Impact Assessment

The Effects of Business Environments on Development: Surveying New Firm-Level Evidence, Lixin Colin Xu (World Bank), 2010

    Using firm-level research related to the World Bank Investment Climate Surveys, Lixin Colin Xu examines the effects on development of various elements of business environment reform. He finds that the relative success of many reforms depends on which industries are most affected, whether institutions exist that complement the reforms, and on the nature of the initial business environment.

    Xu finds the quality of infrastructure to be more important in explaining firm performance in the least developed countries than in middle-income developing countries such as China.

    Secure property rights, meanwhile, are found to be meaningfully linked to higher rates of reinvestment of profits across countries. That said, the importance of a fast and reliable legal system varies by the country’s stage of economic development. ‘In the early stage of development and transition, substitution institutions, such as clustering, reputation mechanisms, relationship contracts, and informal trade credit, could be sufficient to induce economic growth.’ Where alternatives exist, it may even be beneficial to reduce legal formalism (e.g. in the case of bankruptcy, enabling foreclosure as an alternative to court proceedings). However, ‘as transition and development moves along, the extent of the market becomes larger, transactions become more complicated, and contracting relationships based on personal ties become insufficient. Now market-supporting formal institutions are needed to encourage arms-length contracting.’ High levels of corruption are especially damaging to business performance, more so than high taxation.

    Xu suggests that labour flexibility facilitates better firm performance, as well as faster adjustments in the factors of production and a more efficient distribution in firm sizes. The author also cites evidence from Indonesia and India which indicates that there can be a trade-off between quality and quantity of employment for workers in local industries such as textiles.

    While Xu finds low levels of regulation on firm entry (e.g. light-touch business registration procedures) to be favourable to developing countries, he notes a variation in the likely effects. For example, the benefits of opening up entry to foreign firms are stronger where domestic firms are already competitive. Increased competition through foreign entry will also have a productivity-enhancing effect on firms close to the technology frontier, yet for domestic firms completely behind in the technology race, this increased competition may lead give up them on innovation, as they lose hope of ever becoming a market leader.