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2005world development report

A Better Investment Climatefor Everyone

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The World Bank

Washington, D.C.

2005world development report

A Better Investment Climatefor Everyone

Overview

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© 2004 The International Bank for Reconstruction and Development/The World Bank1818 H Street, N.W.Washington, D.C. 20433Telephone 202-473-1000Internet www.worldbank.orgE-mail [email protected]

All rights reserved.

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Cover and interior design: Susan Brown SchmidlerCover illustration commissioned by the WDR 2005 team; © Linda Frichtel

This document summarizes the World Development Report 2005, a copublication of the WorldBank and Oxford University Press. It is a product of the staff of the World Bank. The findings,interpretations, and conclusions expressed herein do not necessarily reflect the views of theBoard of Executive Directors of the World Bank or the governments they represent.

The World Bank does not guarantee the accuracy of the data included in this publicationand accepts no responsibility whatsoever for any consequence of their use.

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ISBN 0-8213-6005-1ISSN 0163-5085

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Overview 1The investment climate is central to growth andpoverty reduction 1

Tackling costs, risks, and barriers to competition 4

Progress requires more than changes in formalpolicies 5

A process, not an event 7

Focus on delivering the basics 9

Going beyond the basics involves additionalchallenges 12

The international community can lend a hand 14

PA RT IImproving the InvestmentClimate 17

1 The investment climate, growth,and poverty 19Understanding the investment climate 20

How investment climate improvements drivegrowth and reduce poverty 24

Sharpening the focus on poverty reduction 31

Creating a better investment climate for everyone 35

2 Confronting the underlyingchallenges 36The basic tension: Firm preferences or the publicinterest? 37

Restraining rent-seeking 40

Establishing credibility 45

Fostering public trust and legitimacy 50

Ensuring policy responses reflect a goodinstitutional fit 53

Making progress 54

3 Tackling a broad agenda 56The investment climate as a package 56

Setting priorities 58

Managing individual reforms 68

Maintaining momentum 71

Strengthening capabilities 74

Contents of the World Development Report 2005

v

PA RT IIDelivering the Basics 77

4 Stability and security 79Verifying rights to land and other property 80

Facilitating contract enforcement 84

Reducing crime 89

Ending the uncompensated expropriation ofproperty 92

5 Regulation and taxation 95Regulating firms 95

Taxing firms 106

Regulating and taxing at the border 111

6 Finance and infrastructure 115Financial markets 115

Infrastructure—connecting firms and expandingopportunities 124

7 Workers and labor markets 136Fostering a skilled and healthy workforce 137

Crafting interventions to benefit all workers 141

Helping workers cope with change 151

PA RT IIIGoing Beyond the Basics? 157

8 Selective interventions 159The allure—and traps—of selective interventions 159

Experience in specific areas 163

9 International rules and standards 175International arrangements and the investmentclimate 175

Enhancing credibility 176

Fostering harmonization 180

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Selected Indicators 243

Measuring the investment climate 244Challenges in measuring the investment climate 244

The World Bank’s new measures 245

Technical notes 250

Selected world development indicators 253Data sources and methodology 253

Changes in the System of National Accounts 253

Classification of economies and summary measures 254

Terminology and country coverage 254

Technical notes 265

vi WORLD DEVELOPMENT REPORT 2005

Addressing international spillovers 182

Future challenges 184

PA RT IVHow the InternationalCommunity Can Help 187

10 How the international community canhelp 189Removing distortions in developed countries 189

Providing more, and more effective, assistance 190

Tackling the substantial knowledge agenda 195

Bibliographical note 198

Endnotes 199

References 210

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This World Development Report is about creating opportunities for people to escape frompoverty and improve their living standards. It is about creating a climate in which firms andentrepreneurs of all types—from farmers and microenterprises to local manufacturing con-cerns and multinationals—have opportunities and incentives to invest productively, createjobs, and expand, and thereby contribute to growth and poverty reduction. The Report thusdeals with one of the central challenges of development.

Expanding opportunities for people in developing countries is a pressing concern for gov-ernments and for the global community. Nearly half the world’s population lives on less thanUS$2 a day, and 1.1 billion barely survive on less than US$1 a day.Young people have more thandouble the average unemployment rate in all regions, and population growth will add nearly2 billion more people to developing countries over the next 30 years. Improving the climate forinvestment in developing countries is essential to provide jobs and opportunities for youngpeople and to build a more inclusive, balanced, and peaceful world.

