Business Environment and Firm Entry: Evidence from International Data

1
Business Environment and Firm Entry Evidence
from International Data

• Leora Klapper
• (World Bank)
• Luc Laeven
• (World Bank and CEPR)
• Raghuram Rajan
• (IMF and NBER)
• World Bank SME Conference, October 14-15, 2004

2
Motivation

• New firm entry is a critical part of the process
  of creative destruction that Schumpeter (1911)
  argued is so important for the continued dynamism
  of the modern economy.
• Little is known about the business environments
  that promote new firm creation. This is an
  important concern for policymakers, who are
  trying to implement policies that will foster
  entry.
• A cross-country study may provide some insights.
  For instance, one might believe that Italy, with
  its myriad small firms, should have tremendous
  entry. Actually, entry in Italy is about 3.5
  times lower than in the other European G-7
  countries.
• What is the role of entry regulations, especially
  bureaucratic regulations on setting up limited
  liability companies, in explaining variations in
  patterns of firm entry ?

3
Background

• The early debate on such corporations emphasized
  the possibility that crooks might register with
  little capital and dupe unsuspecting investors or
  consumers. According to this view, entry
  regulations serve the public interest by
  preventing fraud.
• Others describe regulations as devices to protect
  private interests of industry incumbents (Smith
  1776, Olsen 1965, Stigler 71) or the regulators
  (Krueger 1974, Bhagwati 79, Shleifer and Vishny
  97).
• The evidence in Djankov et al. (2002) that
  countries with heavier regulation of entry have
  higher corruption and larger unofficial economies
  is consistent with the private interest view of
  regulation.
• But regulations could be less burdensome in
  corrupt countries because officials can be bribed
  to ignore them so there is no strong demand to
  streamline them.
• The case against entry regulations is primarily
  based on aggregate impressions modulated by
  theory rather than by actual detailed evidence on
  their microeconomic consequences.

4
Contribution

• We first show that these entry regulations do
  affect entry.
• We then study the consequences of preventing free
  entry for the growth of incumbent firms.
• A cross-country regression of firm entry against
  regulations may suffer from a causality problem
  that in countries with generally low entry,
  people are not sufficiently motivated to press
  for the repeal of regulations that impede entry.
  Thus even though regulations may have no direct
  effect on entry, there could be a negative
  correlation between regulatory restrictions and
  entry.
• To address this sort of problem, we focus on
  cross-industry, cross-country interaction
  effects, following Rajan and Zingales (1998). In
  particular, we test whether entry is relatively
  lower in naturally high entry industries when
  they are in countries with high bureaucratic
  restrictions on entry.

5
Related Literature

• Desai, Gompers, and Lerner (2003) use a
  cross-country approach and find that entry
  regulations have a negative impact on firm entry.
  Their cross-country findings are complementary to
  ours.
• Another related cross-country study is Scarpetta
  et al. (2002), who use firm-level survey data
  from OECD countries to analyze firm entry. They
  find that higher product market and labor
  regulations are negatively correlated with the
  entry of SMEs.
• A paper that is closer in methodology to ours is
  Di Patti and DellAriccia (2004). They examine
  whether entry is higher in informationally opaque
  industries in Italian regions that have a more
  concentrated banking sector (they find it is).
• Bertrand and Kamarz (2002) examine the expansion
  decisions of French retailers following new
  zoning regulations introduced in France. They
  find a strong relation between increases in entry
  deterrence and decreases in employment growth.

6
Data

• Our primary source of firm-level data is the
  Amadeus database with information on gt5 million
  firms in 34 European countries.
• It improves upon previously used datasets in that
  it includes a large number of private firms and
  all industrial sectors.
• The database includes up to 10 years of
  information per company, although coverage varies
  by country.
• Amadeus is especially useful because it covers a
  large fraction of new companies and SMEs across
  all industries.
• The Amadeus database is created by collecting
  standardized data received from 50 vendors across
  Europe. The local source for this data is
  generally the office of the Registrar of
  Companies.
• Focus on limited liability companies for which
  data is complete.
• Final sample of 3,371,073 firms in 21 countries.

