WPS5493 Policy Research Working Paper 5493 Impact Evaluation Series No. 49 The Impact of Business Environment Reforms on New Firm Registration Leora Klapper Inessa Love The World Bank Development Research Group Finance and Private Sector Development Team December 2010 Policy Research Working Paper 5493 Abstract This paper uses panel data on the number of new firm procedures or 50 to 60 percent reduction in costs and registrations in 91 countries to study how the ease of days, do not have a significant effect on new registrations. registering a business and the magnitude of registration They also find important synergies in multiple reforms reforms affect new firm registrations. The authors find of two or more business environment indicators. that the costs, days and procedures required to start Finally, they show that countries with relatively weaker a business are important predictors of the number of business environments prior to reforms require relatively new firm registrations. However, they find that small larger reforms in order to impact the number of newly reforms, in general less than a 40 percent reduction in registered firms. This paper—a product of the Finance and Private Sector Development Team, Development Research Group—is part of a larger effort in the department to study entrepreneurship and growth. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The author may be contacted at ilove@worldbank.org. The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent. Produced by the Research Support Team The Impact of Business Environment Reforms on New Firm Registration Leora Klapper and Inessa Love* Paper revised in October, 2012 JEL Classification: G18, G38, L51, M13 Key Words: Entrepreneurship, Business Environment, Government Reforms * Klapper is in the Finance and Private Sector Development Team in the Development Research Group at the World Bank; Love is in the Department of Economics at the University of Hawaii. We thank the Ewing Marion Kauffman Foundation and the World Bank Group for financial support. This paper was prepared with outstanding assistance from Douglas Randall. Thanks to Mary Hallward-Driemer and David McKenzie for helpful comments. This paper’s findings, interpretations, and conclusions are entirely those of the authors and do not necessarily represent the views of the World Bank, their Executive Directors or the countries they represent. Corresponding author: Leora Klapper, E-mail: lklapper@worldbank.org, Address: 1818 H St. NW, Washington, DC, 20035, Phone: 1-202-473- 8738, Fax: 1-202-522-1155. 1. Introduction Entrepreneurship is essential for the continued dynamism of the modern market economy and a higher entry rate of new businesses can foster competition and innovation (Klapper, et al., 2006; Ciccone and Papaioannou, 2007; Aghion, et al., 2009). To promote private sector growth, many countries have focused on simplifying the registration process, seeking to reduce the costs, days and/or procedures required to formally register a business. A methodology for measuring the effectiveness of the regulatory framework for firm registration was developed by Djankov, La Porta, Lopez-de-Silanes, and Shleifer (2002). Since 2003, the World Bank’s annual Doing Business report has used this methodology to quantify the registration process in over 170 countries in its “Ease of Starting a Business� section. 1 An outstanding question, however, is whether, and to what degree, there exists an economically meaningful relationship between the costs, days and procedures to start a business and the actual number of new firms that register each year. Given the widespread recognition of the importance of business environment reforms 2, it is surprising that there is little research, and no cross- country panel analyses, on the real effect of these regulatory reforms. Our paper aims to address this gap in the literature by examining the impact of institutional reforms on the number of new firms registered. Understanding the regulatory environment that promotes entrepreneurship is necessary to successfully identify appropriate policies to foster entrepreneurship in local economies. In this paper we empirically investigate the relationship between the regulatory ease of registering a business and actual new business registrations. Next, we explore the magnitude of reform in 1 Reports are available on-line at: www.doingbusiness.org. 2 For instance, a 2008 report of the Multilateral Donor Committee for Enterprise Development states, “Reforming the business environment is a priority for development agencies and governments because of the significant influence the business environment has on the development of the private sector and therefore on economic growth and the generation of livelihoods and jobs.� (DCED, 2002, p.3) 2 entry regulation required for a significant impact on new firm registration. A priori, it is not clear what magnitude of reduction in costs (or other parameters such as days or procedures) is necessary to cause a significant impact on firm registration. In other words, what exactly constitutes a reform? Is a 20 percent reduction in the costs of registration sufficient or is a 50 percent reduction necessary to encourage a significant number of firms to register? We further examine the effect of simultaneous and sequential reforms across measures of entry regulation. Finally, we examine how the impact of reform depends on the level of regulation prior to the reform. We use a new dataset that is uniquely suited for this purpose: a cross-country, time-series panel dataset on the number of newly registered limited liability firms. We supplement this dataset with information from Doing Business reports on the cost, days and number of procedures required for the registration of new companies. Importantly, both datasets focus comparably on only limited liability firms. Our results show that the costs, days and procedures required for business registration are important predictors of new firm registration over time. However, on average, small reforms - in general less than 40 percent for procedures and 50 to 60 percent for costs and days - do not have a significant effect on new firm registration. In addition, reforms in multiple indicators (e.g. the cost and number of procedures required to register a business) have a larger impact on business registration and simultaneous reforms have a larger impact than sequential reforms. Furthermore, we find that a country’s initial conditions matter: Countries that start out with relatively higher initial costs need larger reforms to result in a significant increase in number of new registered firms. 