There is good news. More governments are recognizing that their policies and behaviorsplay a critical role in shaping the investment climates of their societies, and they are makingchanges. China and India provide compelling examples: investment climate improvements inthese countries have driven growth and the most dramatic reductions in poverty in history.Many other governments are also taking on the agenda, but progress remains slow and uneven.Governments still saddle firms and entrepreneurs with unnecessary costs, create substantialuncertainty and risk, and erect unjustified barriers to competition.

This year’s World Development Report, the 27th in the World Bank’s flagship series, looks atwhat governments can do to create better investment climates for their societies. Drawing onnew research, including surveys of nearly 30,000 firms in 53 developing countries, other newdata, and country case studies, it makes four main points.

First, the Report emphasizes that the goal should be to create an investment climate that isbetter for everyone—in two dimensions. The investment climate should benefit society as awhole, not only firms. Well-designed regulation and taxation are thus an important part of agood investment climate. And the investment climate should embrace firms of all types, notjust large or influential firms. Small and large firms, local and foreign firms, and low-tech andhigh-tech firms each have important and complementary contributions to make to growth andpoverty reduction.

Second, the Report argues that efforts to improve the investment climate need to go beyondjust reducing business costs. Those costs can indeed be extraordinary in many countries,amounting to several times what firms pay in taxes. But policy-related risks dominate firms’concerns in developing countries and can cripple incentives to invest. And barriers to competi-tion remain pervasive, dulling incentives for firms to innovate and increase productivity. Gov-ernments need to address all three aspects of a good investment climate.

Third, the Report underscores that progress requires more than changes in formal policies.The gaps between policies and their implementation can be huge, with the vast informaleconomies in many developing countries providing the most palpable evidence. Governments

Foreword

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viii WORLD DEVELOPMENT REPORT 2005viii WORLD DEVELOPMENT REPORT 2005

need to bridge these gaps and address deeper sources of policy failure that can undermine a soundinvestment climate. Governments need to tackle corruption and other forms of rent-seeking, tobuild credibility with firms, to foster public trust and legitimacy, and to ensure their policy interven-tions are crafted to fit local conditions.

Finally, the Report reviews strategies for tackling such a broad agenda. It emphasizes that perfec-tion is not required and that everything does not have to be done at once. But progress requires gov-ernments to address important constraints in ways that give firms the confidence to invest—and tosustain a process of ongoing improvements. Persistence pays off.

These findings are supported by detailed analysis and the many examples discussed throughoutthe Report, which should provide practical insights for policymakers and for others concerned withgrowth and poverty reduction in developing countries.

Improving the investment climate is the first pillar of the World Bank’s overall development strat-egy. The World Development Report 2005 complements last year’s WDR, which addressed key aspectsof the second pillar of that strategy: investing in and empowering people to take advantage of oppor-tunities. Together, these two Reports offer sound advice and research that will help the World Bankand our partners realize our common dream—a world free of poverty.

James D. WolfensohnPresidentThe World Bank

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This Report has been prepared by a team led by Warrick Smith and comprising MaryHallward-Driemeier, Gaiv Tata, George Clarke, Raj Desai, Timothy Irwin, Richard Messick,Stefano Scarpetta, and Ekaterina Vostroknutova. Leora Klapper and Sunita Kikeri also con-tributed. The team was assisted by Yanni Chen, Alexandru Cojocaru, Zenaida Hernandez,Tewodaj Mengistu, Claudio E. Montenegro, and David Stewart. Bruce Ross-Larson was thedevelopmental editor. The work was initiated under the direction of Nicholas Stern and carriedout under the general direction of François Bourguignon.

Many others inside and outside the World Bank provided helpful comments, includingDaron Acemoglu, Erik Berglöf, Robin Burgess, Ha-Joon Chang, Shantayanan Devarajan, DavidDollar, John Haltiwanger, Michael Klein, Howard Pack, and Lant Pritchett. The DevelopmentData Group contributed to the data appendix and was responsible for the Selected WorldDevelopment Indicators. Much of the background research was supported by generous trustfund grants from the U.K. Department for International Development and from the Swedishand Swiss Governments.

