Lahore School of Economics

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The Role of the Firm

Eric Manes*

1.        Introduction

This chapter on the Pakistani firm describes the microeconomic factors underpinning economic growth and wealth creation, focusing on enterprise-level analysis. Notwithstanding the key role of the firm highlighted in the chapter, data at the firm level is difficult to obtain and even more problematic to analyze. While the statistical issues associated with enterprise-level analysis in Pakistan are beyond the scope of this chapter, it is important to note up front the various limitations of the firm-level data available and the caveats stemming from firm-level analysis.
The Census of Establishments for 2005–07 (Pakistan Bureau of Statistics, 2007), gives a relatively clear picture of the family of Pakistani firms: many small, locally focused firms exhibiting varying degrees of formality and market participation, coexisting with relatively few, large formal firms (often multi-product conglomerates that account for the bulk of production, exports, and higher-wage employment). Only 5 percent of a total of almost 3 million establishments surveyed employed more than five persons at that time. In manufacturing, the figure is similar at 91 percent of the half-million firms surveyed, with only 1,100 of these establishments reporting employment of over 50 workers.[1]

Pakistan’s enterprise sector is seen though the duality described above: a set of firms that operate either fully outside the formal market, institutions, and government, or that employ a subset of informal practices and participate in government revenue collection efforts only if necessary. Finally, there remain those firms that are responsible for the country’s economic activity; these firms are few but in Pakistani terms can be quite large.
Two other comprehensive surveys sponsored by the World Bank have attempted to characterize Pakistan’s enterprise sector, and draw generalizations about the Pakistani firm in 2002 and again in 2007. Another survey of firm-level perceptions of the principal obstacles they faced was carried out in 2013. For the purposes of this chapter, the World Bank’s enterprise surveys in 2002 and 2007 are the primary sources of information, along with the International Finance Corporation’s Doing Business (DB) database. Although five years have passed since the last survey, its conclusions are representative of the structural relationships prior to the financial crises and political instability that characterize this period.

2.        The Role of the Firm in Moving the Economy Forward

Since Solow’s seminal work on growth decomposition, the concept of productivity—the idea of producing more with less—has been the key link between the performance of firms, economic growth, and a country’s potential for providing improved welfare to its population. As productivity drivers are organized at the firm level, the firm represents a critical “private sector institution” responsible for driving innovation, employment, and growth in the economy that Pakistan requires if it is to move forward in the 21st century.
This critical role played by the firm in the development process is seen through the decomposition of the microeconomic identity that underpins the growth of income per capita at the macroeconomic level—a key indicator of economic welfare and one of Pakistan’s specific development goals for the near term. Specifically, the identity in Figure 16.1 shows that income per capita is a function of nonindependent social, demographic, and economic forces.
Figure 16.1: Microeconomic underpinnings of income growth
GDP per capita
Labor productivity
Labor force participation
Age composition of population

Labor force
Population aged
Total population

Labor force

Population aged 15–64

In the identity, income per capita is a function of (i) labor productivity, (ii) labor force participation, and (iii) the share of labor force share in the total population. Further decomposing the “economic term”—labor productivity—into changes in capital deepening (the capital–labor ratio) and gains in total factor productivity (TFP) demonstrates the critical role of TFP in one of the key development objectives: growth in GDP per capita.[2]
As more people reach working age and a greater number of those begin to participate actively in the labor force, GDP per capita will increase as long as capital deepening persists through investment[3] and/or a concomitant rise in TFP. Thus, in the short run, with population dynamics and labor force participation (given certain parameters),[4] policymakers’ central focus in growth-starved countries around the world is the role of the firm in achieving the virtuous circles of higher TFP leading to more investment, capital deepening, higher labor productivity, better wages, and growing income per capita.
For Pakistan, which faces both an increase in working-age population (the so-called “demographic bulge”) along with higher labor force participation (in large part, female), labor productivity has grown slower than in the rest of South Asia and particularly East Asia (Figure 16.2). Moreover, despite a relative high during the 2000s—particularly in the boom years prior to 2009—the lower capital intensity of growth was due to a rapid increase in labor participation, particularly among female workers.

Figure 16.2: Labor productivity growth decomposition in selected economies, 2001–06
Text Box: Percentage growth 2001/06

Source: World Bank (2006).
Importantly, however, while not in the same range of productivity as the East Asian countries, growth in TFP in Pakistan was comparable to other South Asian countries, though slightly lower than the average, owing to India’s high TFP growth over the period (Figure 16.3). Indeed, like most countries, “factor accumulation”—increased labor participation and investment—has been the primary source of growth in Pakistan over the past five decades, although the country’s growth spurts coincided with periods of higher productivity, particularly in the 1980s and 2000s. The most recent example of TFP-led growth was 2002–06 when it accounted for a quarter of the period’s growth rates (Figure 16.3).
Figure 16.3: Growth accounting, 1960–2005 (by year and country)
Source: World Bank (2006).
Currently, there are real binding limits to factor-driven growth in Pakistan, given its high labor participation rates and poor investment climate. Thus, sustained growth in Pakistan, as elsewhere, relies on initiating a virtuous cycle of rising firm-level growth of TFP accompanied by investment deployment directed to productive firms. Yet, as shown consistently throughout the world, unless the process is launched through the efficiency signal generated by firm-level productivity growth, investment is often misdirected to loss-making activities. Indeed, in Pakistan, the period of high growth coincided with macro-stability, microeconomic reforms, and political certainty.

3.        Firm-Level Productivity and the Business Environment

Moving the economy forward, therefore, requires catalytic forces to jump-start firm-level productivity growth in the hope of launching a virtuous circle of efficiency improvement, productive investment, and organic growth by private sector firms in competitive markets. An analysis of the sources of these microeconomic foundations focuses on the collective set of amorphous institutions: (i) factor markets, involving capital, labor, and land; (ii) product markets, involving frictions in markets for domestic and international goods; and (iii) the government–business interface, involving public infrastructure, market regulation, and the provision of various public services. In recent years, considerable attention has been given to the role of (iv) innovation, competition, and industrial organization (entry and exit) in firm-level productivity.
These forces are captured in a summary concept called the business environment or investment climate, which can be growth-enhancing or, indeed, growth-retarding. An accommodating business environment encourages efficient operation and strengthens innovation and productivity. A poor business environment amplifies or even creates obstacles to conducting business activities. TFP is central to both outcomes and is influenced by a series of factors—often considered the elements of the business environment—each with policy playing a central role in determining whether the element facilitates or hinders productivity. Recent research attributes 17 percent of the difference in aggregate productivity across firms in Pakistan to differences in the investment climate they face (see World Bank, 2009).
In gauging a complex and dynamic business environment subject to many exogenous and endogenous forces, it is practically impossible for one static indicator to capture the nature of business for a country, particularly one as dynamic, complex, and geographically diverse as Pakistan. Still, in order to set the scene for the discussion, it is instructive to understand what the incumbent Pakistani firm views as constraints to the business environment, and how they are ranked over the period 2000–13. During this period, three surveys of Pakistani enterprises were undertaken using a similar survey instrument and covering what Pakistani firms perceived as being the most significant constraints to the business environment. However, analyzing the various elements of the business environment needs numerous perspectives because the forces are, in themselves, not only difficult to observe, but also dynamic.

