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 Dell’Ariccia (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 >5 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 D&B 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.

8. 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.

11. 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.

13. Table 9: Industry Performance and Firm Age for Incumbent Firms

14. 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.

17. 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 R&D 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.