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2.2.1. Regulatory Components

Introduction

The regulatory environment influences the choices investors and entrepreneurs make in locating, operating and expanding their businesses. Businesses’ ability to access credit, enforce contracts, buy property, process goods through customs, pay taxes and conduct other everyday activities efficiently depends on a business environment that protects property rights without unnecessarily burdensome or inappropriate regulations. Poor economic policies and onerous regulations can hinder economic growth even when a country makes significant progress on other development fronts. The various components of the regulatory environment are briefly discussed below.

Business Registration

The complexity of business registration varies widely across countries, but three core functions are common to all: (1) checking for uniqueness of a business name, (2) inscription in a public commercial registry, and (3) registration with tax authorities. Richer countries tend to regulate less and instead rely on a firmly established legal system to govern business behavior. Other countries carry out significant ex ante screening of businesses—perhaps because of mistrust of the private sector, perhaps because of the heritage of a command economy. Legal tradition—common law or civil law—also affects which players are involved in business start-up and the level of complexity of the process. Businesses often have to visit the same institution on multiple occasions and comply with procedures in series rather than in parallel. Complexity ranges from the simple requirement of the three core functions to a long list of overlapping obligations and requirements. Most countries go well beyond the three core functions: Doing Business documents countries that require up to 17 procedures, entailing substantial costs.[1]

Efficient business registration is important from an economy-wide perspective. The establishment of a legal entity makes business ventures less risky and increases their longevity and chances of success in several ways:[2]

Successful legal entities tend to outlive their founders and can continue to contribute to the economy over generations—without each generation having to build (a capital stock, for example) from scratch.

  • Resources come together as shareholders join forces in establishing a company’s capital and capabilities.
  • Limited liability reduces the risks of doing business by giving companies and individuals the freedom to innovate and experiment without large negative consequences. They may undertake experiments that the state might not deem prudent.
  • Registered businesses have access to services (provided by public courts or private commercial banks, for example) not available to unregistered businesses.

Licensing

Business licensing is a prominent barrier to doing business in many countries. Relatively few regulatory reform programs have focused specifically on business licensing, so empirical evidence of licensing reform’s benefits remains sparse. However, the evidence is clear that over-regulation and red tape are associated with lower levels of income and productivity, and higher levels of informality and corruption. As licensing is a key potential bottleneck in the business start-up process, the gains from licensing reform stand to be significant.[3]

In good business licensing regimes, licensing is a means to fulfill legitimate regulatory purposes. These include protection of public health and safety, environmental protection, national security and allocation of scarce resources. Licenses should not be used to manage competition in the economy or to generate revenue—these regulatory objectives are more efficiently addressed through competition and tax policy. Well-functioning licensing regimes usually rest on framework laws or other high-level legal instruments. Such instruments guard against constant and unjustified changes in the regulatory environment. The instruments typically specify the activities that shall be subject to licensing and the criteria for acquiring the licenses. Other features of sound licensing regimes include clear appeals procedures and validity of the licenses across sub-national jurisdictions. “Silence is consent” rules, which make licensure automatic when applications are not reviewed within predetermined time periods, are also often desirable. [4]

Labor Regulations

Every country in the world has established a complex system of laws and institutions intended to protect the interests of workers and to help ensure a minimum standard of living for its population. In most countries, in addition to some basic civil rights protections, this system encompasses three bodies of law: employment law, collective relations law, and social security law. Employment laws govern the individual employment contract. Collective or industrial relations laws regulate the bargaining, adoption and enforcement of collective agreements, the organization of trade unions and the industrial action by workers and employers. Social security laws govern the social response to needs and conditions that have a significant impact on the quality of life, such as old age, disability, death, sickness and unemployment.[5]

Regulation of labor markets aiming to protect workers from employers takes four forms. First, governments forbid discrimination in the labor market and endow workers with some “basic rights” in on-going employment relationships, such as maternity leave or the minimum wage. Second, governments regulate employment relationships by, for example restricting the range of feasible contracts and raising the costs of both laying off workers and increasing hours of work. Third, in response to the power of employers against workers, governments empower labor unions to represent workers collectively, and protect particular union strategies in negotiations with employers. Finally, governments themselves provide social insurance against unemployment, old age, disability, sickness or death.[6]

