Economic Research Forum (ERF)

State-business relations: the impact on firm performance and growth

Resource reallocation from low to high productivity firms can generate large aggregate productivity gains with further potential benefits for growth. This column reports evidence on productivity and resource misallocation in a sample of firms in Egypt, Turkey and Yemen from the World Bank’s Enterprise Surveys. The main focus is on state-business relations and the impact on firm performance and economic growth.

In a nutshell

In an economy characterised by low distortions, productive firms will have access to more resources, including capital and labour, leading to an aggregate increase in the productivity of the sector.

In a representative sample of firms in Egypt, Turkey and Yemen over the period 2008 to 2016, obstacles to effective state-business relations had a large negative association with firms’ productivity.

Policy-makers should focus on reducing political instability and corruption, encouraging female entrepreneurship and targeting support to small to medium-sized firms and to exporters.

An extensive body of economic research documents the importance of total factor productivity (TFP) as a source and main driver of sustained economic growth and development. TFP refers to how efficiently inputs are used in the production process. It greatly differs across countries, but large differences are also present across firms operating in the same or very similar industries within a country.

One of the main explanations for productivity differences is resource misallocation, which can be due to the slow diffusion of best practice and management methods, slow technological diffusion and an absence of innovation generated by investment in research and development.

Policies encouraging investment in technology and innovation, upgrading of learning and skills, but also policies that promote access to the labour market for women and the young have been the focus of a great deal of recent research. Along with these factors, the quality of state-business relations can also be a major determinant of resource reallocation from low to high productivity firms.

Our study explores how obstacles in state-business relations may affect TFP and resource misallocation. The analysis relies on data derived from the World Bank’s Enterprise Surveys over the period 2008-2016 of firms in Egypt, Turkey and Yemen.

Since corruption, political instability, tax rates and access to finance are some of the major factors limiting a firm’s access to resources, it is crucial to explore these state-business relations and their relationship with productivity. This includes favours for certain firms that are large or state-owned in terms of granting additional and unnecessary subsidies for political purposes.

At the same time, young, small and more productive firms may face limitations in terms of capital and finance and they could be ‘taxed’ more than the state firms. In addition, political instability and tax rates may significantly affect firms’ performance. Corruption and regulation distort the allocation of resources from their most efficient use and the most productive firms, especially in lower-income economies.

Our main descriptive statistics reveal large differences between firms in the three countries. Regarding firm size and age, we observe that the averages are very close to all economies, where the average number of employees is 115 and the average age is 21 in Egypt, 138 employees and 24 years in Turkey, while the respective values in Yemen are 17 and 19. Thus, while the average age is similar across countries, the average firm size is significantly lower in Yemen.

There are also significant differences in other characteristics. In particular, while female ownership of firms in Egypt and Yemen is only 7%, the share in Turkey is 30%. This shows that female entrepreneurship is more common in Turkey, while women in Egypt and Yemen have rather fewer opportunities to establish or take part to business activities. It would be useful to explore whether female ownership has a significant relationship with resource misallocation, as it may shed insights on the labour force, ownership structures and the potential role of women in economic growth.

Among Egyptian and Turkish firms, 6% and 4.3% respectively are classified as having foreign ownership, while the share in Yemen is only 1.3%. Only 4.4% and 10% of the sample are accredited with a quality assurance certification respectively in Yemen and Egypt compared with 31.5% in Turkey.

There are also large differences in the firms that are defined as exporters: only 4.9% in Yemen and 7.6% in Egypt, compared with 20% in Turkey. These statistics illustrate the openness of firms, which is significantly higher in Turkey.

It is remarkable that in Egyptian firms, political instability presents the lowest adverse correlation with their allocative efficiency, while the quality of electricity supply and infrastructure seems to be the major constraint in state-business relations. These results may provide valuable insights to public authorities and policy-makers that frequent and long electrical outages may create significant problems in productivity.