The team undertook a wide range of consultations for this Report, which included work-shops in Berlin, Dar-es-Salaam, London, New Delhi, Shanghai, and Washington, D.C.; video-conferences with sites in Brazil, Egypt, Guatemala, Honduras, Japan, Lebanon, Nicaragua, Rus-sia, and Serbia and Montenegro; and an on-line discussion of the draft report. Participants inthese workshops, videoconferences, and discussions included researchers, government officials,and staff of nongovernmental and private-sector organizations.

Rebecca Sugui served as executive assistant to the team, Ofelia Valladolid as program assis-tant, and Madhur Arora and Jason Victor as team assistants. Evangeline Santo Domingo servedas resource management assistant.

Book design, editing, and production were coordinated by the World Bank’s Office of thePublisher under the supervision of Susan Graham, Denise Bergeron, and Janet Sasser.

Acknowledgments

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1

Private firms are at the heart of the develop-ment process. Driven by the quest for profits,firms of all types—from farmers andmicroentrepreneurs to local manufacturingcompanies and multinational enterprises—invest in new ideas and new facilities thatstrengthen the foundation of economicgrowth and prosperity. They provide morethan 90 percent of jobs—creating opportuni-ties for people to apply their talents andimprove their situations. They provide thegoods and services needed to sustain life andimprove living standards. They are also themain source of tax revenues, contributing topublic funding for health, education, andother services. Firms are thus central actors inthe quest for growth and poverty reduction.

What determines the contributions firmsmake to society? Mainly the investment cli-mate—the location-specific factors that shapethe opportunities and incentives for firms toinvest productively, create jobs, and expand(box 1). Government policies and behaviorsplay a key role in shaping the investment cli-mate. While governments have limited influ-ence on such factors as geography, they havemore decisive influence on the security ofproperty rights, approaches to regulation andtaxation (both at and within the border), theprovision of infrastructure, the functioning offinance and labor markets, and broader gov-ernance features such as corruption.

Improving government policies andbehaviors that shape the investment climateis fundamental to driving growth andreducing poverty. That makes progressespecially critical for governments in thedeveloping world—where 1.2 billion peoplebarely survive on less than US$1 a day,where young people have more than doublethe average unemployment rate, and wheredemographic changes will add nearly 2 bil-

lion more people over the next 30 years.Expanding jobs and other opportunities foryoung people is essential to create a moreinclusive, balanced, and peaceful world.

New data from the World Bank providefresh insights into how investment climatesvary around the world—and how they influ-ence growth and poverty. These includeInvestment Climate Surveys, which covermore than 26,000 firms in 53 developingcountries, and the Doing Business Project,which benchmarks regulatory regimes inmore than 130 countries (box 2). WorldDevelopment Report 2005 draws on thosedata, other new evidence, and emerginglessons of international experience to showwhat governments at all levels can do to cre-ate a better investment climate—an invest-ment climate that benefits society as a whole,not just firms, and one that embraces allfirms, not just large or politically connectedfirms. In short, a better investment climatefor everyone.

How investment climates varyGovernment policies and behaviors shapethe opportunities and incentives facingfirms through their influence on costs, risks,and barriers to competition. All three mat-ter for firms—and for growth and poverty.

CostsWages, raw materials, and the like are nor-mal costs associated with any commercialactivity. But many costs flow more directlyfrom government policies and behaviors.Taxes are the most obvious example. Butgovernments also have an important role inaddressing market failures, providing pub-lic goods, and supporting the provision ofinfrastructure. Weaknesses in governmentperformance in these roles can greatly

Overview A better investment climate for everyone

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increase the costs for firms and make manyinvestment opportunities unprofitable.How greatly? The Bank’s surveys show thatthe costs of unreliable infrastructure, con-tract enforcement difficulties, crime, cor-ruption, and regulation can amount to over25 percent of sales—or more than threetimes what firms typically pay in taxes. Boththe level and the composition of these costsvary widely across countries (figure 1).

Costs also have a time dimension. TheBank’s firm surveys highlight big variationsin the time taken to get goods through cus-toms and to obtain a telephone line as well asin the amount of time firms need to spenddealing with officials. The Bank’s Doing

Business Project shows that the time it takesto register a new business ranges from 2 daysin Australia to more than 200 days in Haiti.