4.        The Business Environment: The View of the Firm

Scaling up from a low level of equilibrium requires collective action. In most cases, due to the well-known “free rider” problem that prevents it from emerging on a private basis, collective action is effectively provided by the public sector—nationally, regionally, or locally, depending on the issue and the country. Such critical areas requiring collective action, which would allow economy-wide efficiencies through network effects (courts, regulation, functioning markets), may be undervalued in the face of individual inability to cope with the deficiencies of the investment climate.
This is particularly so when the public sector’s failure to provide public goods—such as those requiring collective action—causes the economy to adjust to second- or third-best solutions.[5] By understanding the problems the private sector faces, the authorities send critical signals to the business community that things will improve rather than deteriorate. Such activity is a key part of an overall push to spur reform, particularly when it is not obvious where public actions are needed first and where public–private partnerships can play a role.

4.1.      Firms’ Perceptions of Obstacles Around the Globe

The World Bank’s enterprise surveys have polled firms around the world in a methodologically consistent way to enable the best possible comparisons of opaque and diverse areas. The surveys are conducted by the World Bank and its partners across all geographic regions and cover small, medium, and large companies. They are administered to a representative sample of firms in the nonagricultural, formal private economy. The sample is consistently defined in all countries and includes the entire manufacturing sector, the services sector, and the transport and construction sectors. Public utilities, government services, healthcare, and financial services are not part of the sample. The enterprise surveys collect a wide array of qualitative and quantitative information through vis-à-vis interviews with firm managers and owners regarding the business environment in their countries and the productivity of their firms.
As it turns out, global and regional firm-level perceptions differ from one another but center around a few areas (see Figure 16.4). In South Asia, Africa, the Middle East and North Africa, concerns about power dominate incumbent firms’ perceptions of the investment climate. In Eastern Europe and the OECD countries, other issues matter more. Abstracting from the acute issue of power in less developed countries, key global issues from the private sector’s perspective involve finance, education, informality, and tax rates. Political stability is also a concern almost everywhere, while in the more advanced countries, formal governance institutions responsible for tax administration and the courts are also a concern (though not as much in less mature markets). Issues such as corruption, land, labor, and transport are notable perhaps for the lack of concern they elicit around the world.

Figure 16.4: Firms’ perceptions of obstacles around the world
Text Box: ElectricityText Box: FinanceText Box: PoliticsText Box: LandText Box: CrimeText Box: CorruptionText Box: Tax RatesText Box: InformalityText Box: EducationText Box: Labor RegsText Box: Tax AdminText Box: TransportText Box: LicensesText Box: CustomsText Box: Courts

Text Box: ElectricityText Box: FinanceText Box: PoliticsText Box: LandText Box: CrimeText Box: CorruptionText Box: Tax RatesText Box: InformalityText Box: EducationText Box: Labor RegsText Box: Tax AdminText Box: TransportText Box: LicensesText Box: CustomsText Box: Courts

Source: World Bank, enterprise surveys (various years).
In Pakistan, incumbent managers and entrepreneurs were interviewed three times during 2002–13 on hindrances in the investment climate (see Figure 16.5). The responses were instructive, reflecting the economic issues of the day. Moreover, taking the collective pulse of the business community on a regular basis allowed policymakers to see how views had shifted during the decade, providing insights into the dynamic forces on the ground.

Figure 16.5: Major obstacles cited by Pakistani firms
(percentage of respondent firms)

Text Box: ElectricityText Box: CorruptionText Box: Macro instabilityText Box: Political instabilityText Box: Tax ratesText Box: Crime, theft, disorderText Box: Access to landText Box: Tax administrationText Box: Access to financeText Box: Licensing and permitsText Box: TransportText Box: Anti-competitive
Text Box:  Skill availabilityText Box: TelecomText Box: Labor regulationsText Box: Customs and  Trade

Source: World Bank (2009).

4.2.      In Pakistan: Solid and Shifting Perceptions

The surveys’ results for the period 2002–07 show that firms responded to first-level reforms to remove red tape and lower the cost of doing business during the first part of the 2000s in areas where the government had devoted resources and policy attention. The major improvements they perceived were in finance, tax administration, anti-competitive practices, labor regulations, and customs and trade regulations (Table 16.1). Issues that were perceived to be the top constraints in 2002 became less important, however, in the face of rising concerns about governance-related issues, such as political instability, macro-management, corruption, and law and order, which had worsened considerably.

4.3.      Energy: The South Asia Constant

Electricity, which represented an important area of deterioration in governance, dominated the business community’s concerns in 2007—more than 80 percent of firms identified it as a problem, i.e., double the proportion just five years earlier. Clearly, compared to firms worldwide, Pakistan’s energy problem is one of the most serious operating issues and the most obvious case of public sector failure to provide an appropriate business environment.

Table 16.1: Major obstacles cited by firm (%)

 Political instability
 Crime, theft, disorder

 Tax administration
 Access to finance
 Anti-competitive practices
 Labor regulations
 Customs regulations
Source: World Bank (2009).
The enterprise surveys show that Pakistan’s problem—though severe even in 2007—was not out of line with other South Asian countries (Table 16.2). Firms around the world averaged seven outages per month; firms in South Asia experienced an outage at least once a day and lost more than double the amount of sales. Although the problem in other parts of South Asia was as severe in terms of outages, the number of firms identifying electricity as a constraint is much lower outside of Pakistan, and not far below the mean for the entire world.
Table 16.2: Electricity: The Achilles’ heel of the investment climate

South Asia
No. of electrical outages per month
Losses due to electrical outages (percent of sales)
For those with outage losses due to electrical outages (percent of sales)
Firms owning or sharing a generator (%)
Share of electricity from a generator (%)
For those with generators, share of electricity from a generator (%)
Days to obtain an electrical connection
Firms identifying electricity as a constraint (%)
Source: World Bank enterprise surveys (various years).

4.4.      Idiosyncratic Issues in Pakistan

However, there are two large differences between Pakistan and its South Asian counterparts. The first is the time required to acquire a connection from the electrical company. More telling, however, is Pakistan’s clear inability to cope with the severe deficiencies of the investment climate—in this case, the provision of electricity—as compared with its regional counterparts. Far fewer Pakistani firms rely on electricity from their own generators; those who do—getting almost a third of their electricity from this source—are only able to make up a small percentage of the energy deficit (less than the world average). As is the case for other public services, it is possible for firms to cope with the deficiencies of the investment climate where electricity is concerned but at a cost that many in Pakistan cannot afford.
In 2010, firms were asked to identify “the most important obstacle” rather than a list of major obstacles”; the results showed that the energy crisis—already a desperate concern—had actually worsened in 2010, surpassing all other concerns as the most important problem. In 2007, three quarters of the firms surveyed had cited electricity as a major problem, but less than half had considered it the top problem (Table 16.3). This had changed by 2010 when two thirds of Pakistani firms considered it the most critical problem compared to less than a third in South Asia as a whole.
Table 16.3: Share of firms ranking obstacles as a major problem (share of total)

South Asia
Political instability
Crime, theft, and disorder
Access to finance
Access to land
Informal practices
Licensing and permits
Customs and trade
Inadequate education
Tax rates
Labor regulations
Tax administration
Source: World Bank Group, Enterprise Note 27, J. S. Yang, (2011).
Apart from the overwhelming predominance of the energy sector in the investment climate during 2007–10, major political concerns appeared to overshadow economic issues in the private sector’s view. Even concerns about corruption seemed to dissipate in the face of political events. It is important to note, however, that this does not mean that concerns about political corruption had fallen but that small-time business corruption of the traditional variety was being replaced by political instability concerns. So it is not a surprise to see the concern about corruption fall along with that of tax rates and other concerns while electricity and political stability take the lead role as concerns regarding the business environment.

