input choice
and unobserved productivity shocks (ω) because firms partly de-
termine input quantities based upon prior belief about their pro-
ductivity. Traditional methods such as Levinsohn and Petrin (2003)
deal with this simultaneity in two steps. While these estimators
31
are widely used, the recent production function literature suggests
that a major limitation of these methods is that after the first stage
of non-parametric conditioning of labour, there is no variation
in labour input left for identification of its coefficient (Ackerberg
et al., 2007, 2015). Wooldridge (2009) estimator overcomes this
limitation by proposing the joint estimation of the two equations
under a Generalized Method of Moments (GMM) framework. This
framework uses cross-equation correlation to enhance efficiency.
Besides, the optimal weighting matrix accounts for serial correla-
tion and heteroscedasticity in the errors (see, online supplement
for details).
3. Data
For this paper, we use micro-level data from Prowess database,
CMIE. Prowess database is a comprehensive data source capturing
commercial activity in India and provides annual financial state-
ments data for a large number of firms. The wide spectrum of firms
in the dataset constitute around 70% of the economic activity of the
organized industrial sector in India. For the purpose of our study,
we clean the data in the following way. First, we drop firms for
which data for missing across all years. Secondly, we dropped all
entries with obvious data errors such as, a zero or a negative value
of assets or expenses. After cleaning the data in this way, our final
dataset consisted of an unbalanced panel of 900 firms and spanning
17 years from 2000 to 2016.2 A detailed description of variables is
presented in Table 1.
4. Estimating IT and R&D effects on firm’s labour productivity
Table 2 reports the results of production function estimation
(Eq. (2)) for the full sample period as well as sub-periods using
Wooldridge (2009) estimator.3
For each model, we report production function coefficients of
labour, IT, non-IT and R&D capital inputs per unit of labour and the
number of observations. To test the over-identification restrictions
in the GMM estimator, we employ the Hansen instrument-validity
test. The null hypothesis of this test is that the instruments are valid
and are uncorrelated with the error-term. Results show that the
null hypothesis of instrument validity cannot be rejected across
the three estimations. For the full sample results, our estimated
elasticity with respect to the ordinary capital input is consistent
(1) with other studies on Indian manufacturing firms. Sharma (2018),
for example, estimates the output elasticity of capital input to be
around 0.32 from an OLS estimation of a Cobb–Douglas production
function. Our results indicate for positive and statistically signifi-
cant output elasticities of both IT and R&D capital inputs. This holds
true for both the periods. The coefficient of IT for the full sample is
0.04. The implication is that 1 percent increase in IT capital stock
would lead to around 0.04 percent increase in labour productivity.
Similarly for R&D, the implication is that a unit percent increase
in R&D input would lead to around 0.03 percent increase in labour
productivity.
(2)
2 The Prowess database is based on the National Industrial Classification (NIC)
1998.
3 A more recent method to deal with the identification issue highlighted in
Section 2.2 is Ackerberg et al. (2015) (henceforth, ACF). In contrast with Wooldridge
(2009), the ACF method assumes an input demand function that is conditional upon
the labour input, which allows the ACF estimator the flexibility to accommodate
different patterns of inter-temporal adjustment between productivity shocks and
inputs. However, the authors of Ackerberg et al. (2015) raise certain caveats regard-
ing the use of this method. For instance, based on simulations, the authors confirm
that under situations where the unconditional demand function assumption is
valid, the use of ACF correction produces less efficient estimates (see, Ackerberg
et al., 2015, pp. 21). In a set of unreported results, we make a similar observation,
which restricts us from choosing the ACF method over Wooldridge (2009). We also
note that the latter produces unbiased, consistent and efficient results in our set up.
32 R. Khanna, C. Sharma / Economics Letters 173 (2018) 30–34

Table 1
Variable description.
Dependent variable
Labour productivity (LP) LP refers to value-added per labour
Explanatory variables
Variable Description Expected sign
IT capital–labour ratio (KIT ) Total capital in IT assets ±
R&D capital–labour ratio (RD) Accumulated investment in R&D +
Capital–labour ratio (KO ) Ordinary capital assets of the firm per employee +
Labour (lab) Total employees in the firm –

Export dummy = 1 for firms with positive reported exports ±

= 0 otherwise
Foreign dummy = 1 for foreign firms (firms with > 10 percent foreign ownership) +
= 0 for local firms
IT intensity dummy = 1 for firms with low IT-intensity +
= 0 otherwise

