Investment Climate Reform and Development Impact: A Literature Review

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Oct 28, 2013 (3 years and 9 months ago)

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Investment Climate Reform
and Development Impact: A
Literature Review




By Dorsa
ti Madani







The role of the private sector in economic growth


Governments across the world strive to create

opportunities for
their citizens

to
improve their living
standards

and to escape from poverty through economic growth and employment creation.
Experience
shows that
while the authorities can facilitate the creation of an environment supportive of growth,
the
source of sustainable economic growth
and employme
nt creation
is
the
private sector.


The public sector can employ a set of policies to create a climate in which firms and entrepreneurs of all
types have opportunities and incentives to invest productively, expand,
and create

jobs and income
. On the
ma
croeconomic level, responsible macroeconomic policy is a key factor


with the authorities being
ca
utious on several angles: (i)
to avoid unsustainable
debt burden
, (ii) to
engender
inflation
as a results of
expansionary monetary or fiscal policy;
(iii
)

to

use of public funds towards infrastructure; (iv)
to
encourage

openness of the economy to the outside world; (v)
to expand and sustain
social
sector
expenditures


on health and education


to improve general
wellbeing and
to

buildup of human capital.

A final factor is
institution building and improved
investment climate (
legal and regulatory framework)

to
encourage economic growth

driven by the private sector
.


The 2005 WDR
on the importance of improved investment climate
notes that the goal should

be to create
an investment climate that is better for everyone

in two dimensions. The investment climate should
benefit society as a whole, not only firms. Well
-
designed regulation and taxation are thus an important part
of a good investment climate. And

the investment climate should embrace firms of all types, not just large
or influential firms. Small and large firms, local and foreign firms, and low
-
tech and high
-
tech firms each
have important and complementary contributions to make to growth and pover
ty reduction.





H
ow
the
reform agenda link
s

with development outcomes



There is a
large literature that links
investment climate
reforms to positive development outcomes
around
the world.
For instance, o
n
business entry

reform
, the literature is unequi
vocal that 1) more firms enter
the market when registration procedures and costs are cut; (2) a large percentage of new firms survive and
grow, increasing employment; (3) new firms increase competition, forcing incumbents to become more
efficient or to ex
it the market, which in turn increases overall productivity and investment; and (4) entry
reforms have a greater impact on productivity and employment when coupled with other investment
climate reforms, particularly reforms that increase the flexibility of

the labor market.
1


We have no
uniformly

irrefutable proof of the impact of investment climate (IC) reforms on job creation.
Establishing such a link is difficult as the benefits of IC reforms can be counterbalanced by a panoply of
macro and microeconomic factors (such as macroeconomic instabil
ity, insecurity, government investment
incentives that affect the labor intensity of investment, etc…). However, logic dictates that many of the IC
reforms (such as reducing
the
burden of tax payment,
or of running a
business
or trading across borders
)
fr
ee up money that could be used for more productive and potentially job creating investments. And survey
and analysis repeatedly finds a minimum correlation between IC reforms and business activities.

Several
examples of recent World Bank Group publicatio
ns

find:



A 2005 report on enhancin
g job opportunities in ECA
notes that the disappointing employment numbers
are because firms have not engaged in “strategic restructuring”, which requires investing productively,
hiring more workers, and finding new pro
duction niches.
2

And why do firms not engage in more strategic



1

“The Impact of business entry reform: evidence from the literature” by Marialisa Motta, Ana Maria Oviedo and Massimiliano Sa
ntini (Doing
Business Reform Unit, Investment Climate Departm
ent, World
Bank,

2010.

2

NEEDS reference

restructuring? Often, they are discouraged by the poor investment climate

substantial risks, barriers, and
costs associated with doing business. This study recommends investment climate reform
s as one of the
m
ain strategies to encourage new firms to enter the market, and for existing firms to grow and
create more
and better jobs. The specific needs differ across countries.


A

2007 study finds that in Africa, employment growth is relatively con
centrated in the smallest firms, with
medium and large firms growing less rapidly than in other parts of the world. Part of this is understood by
the business environment in which the firm operates. On average, firms in Africa face greater challenges in
accessing finance, reliable infrastructure services and other public services, all conditions that serve to
lower the growth of larger firms and shifting down the size distribution of firms. While expansion of
employment opportunities through micro firms
can be a good thing, it is also desirable that business
environment conditions could also help achieve greater growth rates among SMEs and large firms too.

3




Tax reforms
-
either tax cuts or simplifications
-

have a less obvious connection to job creation
. Their
impacts are less uniform and more ambiguous than the impact of entry reforms. However, in country
specific cases, we see an important impact. For instance, In Brazil, recent analyses show that the SIMPLES
reforms (simplified tax regime for small

and medium enterprises) had a significant effect on the proportion
of firms that got license to operate, are registered as a legal entity, pay taxes and make social security
contributions. Moreover, newly created firms that opt for operating formally achi
eve higher levels of
revenue and profits, employ more workers and are more capital intensive (only for those firms that have
employees). The channel through which this occurs is not access to credit or contracts with larger firms.
Rather, it appears that t
he lower cost of contracting labor leads to adopting production techniques that
involve greater permanence and a larger paid labor force. Formality affects firm performance by sharply
increasing returns and profits in firms with employees (by 70 and 60
percent respectively). Formality also
leads to an increase of 10 to 40 percent in the share of paid employees in employment. In fact, the big gain
seems to be gaining a permanent location for firms’ businesses, which allows expansion of capital and
employ
ment.
4



A recent literature review on the correlation between cost of business creation and operations, business
environment regulations, their reform and corruption. Thought not exhaustive, it finds the following: (1)
corruption affects the economic

cost of doing business; (2) the cost of corruption on businesses is high; (3)
Regulation quality is positively correlated with corruption and more restrictive regulation is correlated with
higher corruption; (4) Ease of doing business and improvements i
n the business environment are
associated with improved governance.
5

Finally, we note that the literature has not yet established a causal
direction between business environment and corruption.


A note

of caution

is necessary here. While we strongly
believe that improved investment climate fosters
private sector growth and by extension job and income creation and improve
d

living standards,
we can’t
infer
direct
causality between
investment climate

reforms and
growth and development
outcomes
. This is
because
a
s noted above economic growth and job creation can be affected by a number of different national
and international policies as well as external shocks the likes of which the world has very recently and
painfully experienced.






3

“The Impact of business entry reform: evidence from the literature” by Marialisa Motta, Ana Maria Oviedo and Massimiliano Sa
ntini (Doing
Business Reform Unit, Investment Climate Department, World Bank

4

Does Formality Improve Micro
-
Firm Performance? Quasi
-
experimental Evidence from the Brazilian SIMPLES Program. Gabriel V. Montes
-
Rojas, William Maloney and Pablo Fajnzylber, WB
discussions paper

No 4531
, October 2009.

5

Gonzalez et. al. (2007). In this

case, ease of doing business and improvements in business regulation reduce the probability that firms are asked
for and pay bribes