RisksBecause investment decisions are forwardlooking, firms’ judgments about the future arecritical. Many risks for firms, including uncer-tain responses by customers and competitors,are a normal part of investment, and firmsshould bear them. But governments have animportant role to play in creating a stable andsecure environment, including by protectingproperty rights. Policy uncertainty, macroeco-nomic instability, and arbitrary regulation canalso cloud opportunities and chill incentives

2 WORLD DEVELOPMENT REPORT 2005

The investment climate is the set of location-spe-cific factors shaping the opportunities and incen-tives for firms to invest productively,create jobs,and expand.Government policies and behaviorsexert a strong influence on the investment climatethrough their impact on costs, risks,and barriers tocompetition—and are the focus of this Report.

Firms are the starting point of theframework.This Report uses the term “firms” toinclude the full range of private economicagents, from farmers and microentrepreneurs todomestic manufacturing establishments andmultinational corporations, regardless of theirsize, activity, or formal legal status.

The horizontal plane in the figure belowrepresents their investment decisions and activi-

ties. Firms decide whether to incur costs todayto change or augment production in the future,such as investing in machinery, facilities, andresearch and development. Firms approach thedecision with different capabilities and strate-gies.Their decision is motivated by the quest forprofits—and profitability is influenced by thecosts, risks, and barriers to competition associ-ated with the opportunity.The volume and pro-ductivity of the resulting investment contributeto growth and poverty reduction.

A good investment climate is not just aboutgenerating profits for firms—if that were thegoal, the focus could be narrowed to minimizingcosts and risks. It is about improving outcomesfor society as a whole. Many costs and risks are

properly borne by firms. And reducing barriersto competition expands opportunities, spursinnovation, and ensures that the benefits of pro-ductivity improvements are shared withconsumers and workers.

The vertical plane in the figure representsthe investment climate. Some aspects of theinvestment climate, including geography andconsumer preferences, are difficult for govern-ments to change. But governments have moredecisive influence over a range of other factors.The specific influences on costs, risks, and barri-ers addressed in the Report are policies closelytied to investment behavior.Thus the forward-looking nature of investment underlines theimportance of stability and security, especiallythe security of property rights. Regulation andtaxation qualify property rights and have first-order implications on costs, risks, and barriers tocompetition. Finance, infrastructure, and laborare key inputs to investment activities.

But firms do not respond to formal policiesalone. They make judgments about how thosepolicies will be implemented in practice. Andfirms (like other stakeholders) try to influencepolicies in ways favorable to them. Issues ofgovernment behavior and governance in thebroadest sense—including corruption andcredibility—are thus paramount. It is the inter-action of formal policies and governance char-acteristics that firms assess when makinginvestment decisions.

Improving the investment climate is the firstpillar of the World Bank’s overall developmentstrategy. A critical complementary agenda,reflected in the second pillar of the Bank’s strat-egy, is to invest in and empower people so thatthey can take advantage of these opportunities.The World Development Report 2004: Making Ser-vices Work for Poor People focused on keyaspects of that second pillar.

B O X 1 What do we mean by the investment climate?


Barriers to competitionFirms prefer to face less competition, notmore. But barriers to competition that ben-efit some firms deny opportunities andraise costs for other firms and for con-

Overview 3

Figure 1 Costs vary widely in level and composition

Note: The survey asked registered firms to report values either in monetary terms, directly as a shareof sales, or in terms of time. “Contract enforcement difficulties” captures the share of inputs that arebelow agreed-upon quality (weighted by material inputs in total sales) and overdue payments (as ashare of total payments, using an interest rate of 10 percent for the average length of overdue pay-ments). “Regulation” captures management time spent dealing with officials (weighted by the cost ofmanagement compensation to total sales), and the gap in actual employment relative to desired lev-els due to regulatory costs associated with hiring and firing workers (weighted by total labor costs insales). “Bribes” are the total costs of bribes as a share of sales. “Crime “ is the sum of losses due totheft, security costs, and protection payments (as a share of sales). “Unreliable infrastructure”includes sales lost due to interruptions in power and telecommunications and due to the loss ordamage of goods in transit. Countries selected to illustrate range.Source: World Bank Investment Climate Surveys.

TanzaniaAlgeriaBrazilChinaPoland0

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Cost

as

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30Contract enforcement difficultiesRegulationBribesCrimeUnreliable infrastructure

Crime 2%Skills 2%

Electricity 2%Finance 4%

Corruption 10%

Regulation10%

Tax 19%

Macroeconomicinstability 23%

Policyuncertainty28%

Figure 2 Policy-related risks dominate theinvestment climate concerns of firms

Note: Share of countries where firms report issue as top constraintin surveys of 48 countries.Source: World Bank Investment Climate Surveys.

to invest. The Bank’s surveys show that policy-related risks dominate investment climateconcerns across developing countries (figure2). The surveys also highlight some of thevariations across countries (figure 3).