5.        The Role of the Business Environment: Empirical Evidence

Gauging the role of the business environment based largely on the views of the incumbent business community can, however, bias the overall perception in several important ways. First, productivity gains are seen myopically and, therefore, cost reductions are valued over other types of improvements, such as those involving competitive pressures from increased formality and the process of creative destruction that may follow. Second, the issues cited reflect firm-level experience of coping with a fragmented, opaque investment climate; this may underplay institutional issues involving rules—courts, contracts, regulators—that incumbents have overcome but at a potential loss to innovation and a “low-level equilibrium.”
An econometric analysis seeking to empirically test the top constraints to productivity growth reveals that, in Pakistan’s case, the results are consistent with firms’ perceptions of the constraints described earlier. Using data from the same firms surveyed in 2002 and 2007, a clear set of specific variables—many of them necessary proxies for standard investment climate issues—have important statistical significance in explaining firm-level changes in productivity between 2002 and 2007.
As shown in Table 16.4, the data on Pakistani firms not only indicates a positive correlation between productivity and employment and facets of the country’s investment climate, it also confirms the various hypotheses derived from firm-level perceptions. In particular, the key variables that stand out as being associated with firm-level productivity include: (i) power outages and the quality of power supply, (ii) the time, cost, and hassles involved in complying with regulations, and (iii) crime and security in a negative sense. Those variables associated with higher-productivity firms are (iv) access to finance, (v) training and skills up and down the line, (vi) innovation, and (vii) corporate governance. The proxy for female worker is negative due to women being represented in lower-productivity activities.
Table 16.4: Key investment climate variables, 2002–07
Number of power outages
Low quality supplies
Economic governance
Security expenses
Crime losses
Manager’s time spent on red tape
Number of inspections
Informal payments for contracts
Illegal payments in protection
Credit line
Loans (with and without collateral)
Trade association
Labor markets and skills
Management training
Female workers
University education for staff
Corporate governance
Source: World Bank (2009).
Statistical attempts to quantify the contribution of different variables to firm-level outcomes demonstrate that, in 2007 at least, the investment climate issues facing Pakistan firms did not differ significantly across provinces (Figure 16.6). Not only were the issues similar—infrastructure, economic governance, finance, and corporate governance—they mattered to about the same degree across Pakistan. Governance and infrastructure were cited as concerns in all the provinces, led by Punjab, while the larger more globalized firms in Karachi brought into consideration issues of innovation and competition.
On the other hand, in Khyber Pakhtunkhwa, where economic governance and infrastructure contributed less to the investment climate, finance and corporate governance emerged as stronger contenders. To some extent, the different contribution of the various dimensions of the investment climate reflects the type of firm dominant in each province. Smaller informal firms are associated with less economic governance, less need for infrastructure and formal finance, and usually exhibit little, if any, formal corporate governance. These firms are lower-scale, more penalized by the investment climate, and exhibit lower productivity than larger, more formal firms.
Figure 16.6: Investment climate’s contribution to productivity
Text Box: Percentage

Source: World Bank (2009).

6.        The Transmission of Efficiency from the Business Environment to the Firm

The empirical analysis confirms the perceptions and opinions of Pakistani firms while providing insight into how various aspects of the investment climate contribute to productivity and efficiency. Certainly, such information is important to policymakers wanting to improve the investment climate in order to strengthen the economy’s competitiveness and growth. However, for policy to be deployed strategically—while remaining aware of all the consequences—it is necessary to understand the various dynamic processes that take place at the micro-, sector and economy-wide level that have the potential to affect “aggregate” productivity.
For Pakistan, policies geared toward improving the economy’s productivity can entail three distinct but highly related processes: (i) lowering the “cost of doing business” to enable the same output at a lower cost; (ii) increasing the productivity of the enterprise sector through policies that make formality and scale attractive to encourage firm-level growth; and (iii) increasing firm entry and exit to enable competition, innovation, and a shift in resources from lower-productivity firms to more competitive firms through the process of “creative destruction.” In all three dimensions of productivity-induced growth, the business environment has a critical role to play in enhancing or obstructing private sector efficiency. Each of these areas forms the basis of the analysis below and the set of policy recommendations provided at the end of the chapter.

6.1.      Lowering the Cost of Doing Business

Analyzing the cost of doing business in Pakistan involves examining three separate dimensions: (i) the cost of complying with official regulators; (ii) the unofficial cost of doing business as represented by the need to (and expectation of) to provide gifts to acquire public services; and (iii) given the amount of regulation and discretion, the difference between de jure and de facto regulation and its important impact on the general fitness of this activity. Given that, the firms that are most able and likely to avoid such informal costs, and those least able to afford them, as firms that can most easily cross the line into the state of informality.

6.1.1.        Official Costs of Doing Business

The cost of doing business affects all firms, but different costs affect different firms in various, often unpredictable, ways. Formal costs relate to the rules and regulations affecting the fees, time, and effort incurred. These “official” costs have been measured using indices and comparisons captured by the World Bank Group’s DB project, which collects annual data on the state of regulations for 181 countries. The project measures regulations in eight areas and has recently expanded this to ten (see Figure 16.7); the number of countries measured has also grown.
Figure 16.7: Pakistan’s DB ranking: From 94 in 2004 to 104 to 107 in 2012/13
Text Box: ElectricityText Box: Tax ComplianceText Box: Contract EnforcementText Box: Property RegistrationText Box: Construction PermitText Box: Business RegistrationText Box: Trade Logistics Text Box: Collateral EnforcementText Box: Access to CreditText Box: Investor Protection

Source: World Bank Doing Business database, 2013.
Pakistan has generally appeared relatively open and favorable on scales that measure the official regulation of firms. For much of the early 2000s, its composite index ranked highest in South Asia after the Maldives, hovering around halfway among the 180 countries measured. However, in recent years, what seemed on paper to be a relatively liberal and efficient regime has deteriorated in relative terms, based on the DB methodology, which ranks countries according to the composite DB index. Pakistan’s ranking has since fallen steadily, dropping 13–15 places in the world rankings since 2004. The fall is sometimes associated with the introduction of an unfavorable business regulation or the elimination of a favorable one, but is more often linked to limited reforms at the micro-level while other countries have attempted to improve their own rankings.
Unfortunately, there is little consolation that the fall in ranking stems from inertia rather than policies harmful to the DB indicators. In the face of other reforming competitors, a country can fall behind simply by failing to reform. In the end, falling behind in relative terms is not costless, irrespective of how it has occurred. An analysis of firms’ responses to regulatory issues—particularly official regulations of the kind measured in the DB project—reveals that firm performance is affected by variability, expectations, and perceptions of immanent policy implementation as much as the state of official regulation. In other words, the level of the indicator does not matter as much as firms’ intuitive expectations of future policy implementation. Thus, in Pakistan, where regulatory streamlining is relatively recent, the inertia of the de jure policy regime over the past few years has been viewed by businesses as anything but benign neglect, particularly given the active reform being pursued by many of the country’s competitors.