Property Registration

Land and buildings account for between half and three-quarters of a country's wealth in most economies. With formal property titles, entrepreneurs can obtain mortgages on their homes or land to start or expand businesses. Banks prefer land and buildings as collateral since they are difficult to move or hide. However, a large proportion of property in developing countries is not formally registered. Peruvian economist Hernando de Soto estimates the value of unregistered property at $9.3 trillion, calling it “dead capital.”[7] Although governments have embarked on extensive property titling programs in developing countries, many have proved futile (particularly in Africa) because people continue to buy and sell property informally—neglecting to update the title records in the property registry. Worse, property registries are so poorly organized that they provide little security of ownership. For both reasons, formalized titles quickly become informal again. Even if titles remain formal, they have little value when the government controls property prices and restricts the ability to trade property. Property markets will not function effectively if regulations restrict investment from being channeled to its most productive use, and titles will not increase the availability of credit if collateral laws make it expensive to mortgage property and inefficient courts prevent banks from seizing collateral when a debtor defaults. Not surprisingly, some studies document cases where titling has failed to result in expected increases in investment or income. Efficient property registration reduces transaction costs and improves the security of property rights. This benefits all businesses, especially small-scale entrepreneurs. Wealthy business owners have few problems protecting their property rights: They can afford the costs of investing in security systems and other measures to defend their property. Small-scale entrepreneurs cannot. Property registration reform can help change this. Improving the security of property rights in Peru was shown to increase productive activities. Across countries, firms of all sizes report that their property rights are better protected in countries with more efficient property registration, but the relationship is much stronger for small firms.[8]

Credit Regulations

In most countries, banks will not extend credit without assurances that borrowers are creditworthy and that it will be possible to recover the debt if there is a default. As a consequence, entrepreneurs with promising business opportunities cannot obtain loans if the bank does not have enough information on the value of the property and the credit history of the borrower—and if the legal system does not protect creditors. Two types of institutions expand access to credit and improve its allocation: credit information registries or bureaus, and creditor rights in the country’s secured-transactions and bankruptcy laws. They operate best together—information sharing allows creditors to distinguish good clients from bad, while legal rights to enforce claims help in the event of default. Sometimes, information-sharing mechanisms remedy poor legal protection. Good credit institutions define property rights for both creditors and debtors. Collateral and insolvency regulations define the rights of creditors to recover their loans. In addition, collateral regulation helps debtors by extending the right of property title to the right to use property as security for finance. Information-sharing institutions, on the other hand, enable debtors to build reputational collateral.[9]

Governments can help creditors believe they will be repaid by establishing appropriate regulations for the operation of private credit bureaus. Removing legal restrictions to exchanging credit information, unambiguous endorsement of credit bureaus by central banks, and well-designed consumer protection and privacy laws will create incentives for the sharing and proper use of good quality credit information. In developing countries where commercial incentives for private bureaus are low, establishing public credit registries can help compensate for the lack of private credit bureaus or can complement private bureaus by focusing on banking supervision. Legal creditor protections can be improved by reforming collateral law: introducing summary enforcement proceedings, eliminating restrictions on which assets may be used as security for loans, and improving the clarity of creditors’ liens through collateral registries and clear laws on who has priority in a disputed claim to collateral. More-efficient courts are crucial for the legal protections to take effect. Reforms of insolvency laws are also sometimes necessary. [10]

Corporate Governance

Recent corporate governance scandals in the United States and Europe—some of which have triggered the largest insolvencies in history—have caused a crisis of confidence in the corporate sector. As a result, corporate governance has entered the vocabulary not only of financial economists but also of day traders, pension fund beneficiaries, employees of all ranks, chief executive officers and prime ministers. During the wave of financial crises of 1997–98 in Asia, Russia and Latin America, the behavior of the corporate sector affected entire economies. Deficiencies in corporate governance endangered the stability of the global financial system. Improving corporate governance is now recognized in most countries and policy circles to have first-order macroeconomic consequences and has become a mainstream concern.[11]