7
Entry Variables

• Entry Rates Share of new firms (defined as firms
  of age 1 or 2)
• Calculated by 2-digit NACE industry codes,
  average over 1998-99
• Large variations in the share of new firms across
  countries, varying from a high of 19.2 in
  Lithuania to a low of 3.5 in Italy
• Highest entry in communications, computer
  services, and services, and lowest entry in
  chemicals, construction, and transportation
• EntryUS As a comparison, we calculate 1-year
  entry rates in the U.S. from the DB database of
  over 7 million corporations. Industry-level entry
  rates in the U.S. and Europe are very similar.
• EntCost We use the direct costs of setting up a
  new business as a of per capita GNP (from
  Djankov et al 2002) as a measure of the cost of
  entry regulation. Cost of entry varies from 1 of
  GNP per capita in the UK to a high of 86 in
  Hungary.

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Table 6A Basic Results
9
Interpretation of Basic Results

• The negative coefficient on the interaction term
  means that we find that relative entry into
  industries with high entry in the U.S. is
  disproportionally higher in countries with low
  entry costs. Hence, firms in industries with high
  entry benefit most when moving from a high to a
  low entry cost environment.
• For robustness, we employ a non-parametric
  difference-in-difference estimation strategy to
  investigate whether the effect is generally
  present in all countries and industries. No
  industry or country appear to be driving the
  results.
• Results are robust to the substitution of entry
  rates based on official data from Eurostat,
  which is calculated by EU using confidential
  census data for a sample of 9 EU countries.
• The results are robust to using alternative
  measures of the natural propensity to enter,
  including U.S. exit rates, SME shares, and
  average firm size and scale variables.

10
Causality

• There could be omitted variables that jointly
  drive the propensity to enter and the degree of
  bureaucratic entry barriers but the results hold
  when we instrument entry regulation with legal
  origin.
• Perhaps countries with large high natural entry
  industries have a strong entrepreneurial culture
  and select low entry regulation but the results
  hold when we restrict the sample to industries
  that are relatively small. These industries are
  unlikely to be responsible for entry barriers
  since they have limited political clout.
• Countries with more untrustworthy populations may
  erect higher bureaucratic barriers so as to
  screen would-be entrepreneurs more carefully. If
  such barriers were meant to screen entry
  efficiently, we should expect them to be
  particularly effective in low-income/
  high-corruption countries relative to
  high-income/low-corruption countries. They are
  not. Hence, while the purpose of entry barriers
  in corrupt countries may well be to extract
  bribes and not so much to prevent entry, their
  purpose in less corrupt countries may indeed be
  to protect incumbents.

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Table 7 Selection Issues
12
Are Entry Barriers Socially Harmful or
Beneficial ?

• If entry barriers screen appropriately (public
  interest view), we should find that incumbent
  older firms in naturally high entry industries
  should grow relatively faster in countries with
  high entry regulations. We find the opposite
  (private interest view).
• We find that older firms in naturally high entry
  industries grow relatively more slowly in
  countries with high bureaucratic barriers. This
  is consistent with older firms, who survived
  greater competition in countries with low entry
  barriers, becoming relatively more efficient.
• Example Take high entry barrier Italy and low
  entry barrier UK. Firms start out larger when
  young in Italy, but grow more slowly so that
  firms in the UK are about twice as large by age
  ten.
• Taken together, these results strongly suggest
  that entry regulations are not intended in the
  public interest.

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Table 9 Industry Performance and Firm Age for
Incumbent Firms
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Figure 3 Firm Size and Age
15
Table 11 Other Regulations and the Business
Environment
16
Summary of Results

• We use cross-country, firm-level data to identify
  the impact of regulations on entry with a view to
  determining what motives might prompt such
  regulation.
• We find that
• Entry regulations hamper entry, especially in
  industries that naturally should have high entry.
• The value added by naturally high-entry
  industries grows more slowly in countries with
  high entry barriers. The effect is primarily seen
  for older firms suggesting that entry barriers
  mute the disciplining effect of competition.
• Entry regulations have these adverse effects
  primarily in countries that are more developed
  and less corrupt an interesting example of a
  situation where more advanced countries have
  bad institutions.

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Conclusions

• Taken together, these results suggest that entry
  regulations are neither benign nor welfare
  improving. These regulations seem purposeful
  intended to protect incumbent firms.
• We do not imply all regulations inhibit entry.
  Regulations that enhance the enforcement of
  intellectual property rights or those that lead
  to a better developed financial sector do lead to
  greater entry in industries that do more RD or
  industries that need more external finance.
• The paper suggests competition has disciplinary
  effects that outweigh any possible screening
  benefits from entry restrictions. If so, moves to
  reduce bureaucratic entry regulations will help
  countries. However, the effects in encouraging
  entry will be most pronounced in developed
  countries, where existing entry regulations are
  most effectively enforced.