6.1.2.        Informal Costs of Doing Business

Related to reforms—or the lack thereof under the de jure policy regime—is the fact that the de jure or official cost of doing business can be quite different from a firm’s actual costs (in terms of time, money, and hassle). The enterprise survey reveals that firms in Pakistan face far higher costs than just the official costs: almost half the firms surveyed reported that they were expected to provide public officials with gifts. This is a much higher share compared to South Asia as a whole and twice the share of respondents for all the countries surveyed (Figure 16.8).

Figure 16.8: Share of firms expected to provide gifts to officials
By type of official
Text Box: Public OfficialsText Box: Electrical connectionText Box: Water connectionText Box: Tax OfficialsText Box: Government contractText Box: Operating licenseText Box: Construction permit

By type of firm
Text Box: AllText Box: South AsiaText Box: PakistanText Box: SmallText Box: MediumText Box: LargeText Box: KPText Box: BalochistanText Box: SindhText Box: PunjabText Box: ExporterText Box: Non-Exporter

Source: World Bank enterprise surveys and World Bank (2009).
The situation’s underlying texture provides some additional insight. The informal costs of doing business are highest with regard to the most significant and elusive government services globally, but particularly in South Asia. The survey’s specific results in this area are revealing, and put into context the very high number of days reportedly required to secure electricity and water connections. Importantly, these areas also score globally as the most problematic from a de jure perspective.
On the other hand, the high level of interface between tax officials and firms seems to have decreased significantly with the rising expectation of receiving gifts. Since required permits and official licensing were less prevalent in daily life due to the regulatory reforms of the early 2000s, there was no pretense of providing gifts in exchange for access, and so gifts in these two arenas do seem as significant today as they were some years ago. Similarly, gifts to secure government contracts are not as needed as the daily interface requirements, as government–business contractual relationships are fewer and more complex.

6.1.3.        De Jure vs. De Facto Application of Regulations

The World Bank and others have made a number of important attempts to carry out surveys, analyze laws, and engage in advanced statistical analysis in order to reveal the impact of the business environment on growth. Two dimensions of the business environment are important to consider, both of which are dynamic and complex. The first involves the de jure environment: the set of official rules and regulations on paper that can be referred to, analyzed, and changed.
The key distinctions between de jure and de facto regulation, as measured by the DB project and enterprise surveys, are listed below.
-       Firms in the same country report, de facto, wildly different times and costs associated with completing the same transaction; de jure compliance involves a single estimate.
-       Cross-nationally, there is very little association between the enterprise survey distributions and DB numbers. The patterns are much more complex as the de jure environment appears to affect only some firms, distinguishing between “favored” and disfavored” firms.
-       In every country, the “favored” firms report little delay in any of the three indicators while the firms that find regulations to be an obstacle vary across countries in terms of the extent of delay.
-       There is little association between DB improvements and reports in the enterprise surveys; improvements in DB are just as likely to be accompanied by deteriorations in the enterprise surveys.
-       There are many substantial reductions in the DB reported time but almost no instances where this was associated with a fall in the ES reported time for compliance.
On one hand, the World Bank’s DB project attempts to benchmark each country’s de jure environment by continually monitoring, measuring, and ranking the composite scores of the country’s official regulations as they translate into time, cost, and procedures involved. On the other hand, firm-level surveys not only gauge perceptions but also attempt to collect and benchmark qualitative and quantitative indicators, measuring the implementation aspects of regulations—the de facto business environment.

6.2.      Bringing a Greater Degree of Formality into the Economy

The addition of unofficial costs to official costs amplifies the cost of doing business; more importantly, though, it adds an added level of uncertainty between the de jure and de facto application of laws and regulations. This friction leads to such high, opaque, and unpredictable costs of doing business that a large part of the economy chooses to sacrifices firm growth and profitability by operating on some level of informality. Three dimensions of informality exist around the world and, indeed, are strong elements of Pakistan’s economy: (i) firms that are unreported because they maintain a small number of employees (10–20), (ii) the avoidance of taxes and fees by firms that remain illegally unregistered; and (iii) informal practices by formal firms, usually in factor markets and property rights.
Almost two thirds of the firms surveyed in 2007 considered the application of regulations to be inconsistent and unpredictable. By remaining informal and consequently small, firms avoid the constraints imposed on them by over-regulation. For instance, senior management in large firms spent, on average, 13 percent of their time dealing with regulations—almost three times what smaller firms spent (5 percent). Large firms met or were inspected by tax officials almost seven times a year compared to three times for small firms. Labor market regulations are also important. Only 6 percent of small firms noted that labor market regulations affected their decision to hire and fire permanent workers compared to over four times that share for large firms (World Bank 2002, 2007).
The impact of over-regulation and weak institutions in Pakistan contributes to high compliance costs as well as to the informal costs of doing business, as described in the previous sections.[6] The result is a high level of cost avoidance through various means under the heading of informal markets. Consequently, the informal sector has been estimated to be as large as 35–40 percent of the official economy (World Bank, 2012b). Given that large firms cater to a different market from small firms, they are relatively unaffected directly by regulatory avoidance, although some firms, particularly in areas of design and other intellectual property, report the unauthorized copying of designs.
A key indicator of formality that clearly reveals Pakistan’s duality is the degree to which firms—whether those producing technology-intensive products for export or more traditional products for local consumption—have an incentive to adapt existing productivity-enhancing technology that is available to any firm at a low cost (Figure 16.9). The degree of adaptation of basic technology reflects the firm’s degree of formality, market orientation, and indeed, incentive to compete with others who are also adapting.
Figure 16.9: Firms’ use of technology, 2007

Source: World Bank enterprise surveys (various years).
Firms in Pakistan comply with quality certification to a relatively high degree, particularly the country’s international chemical industry and stronger elements of the food and textile industry. However, when looking at the use of the Internet in business as well as the degree to which financial statements are formally audited, a much more informal picture of the Pakistan firm emerges compared to firms in South Asia and around the world (see Figure 16.10).

Figure 16.10: Indicators of technology and formality: Groups within Pakistan
Source: World Bank (2007).
Breaking down the country’s market structure by industry, geographic location, size, and trade orientation, further clarifies the picture of the Pakistani firm. As noted, the rising chemical industry in Pakistan, though limited to a small number of large firms, is clearly the most formalized and technologically oriented as would be expected for such high-technology firms. The textile industry, particularly the large sector located in Sindh, is equally formalized and technologically adapted (Figure 16.10). However, most of the enterprise sector is not, which also emerges clearly.