Reductions in allocative efficiency in Egypt because of major obstacles in state-business relations range between 2% and 5%. Similarly, in Turkey, the three main obstacles in state-business relations are access to finance, political instability and tax rates. Tax rates and constraints on finance reduce allocative efficiency by 2% and political instability by 4%. In Yemen, electricity and political instability contribute to resource misallocation by 1.3% and corruption by almost 2%.

Unreliable supply of electricity, expressed by numerous, frequent and long electrical outages have a significant negative effect on firm growth. For example, a 2008 World Bank report shows that unreliable, expensive and in some cases unavailable electricity constitutes a major barrier for Kenyan firms.

We have also highlighted the importance of access to finance and credit and its contribution to the firm growth, where small and medium-sized firms have less access to formal sources of external finance compared with large firms. This is explained by the poor structure of the capital markets, characterising these economies, but also due to corruption that commonly large and privileged firms are the favoured, isolating the small firms that are in more need of financing their operations.

As expected, these obstacles significantly reduce the capability of small and medium-sized firms to have access to finance and capital. The issue becomes even more crucial especially when the specific constraints isolate those firms that are more in need, such as the start-ups, which can be productive and become even more productive in the near future. But poor state-business relations may limit or even stop their potentially promising operations.

Political instability is another major constraint on effective state-business relations and thus on allocative efficiency, especially for exporting firms that are more affected during periods of political turmoil. Smaller firms also tend to perceive political instability as a bigger obstacle to their operations and business environment, compared with large firms, because they have less access to finance and capital markets, and also fewer resources to survive during periods of economic recession and political turmoil.

Furthermore, we find that firm size is related to lower allocative efficiency, confirming our argument that these firms have a significantly larger bargaining power, relative to small firms, to influence policy-makers and obtain preferential treatment.

Tax rates are also an important factor of allocative efficiency, and a major obstacle to the business environment. This is especially the case for small firms having low access to capital and financial markets: because of higher rates, they are unable to hire high-skilled employees and embed high-technology capital, resulting in productivity reduction.

Tax-related compliance costs add significantly to the tax burden that firms face and these are particularly high for the small and young firms. A high tax corporate rate implies a high compliance burden, diverting resources from productive activities, such as investment in physical capital and productivity-enhancing innovations. The result is an increasing rate in the costs of input factors accompanied by a trivial additional production output or creating a low quality output, leading to a decline in firm productivity and allocative efficiency.

In the case of Egypt and Turkey we find that firm age has a negative effect on allocative efficiency. Firms with at least one female employer, with foreign ownership and having been accredited with an international certification of quality assurance have higher levels of allocative efficiency. On other hand, in Yemen, we find a negative impact of female ownership on allocative efficiency, while foreign ownership and international certification of quality assurance have no effect.

Overall, our findings show that severe and major obstacles related to specific state-business relations – expressed by access to finance, political instability, electricity, corruption and tax rates – are negatively associated with the productivity and allocative efficiency in a sample of firms in Egypt, Turkey and Yemen.

These findings indicate the need for policy-makers to provide a reliable infrastructure of electricity and transport supply. Furthermore, they should give incentives in terms of lower tax rates or favourable tax credits to firms that are highly productive, such as firms with high-skilled employees and technology, and those using energy efficient resources. First and foremost, policy-makers should shield the economy against corruption and destabilising political events.

Further reading

Giovanis, E, and O Ozdamar (2018) ‘Productivity and Resource Misallocation: Evidence from Firms in Middle East and North Africa (MENA) Region Countries’, ERF Working Paper, forthcoming.

World Bank (2008) ‘Kenya: Accelerating and Sustaining Inclusive Growth’, Report No. 42844-KE.

Acknowledgment

The authors gratefully acknowledge financial support from the Economic Research Forum (ERF) under the project ‘Structural Change, Resource Misallocation and Growth Dynamics in the MENA Region’. The views expressed in this paper are those of the authors and do not necessarily represent those of the ERF.

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