Table 2
Production function estimates: full sample and sub-periods.
DV: lnLP Full sample Sub-sample I Sub-sample II High IT-intensive Low IT-intensive
2000–2016 2000–09 2010–16 2000–2016 2000–2016
ln(KIT ) 0.047** (0.000) 0.042** (0.000) 0.051** (0.000) 0.066** (0.000) 0.038** (0.000)
ln(KO ) 0.323** (0.000) 0.307** (0.000) 0.353** (0.000) 0.354** (0.000) 0.310** (0.000)
ln(lab) 0.018** (0.003) 0.016* (0.084) 0.017** (0.027) 0.041** (0.000) 0.003 (0.738)
ln(RD) 0.035** (0.000) 0.028** (0.000) 0.041** (0.000) 0.021** (0.000) 0.048** (0.000)
N 5303 2274 3029 2237 3066
Hansen test 4.34 (0.23) 1.22 (0.75) 0.52 (0.91) 6.78 (0.09) 4.43 (0.22)

Note: p-values are reported in parenthesis. Standard errors are based on bootstrapping method.
*p < 0.10.
**p < 0.05.

A priori, there may be many reasons why the impact of IT
on some industries is different from others. For instance, some
industries may be lacking the absorptive capacities such as, an
appropriate level of human capital or other complementary fac-
tors such as R&D expenditures and therefore gain less than the
other industries (Wu et al., 2004). Recent literature on IT suggests
that the returns to IT vary across industries based on intensity of
use (Jiménez-Rodríguez and Sánchez, 2012; Niebel, 2018).4 Pilat
(2004) argues that the additional productivity benefits in high-IT
industries could be triggered by IT-related network effects as IT
may lower transaction costs and catalyze the process of knowl-
edge creation. Some scholars explain these differential returns on
IT in terms of a leapfrogging argument i.e. IT enables industries
to bypass some of the processes of accumulation of human ca-
pabilities and fixed investment in order to narrow productivity
gaps (Jiménez-Rodríguez and Sánchez, 2012). Therefore, following
these scholars, we test for the ‘leapfrogging’ hypothesis by dividing
the industries into two groups based on intensity of IT use: low
IT intensive sector and high IT intensive sector. The threshold
variable chosen for this empirical exercise is IT intensity (a ratio
of IT capital stock to total assets) in year 2004 prices. A threshold
test is further conducted by regressing the IT intensity variable
over a dummy for high intensity industries. The results confirm
statistically significant (estimated t-statistics 7.55 with p-value <
0.01) difference in IT use across the two groups.
The sub-group results for high IT and low IT industries are given
in the last two columns of Table 2. We find the coefficient of IT
to be 0.066 for high IT industry sub-sample and 0.038 for low IT
industry sub-group, where the latter refers to industries where
IT penetration is largely lacking. Further, a Chow-type test on the
4 There may be many reasons why the impact of IT on some industries is
different from others. For instance, some industries may be lacking the absorptive
capacities such as an appropriate level of human capital or other complementary
factors such as R&D expenditures and therefore gain less than the other industries
(Wu et al., 2004).
differences of the IT coefficients between the groups is conducted
in the spirit of Niebel (2018) in three steps: first, estimate the
regression for each sub-group, second, estimate them using a SURE
and finally, test whether the difference between the coefficients
of the pair is zero. The results of this exercise suggest that there
is a statistically significant difference in the output elasticity of
IT capital in the groups based on IT intensity (where, χ 2 (1) =
47.49, p < 0.01 for the full period). Hence, given these results,
we find evidence to support the hypothesis that high-IT using
industries ‘leapfrog’ through IT, as described by Wu et al. (2004).
Besides, interestingly, we are unable to reject the null hypothesis
of constant returns to scale for the group with low IT-penetration,
contrary to the other group where we find statistically significant
evidence for increasing returns to scale.
A weakness of the earlier works on IT and its contribution
towards output growth (e.g., Brynjolfsson and Hitt, 2003; Erumban
and Das, 2016) is that these studies impose uniform production
technology across heterogeneous manufacturing sectors. We es-
timate and present the results for four manufacturing industries
separately, i.e. transport and machinery, metals, chemicals and all
other industries.5 Table 3 presents the results for each of these
sectors for the full sample covering 1998–2016. The estimated
coefficients show statistically significant output elasticities of IT
ranging between 0.040 and 0.064 across these sectors, while the
elasticity of R&D across these sectors lie between 0.015 and 0.086.
5 Our disaggregation of the full sample into these broad sectors is determined
by two factors. First, we are constrained by data on both IT and R&D, which we
address by clubbing some sectors with others. Second, estimates based on factory
data confirm that together these sectors, i.e. chemicals, transport and machinery
and metals, contribute to more than 50 percent of the total IT investments in
India’s organized manufacturing sector (see also, Krishna et al., 2018), while the
other sectors do not singularly make a significant contribution on this front. Our
dataset confirms that these sectors contribute heavily to total R&D investment also.
Therefore, we find it interesting to study these sectors separately. Fortunately, we
have sufficient data on these sectors to study them separately.
 R. Khanna, C. Sharma / Economics Letters 173 (2018) 30–34
Table 3
Production function regressions: broad industry groups.
DV: lnLP Chemicals Machinery & Transport
ln(KIT ) 0.044** (0.000) 0.040** (0.009)
ln(KO ) 0.266** (0.000) 0.421** (0.000)
ln(lab) 0.058** (0.000) 0.020** (0.006)
ln(RD) 0.048** (0.000) 0.015** (0.029)
N 1606 1767
Hansen test 6.23 (0.11) 9.73 (0.02)
Note: Other industries group includes sectors such as construction, food, textiles, consumer goods and miscellaneous
industries.
*p < 0.10.
**p < 0.05.
The estimated coefficient for the metal industry is 0.064, the im-
plication is that 1 percent increase in IT capital stock per labour
would lead to around 0.06 percent increase in labour productivity.
Another interesting finding is that both metals and transport and
machinery sectors seem to undergo increasing returns to scale,
with a positive and significant scale coefficient, which is depicted