Early efforts to understand how government poli-cies and institutions influenced growth relied onaggregate indicators of a country’s institutionalframework, such as the rule of law and corruption.This work generated useful insights, the mostimportant of which are that secure propertyrights and good governance are central ineconomic growth. But aggregate data providelimited insights into the heterogeneity of institu-tional arrangements across and within countries,or the impact of those arrangements on theinvestment decisions of different types of firms.They also make it hard to distinguish the effects ofspecific policy actions from broader backgroundinstitutions.These limitations inspired a quest formore disaggregated evidence.

As a contribution to this effort, the WorldBank recently launched two major initiatives tobetter understand how the quality of a location’sinvestment climate influences the investmentdecisions and performance of firms and so con-tributes to growth and poverty reduction.

• Investment Climate Surveys. Large randomsamples of firms have been interviewed tocollect assessments of constraints facingfirms as well as objective quantitative data onmeasures of the investment climate and firmperformance.This allows investment climateindicators to be linked with firm performanceto better understand their impact on produc-tivity, investment decisions, and employmentdecisions. In many cases subnational jurisdic-tions are included, capturing variations acrosslocations within a country.The surveys werelaunched in 2001, with about 20 new surveysconducted each year since.This Report drawson early results from this work, covering morethan 26,000 firms in 53 countries.The Invest-ment Climate Surveys build on the WorldBusiness Environment Surveys, launched in1999, which covered smaller samples of firmsand relied more heavily on perception data.

• Doing Business Project. The project developsbenchmark information on the operation of

various regulatory regimes in more than 130countries. It reports on the costs of doingbusiness for a defined hypothetical firm andtransaction based on the views of selectedlocal experts (lawyers, accountants).Theunderlying information includes the time andcosts of complying with various policy andregulatory frameworks—including businessregistration, contract enforcement, and laborregulation. A first report was published in2003, with annual updates scheduled withadditional topics.

To complement these initiatives the Reportsurveyed 3,250 microentrepreneurs in the infor-mal economy in 11 countries recently complet-ing Investment Climate Surveys.

Further details on the new data sources areprovided in the Report and also available at:http://econ.worldbank.org/wdr/wdr2005.

Source: Kaufmann, Kraay, and Mastruzzi (2003);Burgess and Venables (2003); Pritchett (2004).

B O X 2 New sources of investment climate data from the World Bank


sumers. Barriers can also dull the incentivesfor protected firms to innovate and increasetheir productivity. Some barriers stem fromnatural features, such as distance andeconomies of scale associated with particu-lar technologies. High costs and risks canact as barriers to entry. Governments alsoinfluence barriers more directly throughtheir regulation of market entry and exit


Figure 3 Concerns about policy-related risks vary widely acrosscountries

0.0

0.2

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0.6

0.8

1.0

Macroeconomicinstability

Unpredictable interpretationof regulations

Policyuncertainty

Lackconfidence

in courts

BangladeshEstoniaPhilippinesZambia

Note: Smaller numbers reflect less concern. Countries selected to illustrate range.Source: World Bank Investment Climate Surveys.

Figure 4 Investment climate conditions vary within countries, as in China

0

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TianjinShanghaiGuangzhouChenduBejingChina

Number of days to obtain a mainline telephone connection

Number of days to clear customs for imports

Percent of production lost because of power outages

Source: World Bank Investment Climate Surveys.

and their response to anticompetitivebehavior by firms. While difficult to mea-sure at the aggregate level, firm surveysshow how the competitive pressure felt byfirms can vary greatly across countries. Forexample, competitive pressure is reportedto be significant for 90 percent of firms inPoland, but only 40 percent of firms inGeorgia.

Variations within countries and across firmsInvestment climates vary on these dimensionsnot only across countries, but also withinthem, as a comparison among locations inChina makes clear (figure 4). Variations canstem from differences in the policies andbehaviors of subnational governments, orfrom the way national policies are adminis-tered. Investment climates tend to be less hos-pitable in rural areas, reducing opportunitiesfor farmers and nonagricultural firms alike.

