investment climate review

8/12/2019 Investment Climate Review

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Investment Climate Reform

and Development Impact: ALiterature Review

By Dorsati Madani


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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 andemployment 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, responsiblemacroeconomic policy is a key factorwith the authorities being cautious on several

angles: (i) to avoid unsustainable debt burden, (ii) to engender inflation as a results ofexpansionary monetary or fiscal policy; (iii) to use of public funds towards

infrastructure; (iv) to encourage openness of the economy to the outside world; (v) toexpand and sustain social sector expenditureson health and educationto improve

general wellbeing and to buildup of human capital. A final factor is institution building

and improved investment climate (legal and regulatory framework) to encourageeconomic 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 theinvestment 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 outcomesThere 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 costsare 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) entryreforms have a greater impact on productivity and employment when coupled with other


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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 asmacroeconomic instability, insecurity, government investment incentives that affect thelabor 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 jobcreating 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 productionniches.2And 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 existingfirms 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 thesmallest 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 lowerthe 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 greatergrowth rates among SMEs and large firms too.

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Tax reforms -either tax cuts or simplifications- have a less obvious connection to jobcreation. 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 gotlicense 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

1The Impact of business entry reform: evidence from the literature by Marialisa Motta, Ana Maria Oviedo and Massimiliano Santini (Doing

Business Reform Unit, Investment Climate Department, World Bank, 2010.2NEEDS reference3The Impact of business entry reform: evidence from the literature by Marialisa Motta, Ana Maria Oviedo and Massimiliano Santini (DoingBusiness Reform Unit, Investment Climate Department, World Bank


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