Prometheus unbound? The modest benefits of entry deregulation in Portugal

Lee Branstetter, Francisco Lima, Lowell Taylor, Ana Venâncio

18 September 2014

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As the West struggles to rekindle growth in the lingering aftermath of the Great Recession, pro-business groups on both sides of the Atlantic have fingered government overregulation as a barrier to entrepreneurship and firm formation.  Advocates of deregulation (as a growth strategy) point to a large economic literature that associates regulatory barriers to entry with slow growth in developed countries, and a failure to develop in poor countries.  Some of the central ideas in this stream of research were elegantly articulated by De Soto (1989, 2000), and important empirical evidence was provided by Djankov et al. (2002) – who created the first cross-national comparative data set on the costs of new business formation and explored it in a series of subsequent papers (Djankov et al. 2006, Djankov 2008, 2009). Other researchers have followed, including Bertrand and Kramarz (2002), Aghion et al. (2008), Bruhn (2011), Kaplan et al. (2011), and others.   The plausible economic logic and the striking negative correlation in the cross-section of countries between measures of entry regulation and overall economic performance led the World Bank to set up a Doing Business Project that placed significant emphasis on these entry barriers.  The World Bank has actively sought to encourage governments around the world to reduce these barriers, and has had a significant impact on policy.  The Doing Business Project website documents 238 entry (de)regulatory reforms in 114 economies over the past several years.  Djankov (2008) goes so far as to describe business entry reforms as the "prevalent legal and administrative reform around the world in the past decade."

But what has all this actually accomplished?  Or to put the question another way, how much growth can be plausibly generated by a reduction in barriers to entry?  We address this question in our recent paper (Branstetter et al. 2014).  We use a theoretical model of entrepreneurship based on the seminal work of Lucas (1978) to show that the most productive, promising start-up firms are the ones least likely to be dissuaded from entry by regulations and fees – even fairly significant ones.  Conversely, the firms most likely to be dissuaded from entry by government regulation are low quality firms founded by less capable entrepreneurs that operate predominantly in low-tech sectors, innovate little, stay small, and make at best modest contributions to aggregate growth in employment, output, and productivity.  We then take the implications of this model to a matched employee-employer data set that measures the impact of one of the most ambitious entry de-regulation programs in recent history: the "On the Spot" Program implemented in Portugal in the mid-2000s, well before the onset of the Great Recession or the Eurozone sovereign debt crisis.

In 2000 Portugal had one of the most restrictive entry regimes in the Western world.  Portugal ranked 113th out of 155 countries in the World Bank's ‘Doing Business Index’.  A would-be entrepreneur had to visit several different public agencies, complete 11 procedures, fill out 20 forms and documents, wait between 54 and 78 days, and pay almost €2,000 – nearly 14% of per capita national income in the  mid-2000s – before establishing a new firm.  In 2005 a new law swept away most of these restrictions, replacing them with a gradually implemented national network of "one-stop shops," in which the would-be entrepreneur need only visit a single facility, complete just seven procedures, and register the new firm within one hour – paying only €360.   In 2005-2006 the Portuguese government received an award from the European Commission for this far-reaching deregulation, and the World Bank moved Portugal from 113th to 33rd in its Doing Business ranking.  Figure 1 provides a graphical summary of the extent of Portugal's reform.

Figure 1. Portugal slashes the red tape constrining business entry

Because of resource constraints, the new one-stop shops were implemented gradually across the country, in a manner that was not systematically correlated with the fertility of the different regions as sites for entrepreneurship.  This allowed us to take a difference-in-differences approach to quantifying the impact of this reform on firm formation and employment creation.  The matched employer-employee database also allowed us to break new ground in this literature by measuring the characteristics of the ‘marginal’ firms and founders who entered the market as this deregulation was gradually implemented across the country. 

The good news is that the reform worked as expected:  it increased the number of monthly start-ups by approximately 17% and the number of new jobs by 22%.  Our regression coefficients imply that full nationwide implementation would generate roughly 4,500 firms and 17,500 jobs over two years – certainly non-trivial.  On the other hand, the impact is clearly limited in the broader context of a labour force of 5.5 million, with 400,000 unemployed in 2005. 