Even within a single location, the sameconditions can affect firms differently. Thiscan be true across activities—farmers, manu-facturers, and hairdressers can each have dif-ferent perspectives and priorities. Manyaspects of a poor investment climate also hitsmall firms and those in the informal econ-omy the hardest (figure 5).

50

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Have a loanfrom aformal

financialinstitution

Confidentthat courtswill uphold

propertyrights

Believeregulations

will beinterpretedconsistently

Large

MediumSmall

Informal

Note: Based on 10 countries for which formal and informal surveyswere conducted, controlling for industry, country, ownership, andfirm age. Source: World Bank Investment Climate Surveys and WDR Sur-veys of Micro and Informal Firms.

Figure 5 Small and informal firms are often hit hardest by investment climate constraints


Overview 5

How the investment climateinfluences growth and povertyFirms naturally care about the investment cli-mate. So should societies. Improving theinvestment climate plays a central role in driv-ing growth and reducing poverty. How?

Driving growthAs populations get larger, economic growthprovides the only sustainable way of improv-ing living standards. A good investmentclimate drives growth by encouraging invest-ment and higher productivity. Investmentunderpins growth by bringing more inputs tothe production process. Foreign investment isbecoming more important in developingcountries, but the bulk of private investmentremains domestic (figure 6).

A good investment climate encouragesfirms to invest by reducing unjustified costs,risks, and barriers to competition. As a resultof investment climate reforms, privateinvestment as a share of GDP nearly dou-bled in China and India; in Uganda it morethan doubled. The same result is confirmedby more micro-level evidence. In Poland,Romania, Russia, Slovakia, and Ukraine,firms that believe their property rights aresecure reinvest between 14 and 40 percentmore of their profits in their businesses thanthose that don’t.1 Farmers in Thailand withmore secure rights to land invested so muchmore in their land that their output was14–25 percent higher than those working onuntitled lands of the same quality.2 Reduc-ing barriers to competition in telecommuni-cations in the 1990s unleashed a surge ofnew investment—including by microentre-preneurs in Bangladesh and Uganda. Firm-level data show that improving policy pre-dictability can increase the likelihood offirms making new investments by morethan 30 percent (figure 7).

But it is not just the volume of invest-ment that matters for growth—it is the pro-ductivity gains that result.3 Indeed, cross-country studies show that total factorproductivity accounts for around the sameshare of growth in GDP as does capitalaccumulation (figure 8).

A good investment climate encourageshigher productivity by providing opportu-nities and incentives for firms to develop,

adapt, and adopt better ways of doingthings—not just innovations of the kindthat might merit a patent, but also betterways to organize a production process, dis-tribute goods, and respond to consumers.What is required? Low barriers to the diffu-sion of new ideas, including barriers toimporting modern equipment and adjust-ing the way work is organized, are essential.And an environment that fosters the com-petitive processes that Joseph Schumpetercalled “creative destruction”4—an environ-ment in which firms have opportunitiesand incentives to test their ideas, strive forsuccess, and prosper or fail. A good invest-ment climate makes it easier for firms toenter and exit markets in a process thatcontributes to higher productivity andfaster growth. Net market entry can accountfor more than 30 percent of productivitygrowth. And firms reporting strong com-petitive pressure are at least 50 percentmore likely to innovate than those report-ing no such pressure (figure 9).

Reducing povertyImproving the investment climate is criti-cal in the fight against poverty. The contri-bution can be seen in two ways. First, atthe aggregate level, economic growth isclosely associated with reductions inpoverty (figure 10).

Second, the contribution can be seen inthe way a good investment climate enhances

Figure 6 Domestic private investment dominates foreign direct investment

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20001990

Private gross fixed capital formation

1980

FDI

Note: Annual averages of 92 developing countries.Source: World Bank (2004b).

Figure 7 Improving policypredictability can increase thelikelihood of new investment by over30 percent

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Changes in unpredictabilityof laws and regulations

Significantimprovement

Someimprovement

Minorimprovement

Note: Percentage increase is relative to firmsreporting no improvement in predictability. Sim-ulations based on firm responses to survey, with80 countries, controlling for region, firm size,and sector.Source: World Bank World Business Environ-ment Survey.

Education 14%

Capital 45%

TFP 41%

Note: Sources of growth for 84 countries from1960–2000. “TFP” is total factor productivity. Source: Bosworth and Collins (2003).