6.2.1.        Nature of Firm-Level Governance

Academics, journalists, and casual observers have written widely on the governance aspects of the Pakistan economy and the resulting degree of “social capital” in use in the form of informal, localized firm and market arrangements. In some analyses, this type of enterprise sector is the result of a “low-trust society” that forgoes arms’-length market arrangements even within the country for more informal arrangements due to the lack of property right protection and adherence to legal rules in conducting business.
Pakistan typically rates quite low on many governance indicators, represented by the 2012 composite indicator, covering such areas as the rule of law, quality of regulation, and political stability. Only Afghanistan scores worse than Pakistan in South Asia, which itself ranks the lowest among all regions. Without strong market governance by trusted institutions, predictability and transparency in the business environment are likely to suffer, keeping a large share of the economy outside the formal sector and creating a drag on the economy’s productivity.

6.2.2.        Impact of Firm-Level Governance

The perception that governance is an issue faced at the firm level emerges clearly when we compare Pakistan with the rest of South Asia and the world in terms of views on corruption, bribes, and the role of the courts in the investment climate. Clearly, in 2007, firms in Pakistan showed more concern about governance at the firm level and likely continue to do so today. Importantly, while their perception and experience of corruption does not differ much across different sizes of firms, the concern with courts rises as the size of the firm grows, indicating the need of the more formal economy to have a more formal governance system. Across the provinces, corruption and the courts emerge as key concerns, apart from in KP where the concern seemed to outstrip the experience (see Figure 16.11).
Figure 16.11: Strength of market governance (share of firms that… )
Text Box: AllText Box: South AsiaText Box: PakistanText Box: SmallText Box: MediumText Box: LargeText Box: KPText Box: BalochistanText Box: SindhText Box: PunjabText Box: ExporterText Box: Non-Exporter

Source: World Bank enterprise surveys (various years).
The impact of a strong degree of informality in the enterprise sector is that productivity is limited by the distribution of enterprises across the formal/informal spectrum, given that informality in any form is typically less efficient than a formal, market-based structure. In other words, the aggregate productivity of the enterprise sector is based on the productivity of the average firm, as well as the range and weighting around the average. For high-average firms with a low level of dispersion, the aggregate will generally be high. However, a wider dispersion will allocate resources to low- as well as higher-productivity firms and the country aggregate will depend on how much weight each firm is assigned.

6.2.3.        Impact on Productivity

Figure 16.12 shows estimates of TFP broken down by aggregate and average productivity for eleven countries where data was available. The statistical relationship between the investment climate variables and productivity is positive, but is due mostly to the allocative term rather than average firm productivity. Pakistan’s mean productivity—that is, the part of productivity affected by the investment climate—is comparable with that of Mexico and South Africa, lower than that of Chile and Brazil, and higher than that of other countries in the region (Indonesia, Turkey, and the Philippines). This underscores the investment climate’s positive impact.
However, in Pakistan, the investment climate’s contribution to aggregate productivity is made prominent by the fact that it has a negligible and marginal impact on average productivity. This market characteristic is observed strongly in Brazil and Pakistan and to a lesser extent in India and Bangladesh. On the other hand, countries like Chile, Mexico, and South Africa derive their high levels of aggregate productivity growth from business conditions that raise the average productivity of the representative firm. The residual term—called “allocative efficiency”—represents the variance of the productivity across firms (size of term) and whether the weighting is associated with higher- or lower-productivity firms (the sign of the term). Countries like Brazil, India, Bangladesh, and at the highest level, Pakistan, have a high variance in productivity across different enterprises. The variance is positive in these cases because larger firms with higher weights have higher productivity.

Figure 16.12: Productivity (mean) breakdown across countries
Text Box: PhilippinesText Box: TurkeyText Box: IndonesiaText Box: BangladeshText Box: IndiaText Box: CroatiaText Box: MexicoText Box: PakistanText Box: South AfricaText Box: BrazilText Box: ChileText Box: TFP in logs

Source: World Bank (2009).
From the perspective of overall efficiency and competitiveness, the high variance of firm-level productivity embodied in the allocative efficiency term may reflect market frictions that enable low-productivity/low-market share firms to exist without exiting. A large allocation term not only supports the hypothesis of duality in the economy where formal and (relatively) high-productivity firms coexist with smaller, informal, low-productivity firms. A positive allocation term indicates that top-ranking firms are using most of the resources in terms of average productivity. However, the coexistence of a high efficiency term and a low average productivity term shows that low-productivity firms dominate in terms of numbers but not market share. Traditionally, aggregate productivity in a dual economy is depressed because too many resources are allocated to low-productivity production in the informal sector.

6.2.4.        Role of Friction in the Economy and Firms’ Ability to Cope

Friction may arise from a variety of factors, including the adjustment costs of entry and exit, difficulties in contract enforcement, lack of property rights enforcement, poor retail systems, competition issues, market structure, and technological factors. These sources of friction are part of the investment climate for doing business and affect the efficiency of the average firm in a given country, but they can also help explain the existence and role of a large allocative efficiency term. When trying to explain a pattern statistically, the most important findings confirm the hypothesis described above:
-       Variables that relate to firms’ degree of formality and the ability of formal firms to cope with business problems are highly significant in terms of explaining productivity patters.
-       In infrastructure, these factors include ownership of a generator, transport, and security, and the number of days of inventory. Location in an industrial estate is also significant, representing productivity gains from agglomeration economies.
-       There is also a strong association between productivity and variables representing the formal nature of firms. Economic governance variables include (i) handling disputes through courts, (ii) reporting sales to the tax authorities, (iii) dispersed ownership concentration, and (iv) access to checking/savings accounts and working capital through private banks.
-       Innovation and skill variables are also significantly associated with productivity differences, including process innovation, new equipment, foreign direct investment, and training.
In terms of infrastructure and economic governance, the evidence shows that firms with a larger market share seem to cope better with the negative elements of the business climate. In particular, the highly negative association with average productivity is muted since the effect is concentrated on firms with a small market share. For instance, ownership of a generator is slightly related to improved productivity but the impact is amplified for aggregate productivity because ownership of generators is concentrated among firms with a large market share. Similarly, the positive association with a firm that has a large amount of inventory, uses the courts, and pays for security is also amplified at the aggregate level through the allocative effect.
In the case of variables reflecting the degree of formality, the allocative efficiency effect is small, implying that the positive association with formality applies to all firms. Two variables are significant in this regard. First, under economic governance, reporting sales to the tax authorities contributes substantially to both aggregate and average productivity. Second, a firm’s access to its own bank account is correlated with increased productivity at the average firm level. There is a small allocative efficiency term here, implying that having a bank account is positively associated with having a large market share. On the other hand, there is a strong negative association with concentrated ownership; unlike the other two variables, however, it is associated with a smaller market share, muting the aggregate impact.
The results strongly indicate that productivity-enhancing variables, i.e., finance, innovation, and labor skills, are associated with firms that have a larger market share. In the case of finance, the negative impact of prepayment for purchases and working capital financed by internal funds is concentrated on firms with a small market share. The positive correlation between productivity and working capital financed through private banks is associated with firms that have a larger market share. For innovation and labor skills, the positive association with productivity—especially for new processes and equipment—is concentrated on firms with a larger market share. The effect is stronger for the training variable because a small degree of association with average productivity is amplified at the aggregate level.

