Investment Climate Reform and Development Impact: A Literature Review

By Dorsati 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 employment 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 macroeconomic level, responsible macroeconomic policy is a key factor with the authorities being cautious 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 everyonein 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 poverty reduction. How the reform agenda links with development outcomes There is a large literature that links investment climate reforms to positive development outcomes around the world. For instance, on business entry reform, the literature is unequivocal 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 exit 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 instability, 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) free 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 publications find: A 2005 report on enhancing 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 production niches.2 And why do firms not engage in more strategic restructuring? Often, they are discouraged by the poor investment climatesubstantial risks, barriers, and costs associated with doing business. This study recommends investment climate reforms as one of the main 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 concentrated 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 achieve 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
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, 2010. 2 NEEDS reference 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
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access to credit or contracts with larger firms. Rather, it appears that the 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 employment.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 in 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 improved living standards, we cant infer direct causality between investment climate reforms and growth and development outcomes. This is because as 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.

Does Formality Improve Micro-Firm Performance? Quasi-experimental Evidence from the Brazilian SIMPLES Program. Gabriel V. MontesRojas, 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