Figure 8 Productivity accounts for asignificant share of growth


tions can be poor (figure 12). Expectedpopulation growth in developing countriesreinforces the importance of acceleratingthe creation of more and better jobs indeveloping countries. Where will the jobscome from? Mostly from the private sector,which accounts for more than 90 percentof employment in most countries, and 95percent in countries such as El Salvadorand India.6 Better employment opportuni-ties also increase incentives for people toinvest in their education and skills—thuscomplementing efforts to improve humandevelopment. More productive firms, nur-tured by a good investment climate, canalso pay better wages and invest more intraining.7

As entrepreneurs. Hundreds of millions ofpoor people make their living as microen-trepreneurs—as farmers, as street vendors,as homeworkers, and in a diverse range ofother occupations—mostly in the informaleconomy. Surveys for this Report show thatfirms in the informal economy face many ofthe same constraints as other firms, includ-ing insecure property rights, corruption,policy unpredictability, and limited accessto finance and public services. Relievingthese constraints increases microentrepre-neurs’ incomes and allows them to expandtheir activities. A good investment climatealso increases incentives to join the formaleconomy.

As consumers. A good investment climateexpands the variety and reduces the costs ofgoods and services, including those con-sumed by poor people. For example, invest-ment climate improvements lowered theprice of food in countries includingEthiopia, Ghana, Kenya, Vietnam, andZambia.8 Lowering barriers to market entryby 10 percent has been estimated to reducethe average price markup by nearly 6 per-cent.9

As users of infrastructure, finance, and prop-erty. Improving infrastructure, finance andproperty rights can deliver broad benefitsacross the community. Constructing ruralroads helps firms, and in Morocco alsoincreased primary school enrollment from28 percent to 68 percent.10 Expanding access


Figure 10 Poverty reduction is closely associated with growth

Note: Data for Uganda are from 1992–2000 and uses its national poverty level due to dataavailability.Source: Chen and Ravallion (2004); World Bank (2004b).

420–2 6Average per capita growth rate, 1981–2001

Decl

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ChinaEast Asia other than China

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UgandaIndia

Middle East & North AfricaLatin America & the Caribbean

Eastern Europe & Central Asia

Sub-Saharan Africa

South Asia other than India

Figure 9 More competitive pressure, more innovation

50

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0

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Introducenew product

Upgradeproduct

Introduce newtechnology

Somepressure

Moderatepressure

Majorpressure

Note: Percentage increase is relative to firms’ reporting no competitivepressure. Based on 27 countries in Eastern Europe and Central Asia. Source: World Bank Investment Climate Surveys/BEEPS II.

the lives of people directly—in their manycapacities.

As employees. The World Bank’s Voices ofthe Poor study found that poor peopleidentified getting a job—whether throughself-employment or from wages—as theirmost promising path out of poverty (fig-ure 11). Young people have more thandouble the average unemployment rate inall regions.5 In many developing countriesmore than half the population work in theinformal economy, where working condi-


to finance helps firms develop their busi-nesses, and also helps poor people weatherfamily emergencies and educate their chil-dren. Providing more secure rights to landcan encourage investment and ease access tofinance, and in Peru was also found to enableurban slum dwellers to increase theirincomes by working more hours outside thehome.11

As recipients of tax-funded services or trans-fers. Firms and their activities are the prin-cipal source of tax revenues for govern-ments, and growing economies generatemore taxes. A good investment climate canthus expand the resources governmentshave available to fund the provision of pub-lic services (including health and educa-tion) and transfers to disadvantaged mem-bers of society.

Some investment climate improvementsdeliver broad benefits across society—suchas better macroeconomic stability and lesscorruption. Others have a more focusedimpact on a particular location or activity,creating opportunities for governments toinfluence the distribution of benefits. Gov-ernments can design those investment cli-mate improvements to be even more “pro-poor” by focusing on constraints wherepoor people live and on constraints to activ-ities poor people benefit from, including intheir capacities as employees, entrepre-neurs, consumers, or users of infrastruc-ture, finance, and property. This means thatpro-poor approaches are not limited toefforts focusing on constraints that facesmaller firms.

Confronting the underlyingchallengesMore countries are improving their invest-ment climates—and reaping the rewards offaster growth and less poverty. Despite thegreat rewards, progress is often slow anddifficult. Why?