6.2.5.        Differences Across Provinces

Differences in the relationship between investment climate variables and productivity are relatively robust across provinces and firm size, but with some small differences that are worth noting (Figure 16.13). Specifically, infrastructure accounts for the highest share of productivity differences in all the provinces with a somewhat lower impact in Balochistan. Conversely, economic governance contributes more to productivity in Balochistan than in the other provinces. In KP, unlike the other provinces, economic governance, finance, and corporate governance contribute relatively equally to productivity, with finance and corporate governance accounting for a larger share than in the other provinces. Innovation contributes to productivity the most in Sindh and the least in Punjab.
Figure 16.13: Productivity (mean) breakdown across provinces
Source: World Bank (2009).

6.3.      The Impact of the Investment Climate on Various Types of Firms: Results from the O&P Decomposition 2002–07

The range of specific investment climate variables that are significantly associated with productivity differences, highlight the wide range of ways in which the investment climate affects economic growth. Some variables—infrastructure, economic governance, and finance—remain robust and significant over time. For example, the negative impact of power outages, crime losses, payments to receive government contracts, and the positive impact of access to formal finance are consistently significant. On the other hand, issues relating to government–business interface—for example, the number of inspections or the time taken to comply with regulations—fall in significance.
The effect of individual investment climate variables is associated with aggregate productivity through average productivity and the allocation of resources. Specifically, 14 percent of the effect that investment climate variables have on aggregate productivity is due to average productivity; the remaining 86 percent is due to the allocation effect. The key significant variables and their share in total average and aggregate productivity are as follows:
-       Number of power outages (infrastructure). The share in average productivity is -13.3 percent and the share in allocative efficiency is 6.7 percent. Hence, the negative effect on productivity is biased toward low-market-share firms.
-       Days of inventory of main intermediate material (infrastructure). The share in average productivity is 14 percent, while the allocation effect (9 percent) amplifies the average, indicating the positive effect concentrated in high-market-share firms.
-       Sales reported for tax purposes (economic governance). This variable accounts for 12.8 percent of aggregate productivity and 12.3 percent of the average productivity effect.
-       Working capital financed by internal funds (finance). Out of a total share of -6.6 percent in aggregate productivity, -8.3 percent is accounted for by average productivity, indicating that the effect is muted and concentrated among firms with a low share of sales.
-       Working capital financed by private banks (finance). This variable is positively associated, accounting for 11.3 percent of productivity. The allocation effect accounts for almost the entire effect (9.6 percent) indicating that the positive effect is concentrated among firms with a high market share.
-       Dummy for process innovation (innovation and competition). Its share in aggregate productivity is 15.7 percent but, like finance, this arises through allocative efficiency (13.1 percent) since the average effect accounts for one sixth of the overall contribution.
-       Dummy for training (labor markets and skills). Of its total share of 12.4 percent in aggregate productivity, 11 percent is due to allocation and 1.4 percent due to the average.
-       Largest shareholders (corporate governance). The aggregate effect is -8.1 percent, decreasing from -16.2 percent (average) by a positive allocative efficiency of 8.1 percent.

6.4.      Encouraging Innovation, Structural Change, and the Process of “Creative Destruction”

Perhaps the most traditional and possibly most important dimension of productivity growth comes from the process of “creative destruction” where competitive pressure forces firms to constantly discover and implement new technologies to produce new products or old products in new ways. In this way, all firms are not equal in terms of productivity growth. Schumpeter considered it the “essential fact about capitalism”; the body of work since then has analyzed firm-level data and confirmed the importance of both direct and indirect productivity effects of firm entry and exit over time (Bartelsman, Haltiwanger, & Scarpetta, 2004).
Firms differ not only in their managerial ability, location, organization, and know-how, but also in their ability to advance in a contestable market by adapting to new knowledge where other firms have not. Recent evidence supports the hypothesis showing that new and relatively more productive establishments displace older and relatively less productive ones. However, the empirical evidence also gives insights into how the process of creative destruction works, and shows that there are reinforcing indirect effects. First, the invention or application of superior technology by a new entrant may encourage incumbent firms to improve their own technology (Bartelsman et al., 2004). Second, the creation or deepening of the contestability of markets through creative destruction also serves to raise productivity through competitive pressure.
There are also impediments to the positive outcomes of creative destruction. Even in markets without friction, the advantages that firms have with which to advance while others fall behind may first show up in the form of profitability and only later, as productivity. New firms are not necessarily more productive as learning needs to take place and the empirical evidence supports this. If learning does not take place, then new entrants exit quickly and only productive ones survive. Empirically, the high level of deaths in the early years of firm life supports this argument.

6.4.1.        Absence of Dynamic Structural Change

This discussion is important in Pakistan’s context as the earlier sections explaining the wide variance in productivity demonstrate that large gains can accompany creative destruction. However, equally importantly for countries such as Pakistan, there are impediments to the process of creative destruction. As described earlier, the lack of strong institutional governance allows laws and regulations to be implemented in ways that favor firms in an unpredictable and opaque manner. Creative destruction thus occurs for reasons other than efficiency or not operating at all.
High-technology exports constituted less than 2 percent in 2008—a share that remains broadly unchanged over the last 25 years (Figure 16.14). This is extremely low for a country that has good educational and research institutions, and a large population. For example, Vietnam’s share of high-technology exports rose from 0.7 percent to 3.8 percent of the total in the same period, whereas India’s increased from 2.8 percent to 6.2 percent. Moreover, while the majority of Pakistan’s exports (around 54 percent) were classified as low-technology products even in 1985 (Lall, 2000), this share has increased further over time, reaching close to 80 percent in 2006.
Figure 16.14: Technological content of Pakistan’s exports
Source: World Bank (2012a).
Generally the consensus is that Pakistan’s economy has shown limited, if any, transformation over the past 20 years. One common aggregate export basket demonstrates that the country remains a low-technology exporter with very little movement in its share of exports, which could be an outcome of creative destruction. This low level of technology content is also reflected in the very low level of technology exhibited by firms operating in Pakistan.
Two other dimensions of Pakistan’s export dynamics support the low level of structural change in the economy over time. First, compared to other countries, and relating changes in export sophistication to changes in income per capita, Pakistan demonstrates far less structural change than countries thought to be going through such dynamics, e.g., China, India, and Vietnam. Second, when examining Pakistani exports, we see that not only is there a high degree of concentration of exports in only a few firms, this has not changed much over time. In 2002, 1 percent of firms accounted for 40 percent of exports and 5 percent accounted for 71 percent. In 2010, exporters became more concentrated among the top 1 percent, and the top five accounted for 76 percent—a trend opposite to that of other dynamic economies in the world, which are geared toward more participation in international trade, not less (see Figure 16.15).
Figure 16.15: Export sophistication and concentration, 2003–10
Export sophistication: Product space

Export concentration: Firm space
Source: World Bank (2012a).