by coefficients of labour. Both the sectors are indeed IT intensive
in nature, as against manufacturing sectors comprising the ‘other
industries’. Similarly, in chemicals, industries such as, and indus-
trial chemicals and rubber and plastic products have been lagging
in terms of IT adoption.
5. Robustness analysis
Next, we relax the assumption that all polynomial terms in the
production function are zero, and include an interaction between
IT and R&D capital inputs. If the interaction variable is positive, we
can conclude that the two types of inputs are complementary in
generating productivity, at least for the present sample. Further,
we augment our basic specifications in Eq. (2) with relevant control
variables. Firstly, drawing from our result on the disparities among
industry sub-groups based on intensity of IT, we control for these
effects using a dummy variable. Secondly, we consider the possibil-
ity that labour productivity could be linked with whether or not the
sample firms are open to export (see, for instance, Yamada, 1998).
This is achieved by way of accounting for an export dummy, which
is 1 for exporters and 0 for non-exporters. Lastly, we also control
for firm ownership by including a foreign firms’ dummy that is 1
for foreign firms, 0 otherwise.6 Results are summarized in Table 4.
The estimated coefficient of ordinary and IT capital inputs are
consistent across all specifications. We find the coefficient of R&D
around 0.06. The implication is that a percent increase in firm’s
R&D capital would increase the labour productivity of firms by
around 6 percent, which appears quite consistent across alternate
models. Further, the estimated coefficient of the interaction term
is significant across all these specifications, and the sign of the
estimated parameter is positive suggesting that the two types of
inputs show a complementary effect in generating productivity
effects. Coming to the results on control dummies, we find that in-
dustry sub-sectors with low levels of IT penetration generally have
realized lower levels of labour productivity as compared to those
with higher levels of IT penetration. Similarly, the positive and sta-
tistically significant sign of the export dummy suggests that firms
that are open to export have higher labour productivity. Finally, in
Column 4, we also consider a foreign firm’s dummy. However, the
estimated coefficient of the foreign dummy is not statistically sig-
nificant suggesting the absence of differential labour productivity
effects in foreign firms.
6 Please note that we do not use conventional fixed effects (firm, industry,
time etc.) in our analysis. Recent work strongly suggests against the use of fixed
effects with control function estimators, such as Ollay Pakes, Levinsohn Petrin and
Wooldridge, as these can exacerbate the attenuation bias caused by measurement
error (see, for instance, Lee et al., 2017). Nevertheless, we do allow for heteroge-
neous technology across disparate industry sub-groups (see, Tables 3 and 4) and
time regimes (sub-period analysis).
33
Metals Other industries
0.064* (0.071) 0.056** (0.000)
0.360** (0.000) 0.281** (0.000)
0.018 (0.535) −0.017 (0.190)
0.086** (0.012) 0.065** (0.000)
397 1545
12.39 (0.01) 2.58 (0.46)
6. Concluding remarks
Summing up our insights from this analysis, our results on the
significant impact of IT on labour productivity are consistent with
the results established by Erumban and Das (2016) and Sharma
and Singh (2012). Erumban and Das (2016) find that the use of
IT input made a positive and significant contribution to output
growth in Indian manufacturing in 1986–2011. Further, estimating
a Cobb–Douglas production function with IT capital as an input,
Sharma and Singh (2012) find the value-added elasticity of IT
input in aggregate manufacturing to be around 17.2 percent for the
period 2003–2007.7 Our estimate, on the other hand, lies between
0.03 and 0.069. Since Sharma and Singh (2012) study IT effects
at the plant-level, our estimates at the firm-level are not directly
comparable with those presented by these authors. Nevertheless,
there are a few reasons suggesting that the accuracy of our results
may be higher as compared to the previous studies, including that
of Sharma and Singh. Firstly, our estimates allow production tech-
nology to vary across sub-groups within the manufacturing sector.
Our analysis already shows that the differences between IT returns
across sub-sectors according to IT penetration and industry-type
are wide, ignoring which would lead to quite misleading results.
Secondly, our estimate based on Wooldridge (2009) estimator is
corrected for simultaneity bias in the input choice, while the GMM
framework used by Sharma and Singh does not explicitly control
for such simultaneity.8 Lastly, our estimate utilizes long panel
properties as we study a considerably longer period than these
studied. Our analysis takes care of many potential econometric
problems such as, the problem of simultaneity bias in the produc-
tion function, cross-sectional correlation and heteroscedasticity of
errors. Further, inclusion of control dummies also help in assessing
the consistency of results. However, these advantages come with a
slight limitation, which is that the framework becomes extremely
complex when testing for firm fixed effects.
In a nut shell, our findings suggest significant effects of IT and
R&D on labour productivity in the sample firms. We also find these
inputs to be complementary to each other.
Acknowledgements
The authors thank the anonymous referee and the Associate
Editor of this journal for their useful comments and helpful sugges-
tions on the previous version of this paper. Any errors or omissions
are solely the authors.
7 The estimates in this paper are particularly sensitive to the methodological
framework employed. The estimate of 17.4 percent is based on generalized method
of moments (GMM) estimator (see, Sharma and Singh, Table 4 (4), pp. 214).
8 The use of traditional estimators such as fixed effects and GMM in productivity
estimations has been criticized recently as these are not well-founded in the
theory of producer behaviour (Griliches and Mairesse, 1995). Wooldridge (2009)
methodology overcomes this criticism.
34 R. Khanna, C. Sharma / Economics Letters 173 (2018) 30–34

