Enabling the Private Sector to Become Self-Financing
This post, authored by William M Butterfield, the Entrepreneurial Environment Team Leader in the Center for Economics and Market Development at USAID in Washington, is the second in a series of blogs about USAID’s Economic Growth Policy.
USAID Economic Growth Policy Principle #1
In my previous post covering USAID’s Economic Growth (EG) Policy Framework, I highlighted the elevated importance USAID is placing on market systems based approaches to inclusive, sustained, and resilient economic growth in the countries where we work. Once we better understand local market systems through economic analysis, we can target our assistance and apply the six principles for effective programming outlined in the EG Policy (see figure) in order to increase our impact. We chose the first principle, enabling partners to become self-financing, because enabling enterprises, the public sector, and civil society to increasingly access their own sources of finance and revenue is central to the enterprise-driven development approach. In this post, I cover three key things to keep in mind when programming to support this goal, specifically as it relates to the private sector.
1. Competition and Commercialization are Critical for Market Systems
When markets are working efficiently, they should not require public subsidies. However, market failures and ineffective governance in almost all of our host countries can hamper growth. Investment decisions depend on incentives generated in part on the belief that complementary investments, both private and public, will be made in the market system. It is important to remember that supporting the market entry of new firms and market exit of firms with low productivity is often just as important for market development as supporting existing firms to grow.
One of the largest issues in developing countries is informality - of both firms and employment. Informality is mainly driven by a lack of more productive firms and job opportunities - informal firms serve mainly as disguised unemployment or subsistence entrepreneurship. Rather than focus on firm formalization directly, donor activities should focus on growing more productive formal firms and jobs where possible, to absorb labor from the informal sector.
Based on evidence, only a very small number of transformational small and medium-size enterprises (SMEs) grow rapidly and increase financial resources within the economy. For these high growth potential formal firms, many could have opportunities to expand their market reach. However, they lack information on how to increase productivity and sales. Access to improved management technologies, for example, has been shown to be effective at improving firm performance. Programming that seeks to expand the market for business development services (BDS) should focus on increasing commercialization and competition - building firm-level trust in local consultants, perhaps through quality certification and demonstration of results.
2. Enabling Environment Constraints Limit Firm Entry and Market Competition
The ability of private sector actors to become self-financing through increasingly competitive markets depends significantly on the regulatory environment for doing business. The average burden of compliance--such as the complexity, time and cost of undertaking regulatory processes, as captured by the World Bank’s Doing Business index--does not always impose similar costs across all businesses in a country. For one, there are marked differences in the business environment across localities within a single country. Perhaps more important is the disparate impact of these procedures on different classes of businesses. Larger, well-established firms tend to be better at navigating and side-stepping onerous business regulations, while newer, smaller firms and potential market entrants suffer the most, directly limiting market competition. USAID programs should therefore focus on improving the enabling conditions that more directly affect market competition; not only the issues certain existing firms tend to complain about.
Ultimately, governments need to rely on the private sector to generate a majority of tax revenues. Simplifying the process for paying taxes is therefore critical to reducing costs and increasing incentives for firm-level compliance and formalization. Digitizing tax registration, filing and payment curbs opportunities for corruption, thus reducing costs to businesses, and may further promote firm entry and formalization. USAID’s Collecting Taxes Database measures 20 indicators across 200 countries and is a useful starting point for programs that seek to increase tax revenue.
3. Investment Climate and Transaction Support are Key to Mobilizing Private Investment
Private capital now accounts for about 90 percent of financial flows to developing countries, while foreign assistance has declined by almost half as a share of developing-country Gross Domestic Product (GDP) since 2006. Yet foreign direct investment in low and lower-middle income countries, while already low, has taken an enormous hit as a result of the COVID-19 pandemic. Most of the constraints to increased private investment fall on the project supply side, not from a lack of demand or available capital. Despite trillions of dollars in private capital and sovereign wealth funds, “regulation, risks and cross-border investment rules often limit investor appetite for infrastructure projects” in developing countries.
Working with the U.S. International Development Finance Corporation where possible, USAID can provide transaction support to connect investors to opportunities, promote policy and regulatory reforms, and work with multilateral development banks to enhance credit systems and reduce financial risks. These efforts may include supporting the commercialization of business incubators and accelerators that provide essential technical assistance to start-up and early-stage enterprises.
Focusing on competition, enabling environment limitations, and investment climate helps partner countries get at the root constraints to growth. How are you addressing these issues? We’re interested to hear from you about how USAID programming can enable market development that is commercially viable and competitive so that the private sector can generate increasing resources within the market system. Stay tuned for the next blog which will cover the second USAID’s Economic Growth Policy principle for effective programming: prioritizing inclusion, sustainability, and resilience.