6.4.2.        Some Low Degree of Discovery and Diversification

The dynamic dimensions of Pakistan’s economy showed some promising signs during the early part of the 2000s. By 2007, there was evidence of structural change but growth in the technological content of exports remained miniscule. Unlike the limited data on firm entry and exit (births and deaths) in the domestic market, there is more firm data available for products bought and sold on international markets. Therefore, granular levels of entry and exit can be examined for export products and exporting firms as a proxy for creative destruction at the economy-wide level (Figure 16.16).
Figure 16.16: Export product discovery and death
Source: World Bank (2012a).
First, when looking at the product level, there is strong evidence of product discovery by exporters at low levels. Each point represents a product in a particular market. When mapping new products in new markets in 2008 and old products in 1998 (which no longer existed in 2008), it is clear that births well exceed deaths at the product level. The results are consistent with a low but positive degree of creative destruction.
Second, important patterns emerge when examining firm-level data on trade. Export entry and exit is lower in Pakistan than in its peer countries but new entrants have consistently offset the losses of exiting firms. This result, consistent with the finding at the product level, confirms some positive degree of churning at the firm level. Pakistani firms are quite dynamic along this margin, as seen by the significant entries and exits over the years from 2002 to 2010. According to the trade data, each year, anywhere between 16 and 37 percent of firms exit as another 19 to 37 percent enter (Figure 16.17).
Figure 16.17: Export entry and exit rates
Source: World Bank (2012a).
Third, at first sight, there seems to be significant destruction and creation of exporters in the data; entry and exit rates are in fact lower than in other lower middle-income countries. Moreover, the net effect on the number of exporters seems to be marginal. This suggests that the number of exporters is not expanding any significantly over time. Firm export growth due to the entry of new firms into the export market during 2002–10 was, on average, 1–2 percent higher than the loss in growth due to firms that stopped exporting.
Finally, dynamism fell significantly after 2004. This emerges clearly if we decompose export growth by intensity and firm, country, sector, and product-extensive margins (Figure 16.18). Fewer firms have entered and exited the export market since 2004 and incumbent exporters have become more conservative in terms of export markets, sectors, and product experimentation. In short, over the second half of the last decade, entries and exits by new firms as well as existing firms in new countries, sectors, and products, all fell consistently.

Figure 16.18: The dynamics of exports: Firms, markets, sectors, and products, 2002–10
Text Box: Firm EntryText Box: Firm ExitText Box: Country 
Text Box: Country 
Text Box: Sector 
Text Box: Sector ExitText Box: Product
Text Box: Product 
Text Box: Intensive 
Text Box: Intensive 

Source: World Bank (2012a).
The declining entry and exit at the firm, sector, and product level provides a strong indication of the decrease in the dynamism of exports in Pakistan over this period. This fall in some of the dynamic aspects of exports in the early part of the decade may have been a rational response to the deteriorating business environment, which, in turn, can be traced to (i) macroeconomic, political, policy or other form of instability experienced by the Pakistani firm, and (ii) a policy framework that offered declining incentives to enter, compete, and innovate.

6.4.3.        Evidence of Reform-Based Productivity

An analysis of the World Bank’s enterprise surveys of 2002 and 2007 to identify limited evidence of creative destruction confirms that aggregate productivity in Pakistan’s manufacturing sector increased over this period.[7] The observed increase in productivity was due mainly to the allocation becoming more biased toward larger-market-share firms and only marginally due to a rise in the term measuring average productivity. This indicates that there was indeed a process of reallocation, but of market shares toward higher-productivity firms, i.e., the larger, more traditional firms (as indicated by their export concentration). The lower-productivity firms lost market share but not while they remained in the market and increased the “average firm” productivity term.
The increase in aggregate productivity is observed for both the datasets and is confirmed by extracting a nonrepresentative panel sample of 400 firms that were surveyed twice. The increase was due to a rise in firm-level productivity as well as economy-wide productivity gains resulting from market shares going to firms with higher levels of productivity. The change in the productivity distribution over 2002–07 indicates a slightly smaller concentration of low-productivity firms in 2007 than in 2002.
This observation is shown as kernel density graphs for the two sample periods where the average productivity distribution of firms moving to higher-productivity areas supports a dynamic analysis of rising firm-level productivity (Figure 16.19). The results clearly show the high concentration of low-productivity firms, which characterizes Pakistan’s enterprise sector. This underscores the results described above, which imply low average productivity and a wide range of productivity differences among coexisting firms. This migration of firms toward the more productive areas of the frequency distribution is consistent with the hypothesis that the period was characterized by policymaking that induced creative destruction, productivity increase, and improved competitiveness.
Figure 16.19: Kernel density for productivity, FY2002 and FY2007
Text Box: Density

Source: World Bank (2009).

7.        The Role of Public Policy

The investment climate plays a critical and determining role in supporting two driving forces of Pakistan’s development strategy: (i) an increase in competitiveness and firm-level efficiency, and (ii) the creation of high-quality jobs to provide employment to a large proportion of the working-age population. In both cases, the investment climate plays a critical role through complex transmission mechanisms.
As described in detail, the business environment has a direct and indirect effect on both these objectives through various transmission channels—each of which contain policy options to help foster the effectiveness of the transmission. As the chapter has described, the investment climate affects firms’ employment and efficiency either negatively or positively by: (i) affecting the cost of doing business, both official and unofficial; (ii) creating incentive for participation or not in the formal economy; and (iii) proactively fostering the process of entry and exit so that creative destruction leads to inclusive growth. All three transmission mechanisms are highly susceptible to the policy frameworks established by governments, regulatory authorities, and judiciaries at various levels of jurisdiction.
Pakistan’s policy and institutional landscape has been shifting since independence, and continues to do so. The most recent seismic shift was the 18th Amendment to the Constitution, which seeks to complete the process of establishing a federation of provinces. Therefore, as the predominant center of executive power shifts from the military to the federal and on to the provincial level, while the judiciary becomes more active and regulators continue to play an independent role, the business environment remains an irrelevant set of rules, a work in progress, a noisy annoyance, or a rent-seeking opportunity depending on the individual businessperson’s perspective.

7.1.      Options in a Public–Private Dialog Framework

Given the continuously shifting sands of Pakistan’s business environment, it is critical that the public sector remains in close contact with the views of the business sector. Naturally, information gathered regularly can be informative in adjusting and calibrating the focus and priority of critical aspects of the public sector’s effort. More important, however, is an ongoing public–private dialogue. This can be done in various ways, for example (i) through dissemination and discussion around surveys such as those analyzed here; (ii) through public–private task forces established for a short period of time, such as that established by the Planning Commission in 2010; or (iii) through the more permanent participation of the private sector on various committees and councils.
In any of its incarnations, the results of maintaining close contact with the Pakistani business community will serve not only to collect input on the most important deficiencies of the business environment, but also to monitor the progress on implementing reforms, and even helping to organize the private sector for collective activities. Such engagement is not only informative but also empowering for the private sector, which will ultimately be making the investment and employment decisions. Indeed, public sector dialog with the business community represents a key aspect of the former’s effort to provide the catalytic force needed to spur a productivity-virtuous circle.