Table 4
Production function estimates with interaction term and additional controls: full sample.
DV: lnLP Model I Model II Model III Model IV
ln(KIT ) 0.069** (0.000) 0.069** (0.000) 0.065** (0.000) 0.066** (0.000)
ln(KO ) 0.319** (0.000) 0.319** (0.000) 0.323** (0.000) 0.325** (0.000)
ln(lab) 0.018** (0.002) 0.018** (0.002) 0.017** (0.005) 0.015** (0.017)
ln(RD) 0.061** (0.000) 0.061** (0.000) 0.061** (0.000) 0.060** (0.000)
Interaction (RD ∗ KIT ) 0.004* (0.062) 0.004* (0.062) 0.005* (0.057) 0.005* (0.056)
Low IT-intensity dummy −0.261** (0.000) −0.260** (0.000) −0.178** (0.000)
Export-dummy 0.408** (0.000) 0.268** (0.000)
Foreign-dummy 0.003 (0.686)
N 5303 5303 5303 4038
Hansen test 5.34 (0.25) 5.34 (0.25) 5.53 (0.24) 9.24 (0.07)

Note: p-values are reported in parenthesis. Standard errors are based on bootstrapping method.
*p < 0.10.
**p < 0.05.

Appendix A. Supplementary data
Supplementary material related to this article can be found
online at https://doi.org/10.1016/j.econlet.2018.09.003.
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