On Determinants of SMEs in Ethiopia: Which Incentives Matter

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On Determinants of SMEs in Ethiopia Which
Incentives Matter?

• By Zuzana Brixiova
• Development Research Department,
• African Development Bank

African Economic Conference Addis Ababa, November
11 13, 2009
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Motivation for this topic

• Ethiopia is one of the poorest countries in the
  world high and sustainable growth is key
  challenge
• Ethiopia presents a unique mixture of
  characteristics
• 1. Ethiopia as a Transition Economy
• Slowly declining share of state sector in the
  economy
• Limited share of the private sector
• 2. Ethiopia as a Low-Income Country
• Large informal sector (low productivity,
  salaries)
• Large and constant share of agriculture in output
• Slow adoption of new technologies and limited
  infrastructure
• High urban unemployment

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Motivation (cont.)

• The importance of SME start-ups and
  entrepreneurship for growth and job creation in
  transition economies is well documented
• An extensive survey and empirical literature has
  examined characteristics of SMEs in Ethiopia,
  their constraints, and the urban labor market
• This paper develops a theoretical framework for
  these processes, then applies to comparing policy
  options
• It presents a simple model that illustrates
• how improved business environment and labor
  market encourage entrepreneurship and employment
• the role that government policies, including
  subsidies, can play

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Motivation (cont.)

• In the past, somewhat extreme approaches to
  development were adopted (Market failure vs.
  Government failure)
• Currently (SOEs), countries are rethinking their
  growth strategies from relying on FDI and exports
  as main drivers of growth to shifting some of
  their resources to domestically-oriented
  enterprises and demand
• Current approach
• Private entrepreneurship is key driver of growth
  and employment
• Government plays coordinating/complementary role
  to market forces, beyond the basic functions
• Facilitating business-friendly climate (standard
  function)
• Adequate supply of human capital
• Active interventions in factors of production
  in the labor market, gov. supports training and
  reduces transaction costs through employment
  exchange offices

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Some facts

• Limited role of the formal private sector
• Derg regime (1974 1991) Central planning
• II. The current government (1991 - now)
• Striving to support private sector development,
  especially SMEs
• Slow progress with privatization of large
  enterprises
• Currently, the private sector accounts for
• less than 50 percent of formal urban employment
• less than 50 percent industrial output

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Ethiopia Distribution of employed population in
urban areas, 2005 ( of total)
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High unemployment, insufficient private job
creation

• Supply factors urban population more than
  doubled during 1990 - 2007, from 6 mln. in 1990
  to 13 mln. in 2007
• Skills provided by educational system do not
  match requirements of the private sector
  (mismatch)
• Demand side factors slow job creation in the
  formal private sector
• 30 percent of those who were unemployed in 1994
  were still unemployed in 2004
• 22 percent left the labor force
• Of those who found jobs, only 17 percent went to
  the formal private sector

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Employment and youth unemployment rates in urban
centers, 2005
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Unemployment and youth unemployment rates in
urban centers, 2005
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Obstacles to SMEs and private sector development

• In early 2000s

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Obstacles to SMEs and private sector development
-- taxation

• Improved tax system SMEs under presumptive
  taxation
• Progressive tax system may discourage creation of
  highly profitable firms

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The most problematic factors for doing business
(ACR, 2009)
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Informal sector

• Large and dualistic informal sector
• Most SMEs in Ethiopia operate in the informal
  sector
• The informal sector consists mostly of
  low-productive firms concentrated in
  manufacturing and trade
• Some successful small-scale enterprises also
  operate in the informal sector (small-scale
  manufacturing)
• This more dynamic tier employs more educated
  workers
• Substantial wage gap exists between the formal
  and the informal sector (30)
• Women and uneducated population tend to be
  disproportionately represented in the informal
  economy

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Ethiopia Informal sector establishments, by
region and industry (2003)
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Frictions in the urban labor market

• Skill shortages -- relatively high returns to
  education
• Unemployment affected the highly-skilled workers
  less, with the notably lower rate for workers
  with tertiary education (9 percent vs. 23 percent
  total rate in 2004)
• But unemployment rates of young people with high
  school and some higher education has been on the
  rise
• Lack of labor market information about available
  jobs/searchers
• Use of the exchange offices low (only 6 percent
  of searchers in 1999) and declining, reflecting
  low trust of the public in this service

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The Model

• Labor Reallocation with Firm Creation
• Shows the impact of quality of institutions,
  specifically (i) business environment and (ii)
  lacking labor market institutions on
• SME start ups and skilled employment
• Firms decision to operate in the formal or the
  informal sector
• Focuses on drivers of firm creation, it does not
  try to explain why some countries adopted a
  particular institutional set ups faster than
  others

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Literature context

• 2 streams of literature
• Search approach to labor markets
• Generally, Mortensen and Pissaridies from 1990s
  on -- most common approach to labor/macro
  analysis today
• Specifically, Snower (1996) externalities in
  labor markets of developed countries
• Models of entrepreneurship
• Brixiova, Li, Yousef (2009) in the context of
  Central Europe, with a focus on skill shortages
  model with perfectly competitive labor markets
  no informal sector draws also on earlier work
• Related to Gelb et. al. (2008) model of
  entrepreneurship in Africa, emphasize differences
  in tax monitoring and cost of concealment

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The Model Set up

• There are two types of agents, entrepreneurs and
  workers, with populations and
• Agents live for 1 period, are endowed with 1 unit
  of time, have risk-neutral preferences
• Entrepreneurs search for business
  opportunities search costs them
  and results in probability x of finding one
  still need to find skilled workers
• Workers acquire skills, which costs them
  still need to find skilled
  jobs, which happens with probability
  
• wage determined through
  bargaining
• Output produced according to

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The Model equilibrium conditions

• .

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The Model optimal allocation
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Informal sector

• Profit of a firm changes to
• Firms choice of a sector to operate in
• Impact of policies
• subsidies to entrepreneurs search s
• subsidies to skilled employment

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Equilibrium conditions with informal sector and
subsidies
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Impact of subsidies

• Search subsidy
• Paid to the potential firms reduces cost of
  search increases entrepreneurs net profits
  (i.e. profit less search cost) stimulates
  start-ups
• does not influence decision about sectors (formal
  vs. informal)
• Wage subsidy
• Paid to the existing firms increases after-tax
  profit party captured by workers and hence it
  also raises training incentives
• Influences decision in which sector to operate
• Needs to be sufficiently large to make a
  difference
• Financing matters

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Impact of unclear property rights

• Denoting probability of expropriation as
• Efficiency component in the production function
  becomes
• Entrepreneurs now more likely to opt for the
  informal sector since the expected profit in the
  formal sector is reduced by the possibility of
  expropriation

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Conclusions and further research

• Conclusions
• In countries such as Ethiopia, where the private
  sector (including informal one) is
  underdeveloped, subsidies to entrepreneurs
  search may encourage start-ups
• They would be more effective than wage subsidies
  to the existing firms, but still need to be
  accompanied by improvements to the business
  environment and functioning of the labor market.
• Since unclear property rights constitute
  potentially the most severe form of taxation,
  reforming them is key. Wage subsidies less
  effective/more costly than reforms of business
  environment
• Further research
• Impact of credit constraints (internal as well as
  shortages of forex)