As our model predicts, we find that the firms whose entry is plausibly induced by the reform tend to be small, owned by relatively poorly educated entrepreneurs, and operate in low-tech industries, and they are less likely to survive over the first two years after entry than the cohorts of entrants that preceded them.  These results suggest that the positive (but limited) impact of entry deregulation is constrained, in part, by the low quality of the firms deregulation brings into the market place.  Prometheus is not unshackled by these deregulation episodes – the best entrepreneurs and firms enter and thrive even in relatively inhospitable environments.  Entry deregulation, even one as sweeping as Portugal's, does not bring Steve Jobs into the marketplace; it opens another convenience shop around the corner.

It would be inappropriate to conclude that efforts to ease entry regulation are misdirected. Their benefits are clear, especially in contexts where the pre-reform levels of red tape were especially high, as in pre-reform Portugal.   We also need to be cautious in over-extrapolating our conclusions beyond the Portuguese context from which they were drawn.  Portugal then, and still today, retains one of the most rigid labour market regimes in Western Europe – a policy choice that may have a much larger negative impact on growth and productivity than the entry restrictions abolished back in 2005.  The need for further structural reform in Southern Europe and elsewhere is obvious.

Still, it is important that we not oversell the growth benefits of entry deregulation reforms.  The best scholars in this literature have always acknowledged the hazards of overreliance on the strong negative cross-sectional relationship between entry restrictions and economic performance at the country level, precisely because countries with overly restrictive entry regulations often suffer from other economic and policy problems (see the discussion in Djankov et al. 2002).  Now would be a good time for the policy ‘experts’ and the more responsible journalists in the business press to practice similar caution.  Economists across various disciplines have experienced first-hand how overselling the efficacy of our favoured policies can backfire, undermining the credibility and influence of the discipline in the long run.  A bit more modesty and honesty in this policy discussion might be not just the right thing for the world, but the right thing for ourselves.

References

Bertrand, M and F Kramarz (2002), “Does entry regulation hinder job creation? Evidence from the French retail industry”, Quarterly Journal of Economics, vol. 117(4), pp. 1369–413.

Branstetter, L, F Lima, L Taylor, and A Venancio (2014), “Do Entry Regulations Deter Entrepreneurship and Job Creation?  Evidence from Recent Reforms in Portugal”, Economic Journal, vol. 124, pp. 805-832.

Bruhn, M (2011), “License to sell: the effect of business registration reform on entrepreneurial activity in Mexico”, Review of Economics and Statistics, vol. 93(1), pp. 382–6.

De Soto, H (1989), The Other Path:  The Invisible Revolution in the Third World, New York:  Harper and Row.

De Soto, H (2000), The Mystery of Capital:  Why Capitalism Triumphs in the West and Fails Everywhere Else, New York:  Basic Books.

Djankov, S (2008), “A Response to Is Doing Business Damaging Business?”, Working Paper, World Bank.

Djankov, S (2009), “The Regulation of Entry:  A Survey”, World Bank Research Observer, vol. 24 (2), pp. 183-203.

Djankov, S, R La Porta, F Lopez-de Silanes, and A Schleifer (2002), “The Regulation of Entry”, Quarterly Journal of Economics, vol. 117, pp. 1-37.

Djankov, S, C McLiesh, and R Ramalho (2006), “Regulation and Growth”, Economics Letters, vol. 92(3), pp. 395-401.

Kaplan, D S, E Piedra, and E Seira (2011), “Entry regulation and business start-ups: evidence from Mexico”, Journal of Public Economics, vol. 95(11), pp. 1501–15.

Lucas, R E (1978), “On the size distribution of business firms”, Bell Journal of Economics, vol. 9(2), pp. 508–23.

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Topics:  Europe's nations and regions Industrial organisation Labour markets

Tags:  barriers to entry, deregulation, firm entry

Professor of Public Policy and Economics, Carnegie Mellon University; Nonresident Senior Fellow, Peterson Institute for International Economics

Assistant Professor of Economics and Econometrics at the Department of Engineering and Management at Instituto Superior Técnico (IST), Universidade de Lisboa

H. John Heinz III Professor of Economics at the Heinz College, Carnegie Mellon University

Assistant Professor of Finance and Entrepreneurship at ISEG – Lisboa School of Economics and Management, Universidade de Lisboa

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