Corporate governance codes are essential tools for enhancing corporate governance practices at the national level. Their primary role is to raise standards and to drive reform efforts. Many developed and developing countries have adopted corporate governance codes of best practice to restore and sustain investor confidence in the wake of a financial crisis or corporate scandals. However corporate governance codes also serve as benchmarks for monitoring and implementing corporate practices and policies at the company level.[12]

Tax Administration

A cumbersome tax system, both in terms of policy and administration, is considered to be one of the main reasons businesses operate in the informal economy. Tax compliance costs are often regressive and put a disproportional burden on small businesses. Nevertheless non-compliance is not a free option for MSEs. It entails substantial costs, which result from expenditures (e.g., bribes) required to avoid penalties and forced registration, and from the lack of services and business development opportunities, such as access to credit, public-sector contracts and publicity programs to promote the small business. While the impact of non-compliance on the overall tax yield might be negligible, it seriously affects the equity of the tax system and increases the tax burden (and reduces the competitiveness) of compliant, registered businesses. Finally, strengthening government accountability requires broadening of the tax net.[13]

Trade Facilitation

Customs reform and trade facilitation programs are critically important if countries are to reduce trade transaction costs and enhance international competitiveness. With total trade transaction costs estimated in the range of 10-15 percent of the total value of world trade, and customs compliance costs likely to be 5-7 percent of that sum, programs that reduce such costs by even 1-2 percent can have a huge positive impact on world trade and economic growth.[14] When reforming customs and introducing trade facilitation measures, it is essential to ensure from the outset that every effort is made to: minimize the incidence of customs interventions; simplify and streamline the complexity of data and documentary requirements, work and paper flows, procedures, processes and controls; and propose reforms that are in full compliance with international customs conventions, recommended practices and agreed standards. Only when this has been completed, should information and telecommunications systems and solutions be applied to support these customs reforms and trade facilitation efforts.[15]

Contract Enforcement

Courts have four important functions. They encourage new business relationships, because partners do not fear being cheated. They generate confidence in more complex business transactions by clarifying threat points in the contract and enforcing such threats in the event of default. They enable more sophisticated goods and services to be rendered by encouraging asset-specific investments in their production. In addition, they serve a social objective by limiting injustice and securing social peace. Without courts, commercial disputes often end up in feuds, to the detriment of everyone involved. Companies that have little or no access to courts must rely on other mechanisms, both formal and informal—such as trade associations, social networks, credit bureaus and private information channels— to decide with whom to do business. Companies may also adopt conservative business practices and deal only with repeat customers. Transactions are then structured to forestall disputes. Whatever alternative is chosen, economic and social value may be lost.[16]

Four types of contract enforcement reform have proven successful:

  • Establishing information systems on caseload and judicial statistics has delivered a large payoff. Judiciaries with such systems can identify their primary users and the biggest bottlenecks.
  • Taking out of the courts transactions that are not disputes—such as the registration of new business entities—can free up resources for commercial litigation. Because such reform may require new laws, governments can in the meantime reorganize the workflow in the courts so that clerks, not judges, are responsible for company registration.
  • Simplifying procedures is often warranted for commercial disputes, especially in developing countries.
  • Modifying the structure of the judiciary may allow for small-claims courts and specialized commercial courts.[17]

Alternative Dispute Resolution

The main idea behind mediation projects is not only to provide alternatives to litigation but to modify the whole dispute resolution system, including litigation, to make it more suitable for parties in commercial disputes. Introducing mediation or arbitration is one way of making the system more appropriate for end-users. Mediation and other alternative dispute resolution methods are not alternatives to the formal justice system in the sense that they aim to replace it. Their goal is to complement the scope of court procedures so that the parties can choose between these processes. However, this choice does not have to be exclusive. In many cases, parties may choose mediation along with litigation or arbitration and conduct them in parallel, until they settle, withdraw or obtain a court decision or arbitration award. Moreover, litigation is and must remain a crucial part of the dispute resolution system in any country. Litigation is particularly vital for the existence of mediation and other non-binding processes because one of the stronger incentives to mediate is often to avoid adjudication.[18]