3 We offer a simple model to motivate our empirical strategy. The model demonstrates how some reforms could be classified as small or large depending on the relative magnitude of the costs and benefits of registration. Our results imply that in countries with high initial registration costs, the benefits of registration are significantly below the costs of registration, likely because of limited access to finance or rigid labor markets. This is consistent with Djankov et al. (2002) who show that high registration costs do not serve public interest, but only benefit politicians and bureaucrats. 3 The results in our paper suggest non-trivial economic magnitudes on the number of newly registered businesses. For example, we find that across OECD countries in our sample, on average, a reduction of 50 percent or more in the number of procedures, days or costs leads to an average increase in the number of new registrations of 14, 19 and 30 percent, respectively. These results are remarkably consistent with previous studies of registration reforms in two different OECD countries. A reform in Mexico that decreased the number of procedures by about 60 percent resulted in a 5 percent increase in the total number of firms, which translates to a 24 percent increase in new registrations in the municipality of Guadalajara (Bruhn, 2008). A reform in Portugal that reduced costs and days by 50 percent or more resulted in an increase in firm startups of about 17 percent, mostly among “marginal� firms that would have been most deterred by burdensome regulations, such as small firms in low-tech sectors (Branstetter, et al., 2010). Our analysis is motivated by earlier studies that find that new firms are the ones most likely to grow (Lingelbach, et al., 2005; Johnson, et al., 2000) and to create new jobs (Audretsch, et al., 2006; McMillan and Woodruff. 2002). For example, studies using longitudinal data sets on 3 Our results are also consistent with de Mel, et al. (2012) who find that firms in Sri Lanka rationally refrain from formalizing, since they see few benefits from doing so – while a few firms seem to be suboptimally informal. Furthermore, their results suggest that a relatively modest increase in the net benefits to firms of formalizing could dramatically increase the rate of formalization. 4 the evolution of firm formation document that economic growth in both Canada and the U.S. is driven by new formal business entry rather than by the growth of existing firms (Brander, et al., 1998; Haltiwanger, 2009). Earlier studies also show that entrepreneurship can foster competition and economic growth (Barseghyan, 2008; Klapper, et al., 2006; Djankov, et al., 2006; Black and Strahan, 2002; Hause and Du Rietz, 1984) and a reduction in informality (Antunes and Cavalcanti, 2009; Dabia- Norris, et al., 2008). Previous cross-country studies have found that new firm creation is significantly related to country-level indicators of economic development and growth, the quality of the legal and regulatory environment, ease of access to finance, and prevalence of informality (Wennekers, et al., 2005; Klapper, et al., 2010; Ardagna and Lusardi, 2010). Our paper is most closely related to the literature showing that costly entry regulations may impede the setting up of businesses and stand in the way of economic growth (De Soto, 1990; Djankov et al., 2002,Klapper, et al., 2006; Kaplan, et al., 2006; Bruhn, 2011). For example, a study of entry regulations across 34 European countries shows that onerous entry regulations are related to lower firm entry, specifically in industries with higher average entry rates (Klapper, et al., 2006). Some studies, however, have cast doubt on the relationship between Doing Business measures and the real world business environment as perceived by actual business owners (Hallward-Driemeier and Pritchett, 2010). This paper helps to reconcile this recent skepticism with an analysis of the relevance of Doing Business measures using a real-world output: new firm registrations. Importantly, this paper offers policymakers empirically-based insight into the impact of the reform process on new firm creation. For instance, insufficiently large reforms may not have 5 the intended impact on firm registrations, resulting in a potential misallocation of money and political capital. These results can help policymakers to design interventions with the biggest impact on private sector growth. The paper proceeds as follows. Section 2 presents our model and empirical methodology. Section 3 discusses our data and summary statistics, Section 4 shows our results and Section 5 concludes. 2. Methodology 2.1. Theoretical intuition We begin with a simple model of reforms to formal business registration that guides our empirical strategy. Assume there are benefits for an entrepreneur to operate a formally registered firm (as compared to not starting a business or operating informally). This benefit might be increased access to finance, a sales tax ID to attract larger or foreign customers, better contract terms with suppliers or customers or a reduced risk of government sanctions. Suppose the total sum of these benefits can be represented by monetary amount b. On the other side, there are costs to registering a formal business, such as official and non-official payments to start and operate the business, personnel and managerial time spent dealing with required procedures and minimum capital requirements that need to be met. Suppose the total cost is represented by c, which also includes the monetary value of employee time and the time value of any delays. Clearly, individuals will only chose to register their firms when the total benefits of registration exceed total costs, i.e. c < b. 6 Since benefits can vary from firm to firm, it follows then, that there should be a negative relationship between the costs of registering a business and the number of new businesses registered. This negative relationship is our first testable hypotheses. Suppose there is a reform that reduces the costs of registering a business. This could be a reduction in required direct fees, or a reduction in the number of procedures, that can be translated to a reduction in costs because of personnel time savings. Assume that before the reform the registration costs are equal to c0 and after the reform the total costs are c1, which is lower than c0 (i.e., c1 < c0). The reform will only lead to new formal sector registrations when post-reform costs fall below the benefits to registration, i.e. c1 < b. Put another way, the reform might be effective in inducing new business registrations or ineffective, depending on the relative magnitude of parameters b, c0 and c1. Specifically, there are two possible cases, which we refer to as a “small reform� or a “large reform�: Small reform: b < c1 < c0 Large reform: c1