7.2.      Addressing the Cost of Doing Business

Reviewing the regulations facing the firm in a structured and comparative way is a necessary first step to gauge where the country, region, or locality stands in terms of a regulatory framework for business. In its de jure form, the regulatory framework is often measured by benchmarking indicators, such as those created by the World Bank’s DB project.
The importance of a DB-type review is threefold: (i) it can be deployed at various levels of jurisdiction and cover the various institutions establishing the rules of the game; (ii) it compares like indicators against those of other countries to help judge the severity of the problem; and (iii) it takes the first step in documenting the time-and-costs requirement based on legal and regulatory rules. The second step is usually a regulatory review of some sort that tries to (i) establish the rationale for a regulation, (ii) eliminate those that are redundant, and (iii) improve those where necessary by looking at front-line implementation issues.
More elusive is the effort to address the unofficial costs of doing business. The evidence shows, however, that some reforms are clearly without controversy in terms of reducing the unofficial costs of doing business. The first and most obvious measure is to minimize steps, procedures, and agencies, while ensuring that the bodies in charge of governance are empowered and accountable. Independence, checks and balances, and third-party verification are all ways that authorities around the world use to minimize the probability of prohibitively large costs imposed through unofficial means. Finally, involving and mobilizing the public, civil society, and other interested bodies through public awareness campaigns, can help change the narrative around the role of bribes and gifts for public officials, which is often part of the enabling environment.

7.3.      Improving the Incentive for Formality

The issue of informality in transitional countries is difficult to understand and is opaque in its causes and effects. Additionally, it is not clear whether it yields a net loss to society or has a role in the way economies operate. Certainly, to the degree that regulations impose such high costs that firms find it profitable to remain informal to avoid them, it may be obvious that the official costs are too high. It may be the case that many of the basic business costs, such as for taxes, labor, and safety, are just too high. To the extent that the informal costs are unpredictable, opaque, and applied inconsistently, firms will avoid engagement.
On the other side of the equation, where the attraction of a formal structure—finance, contracts, land, etc.—is not enough to cause firms to register, pay takes, and play by the rules, then it would be beneficial for society if these “pulls” for informal firms be made available even through a pilot, micro-, or social capital approach. The saying is appropriate that, if the system is not working for the average firm, then the average firm will find it difficult to work for the system. In other words, without the benefits of being formal, available, accessible, and applicable, firms will have no reason to participate in the formal economy.

7.4.      Encouraging and Enabling the Process of Entry and Exit

A key dimension of fostering “good” creative destruction is that the governance of the system should be strong, transparent, and accountable. It is only through such legitimacy bestowed on the system that the process of creative destruction can be viewed by society as stable, beneficial, and worth the costs of structural adjustment. However, it is also the primary and perhaps the only way that an economy can upgrade its production over time so that growth is driven by private sector innovation, investment, and indeed, failure, in a risk-taking environment.
Specifically, the role of institutional governance is critical to an organic and productive process of entry and exit. Entry has to be governed by rules and procedures, and most importantly, have access to land, labor, markets, and services. The legal framework must be such that risk-based finance can be deployed based on clear and solid estimations of risk and uncertainty. At the same time, exit should be quick, decentralized to a creditor-based approach that allows for restructuring as well as liquidation, and is done in such a way that it fosters rather than hinders entrepreneurship. This means that entrepreneurs with ideas that did not work should not be penalized so much that they are unwilling to try again with another idea.
Finally, the principal driver behind the innovation and productivity growth that emerges from a holistic process of creative destruction is the competition generated with a level playing field in contestable markets. As competition is not a natural element of an economic landscape, the policy framework behind the business environment often needs to attend to both explicit as well as implicit competition dimensions. On the implicit side, the framework would include, for example, open markets for all firms who meet the basic criteria, a high propensity to import, and a welcoming attitude toward foreign direct investment. As a second step, an explicit framework would include a competition law and an enforcement agency ready and willing to take concerted efforts to address private competition breaches as well as discuss and lobby against public sector ones.

8.        Conclusions

This chapter has provided evidence from firm-level surveys that, in the grand scheme of poverty reduction and the growth of shared prosperity, the firm plays perhaps the most critical institutional role in a country’s development goals. Total factor productivity, which determines the business sector’s competitiveness and wellbeing, occurs at the firm level where the inputs of labor and finance are added to land and premises in order to make the output and sale such that the value of outputs is greater than the value of inputs.
In Pakistan—where the firm means so many things depending on one’s experience, perspective, and interest—in its simple form, the country appears similar to many others with a dual economy: a large set of very small firms usually operating at some level of informality and coexisting with a small set of seemingly large firms, which, due to their export-oriented nature, large following, and traditional position in society would find it difficult to officially acknowledge the idea of operating informally. In Pakistan’s case, however, the distribution of firms is skewed very much toward the smaller end.
At the same time, it is clear that large firms in Pakistan are not faring as poorly as expected, given their ability to cope with the investment climate’s deficiencies unlike the large number of small informal firms that end up facing highly local markets. Overall, this configuration of productivity growth is beneficial to overall aggregate productivity, but to the extent that nonproductive or less productive smaller firms fail to exit, it will constrain existing opportunities for raising taxes and increasing productivity through new firms.
The way to the heart of Pakistan’s development is, therefore, through the firm. The central focus of policymaking should be to foster the three transmission mechanisms of productivity enhancement at the firm level. In addition, by reaching out to the private sector from time to time, a productive public–private dialog should be initiated, which may create the spark to kick-start a virtuous circle of growth in Pakistan.

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* The author is a senior economist with the World Bank’s South Asia Finance and Private Sector Unit (SASFP) and has covered the Pakistan economy since 2004.
[1] In the census, out of a total of 580,000 manufacturing establishments, 43 percent were associated with the textile and leather industry, 20 percent were food- and beverages-related firms, and 11 percent were engaged in machinery, equipment, and basic metals where higher value-added and intra-industry linkages are evident.
[2] The economic literature attributes differences in output per worker between rich and poor countries to TFP. See Caselli (2005), Hall and Jones (1999), and Klenow and Rodríguez-Clare (1997).
[3] As the labor force increase, labor productivity decreases due to the declining marginal productivity of labor, requiring more capital investment to maintain the same level of labor productivity.
[4] In the medium term, labor force participation can be related to economic factors as people enter or leave based on the probability of finding work.
[5] For example, firms in Sialkot have substituted private collective action for public services in the form of collective infrastructure, including an airport and a dry dock.
[6] Approximately 75 percent of firms state that it is common to have to make an informal payment or gift to get things done.
[7] Caution should be used when interpreting productivity purely as efficiency. There is a debate in the field on whether productivity is better viewed as firm-level revenue generation power; this consists of using factors more efficiently (i.e., technical efficiency) resulting from firm-specific investments in technology, competition, labor, and skills on one hand, coupled with firm-specific market power that allows a firm’s own prices to be raised in relation to the sector deflators being used. In this analysis, such as distinction is not possible, so the term “productivity” is used to cover both instances.

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posted by S A J Shirazi @ 1/09/2014 12:00:00 AM,

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