Bankruptcy

The fundamental goal of bankruptcy law is two-fold: first, to allow for both the fair and efficient dissolution of businesses that are not viable and, second, for those businesses that have a chance at achieving viability, the opportunity to extend, reduce or wipe out debt and protect themselves from pursuit by creditors. A modern, credit-based economy requires predictable, transparent and affordable methods of enforcing debt collection. Although bankruptcy law – also known as the "law of insolvency" – tends to attract interest mainly when enterprises face difficult times or even certain failure, the very existence of a clear and enforceable bankruptcy law plays an important role in fostering economic growth. Insolvency systems provide a pre-determined set of rules concerned with the legal definition of insolvency, the liquidation or reorganization of the insolvent business, and the allocation of the financial consequences between stakeholders. In theory, this allows for efficient reallocation of the debtor’s resources, which itself leads to greater public confidence in the security of their investments. In the absence of such a scheme, large, insolvent companies may persist in draining public resources at the expense of developing potentially productive enterprises; or insiders may unfairly drain the assets of the company while other legitimate creditors are denied access to the payments they are owed. Conditions such as these necessarily discourage foreign direct investment.[19]

Competition Policy

The fundamental goal of competition law is to foster a culture of competition that ultimately benefits consumers through better quality, service and pricing for good and services. Competition law provides a regulatory framework to maintain and improve efficiency in markets, promote competitive pricing practices and restrain price rises in markets. Competition law by itself does not create competition, but when effectively applied, can counteract the dangers of private anticompetitive behavior. For example, cartels may deliberately create artificial shortages, with the result that some consumers are able to obtain the product while other consumers pay an inflated, or monopoly, price. Dominant firms may abuse their market power through such means as mandating the purchase of additional products without a legitimate business purpose. Entry of new participants may be blocked by firms with market power that erect protectionist barriers.[20]

Inspections

There is little international consensus on inspection best practices, but a growing body of recommendations, case studies and research is documenting poor practices and clarifying good practices. There is now a better sense of what “quality” means for an inspection system. Based on a review of good inspection practices and reforms, quality inspection systems:

  • Maximize compliance with clear and legitimate government regulations by detecting and deterring non-compliance consistently and fairly;
  • Minimize uncertainty and regulatory risks for businesses by operating transparently and under the rule of law;
  • Fight corruption by reducing the opportunity for abuse of discretionary powers; and
  • Minimize costs to businesses and optimize costs to governments by using resources efficiently to target the highest risks.

In the difficult legal, institutional and financial environments that are characteristic of transitional and developing countries, the inspection function is highly vulnerable to inefficiency, abuse and under-budgeting. The challenge in addressing these kinds of problems is not faced by inspectorates alone, because they cannot operate in isolation from the institutions of governance around them. Sustainable reform also requires the consolidation of the rule of law throughout national governing structures.[21]

Resources

Footnotes

  1. Source: World Bank Group, Reforming Business Registration Regulatory Procedures at the National Level, 2006
  2. Source: World Bank, Doing Business in 2004
  3. Source: World Bank Group, Business Licensing Reform: A Toolkit for Development Practitioners, 2006
  4. Ibid
  5. Source: Juan C. Botero, Simeon Djankov, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer, The Regulation of Labor, 2004
  6. Ibid
  7. Source: Hernando de Soto. The Mystery of Capital. Basic Books. 2000.
  8. Source: World Bank, Doing Business in 2005: Removing Obstacles to Growth
  9. Source: World Bank, Doing Business in 2004
  10. Ibid
  11. Source: World Bank Group, Developing Corporate Governance Codes of Best Practice: User Guide, 2005
  12. Ibid
  13. Source: World Bank Group, Tax Administrations and Small and Medium Enterprises (SMEs) in Developing Countries, 2005
  14. Source: World Bank Group, Reforming the Regulatory Procedures for Import and Export: Guide for Practitioners, 2006
  15. Ibid
  16. Source: World Bank, Doing Business in 2004: Understanding Regulation
  17. Ibid
  18. Source: World Bank Group, Alternative Dispute Resolution Manual: Implementing Commercial Mediation, 2006
  19. Source: USAID, Commercial Law and Microeconomic Reform: A Practical Guide to Program Implementation, 2007
  20. Source: USAID, Commercial Law and Microeconomic Reform: A Practical Guide to Program Implementation, 2007
  21. Source: World Bank Group, Good Practices for Business Inspections: Guidelines for Reformers, 2006