The basic tensionSocieties benefit greatly from the activitiesof firms. But the preferences of firms don’tfully match those of society—a tensionmost evident in taxation and regulation.Most firms complain about taxes, but taxes

finance public services that benefit theinvestment climate and other social goals.Many firms would also prefer to complywith fewer regulations, but sound regula-tion addresses market failures and cantherefore improve the investment climateand protect other social interests. Similartensions can occur across most areas ofinvestment climate policymaking.

Creating a good investment climaterequires governments to balance these inter-ests. Complicating this task are the differ-ences in preferences and priorities betweenfirms. Firms have common perspectives onmany issues, but their views can diverge onothers—whether on market restrictions, thestructure of taxation, or the priority given toinfrastructure improvements in differentlocations. There can also be differences inpolicy preferences within firms—betweenowners and managers on matters of corpo-rate governance, or between owners andworkers on labor market policies. All gov-ernments must arbitrate those differences inan environment in which firms, officials,and other stakeholders seek to tilt the out-come to their advantage.

Four resulting challengesResponding to this tension requires govern-ments to navigate four interrelated chal-lenges that cut across all areas of investmentclimate policymaking. The way governments

Overview 7

Figure 11 Self-employment and wage income are the ways out of poverty

0 10 20 30 40 50 60 70

Other

Savings

Migration

Education

FemaleMale

Access to credit

Hard work, perseverance, or thrift

Skill acquisition

Access to agricultural land

Income from agriculture, livestock, or fishing

Benefit of family and kin

Income from wages or salaries

Self-employment or business

Percent

Note: Reports views of 60,000 poor people on how they saw their best prospects of escaping poverty.Source: Narayan and others (2000).

Source: Schneider (2002).

0 25

Informal outputas percent of GDP

50 75

Thailand

Nigeria

Tanzania

Peru

Georgia

Russia

Sri Lanka

Morocco

Mexico

Figure 12 The informal economy is substantial in many developingcountries


respond to those challenges has a bigimpact on investment climates and thus ongrowth and poverty (box 3). And eachinvolves going beyond changes in formalpolicies to confront deeper sources ofpotential policy failure. The challenges:restraining rent-seeking, establishing credi-bility, fostering public trust and legitimacy,and ensuring that policy responses reflect agood institutional fit.

Restraining rent-seeking. Investment cli-mate policies are an enticing target for rent-seeking by firms, officials, and other interestgroups. Corruption can increase the costs ofdoing business—and when it extends tohigher echelons of government, it can leadto deep distortions in policies. The Bank’ssurveys show that the majority of firms indeveloping countries expect to pay bribeswhen dealing with officials, and many ratecorruption as the most severe constraint totheir operations. Capture and patron-clientelism—reflecting unequal information

and influence in policymaking—can alsocreate large distortions, tilting policies infavor of some groups at the expense of oth-ers. Markets are restricted, the allocation ofproperty rights skewed, financial marketsdistorted. Eliminating unjustified interven-tions in the economy, curbing discretion,and improving the accountability of govern-ments, particularly through greater trans-parency, help to restrain rent-seeking.

Establishing credibility. Because investmentis forward looking, uncertainty clouds allinvestment decisions. So the confidence offirms in the future—including the credibil-ity of government policies—determineswhether and how they invest. Policies thatlack credibility will fail to elicit the intendedinvestment response. What undermines thecredibility of policy? A legacy of political oreconomic instability does not help. But allgovernments face temptations to compro-mise sound long-term policies to meetshorter-term or narrower goals, such asextracting rents for policymakers or curry-ing favor with some voters. Building credi-bility requires mechanisms for governmentsto commit to sound policies, as well as dis-cipline and persistence.

Fostering public trust and legitimacy. Firmsand governments do not interact in a vac-uum. Trust among market participantsnurtures productive exchange and reducesthe burden on regulation and contractenforcement. Social attitudes—includingtrust in markets and in firms—also influ-ence the feasibility, sustainability (andhence credibility) of policy improvements.Good investment climates are thus nur-tured by broad public support: by a con-sensus in favor of building a more produc-tive society that can facilitate policyimprovements, regardless of the politicalparty or group in office. Open and partici-patory policymaking and efforts to ensurethat the benefits of a better investment cli-mate extend widely in society can help tobuild that support.

Ensuring that policy responses fit local con-ditions. To be effective, policy interventionsneed to take into account sources of poten-


The opportunities and incentives that firmsface to invest productively,create jobs,andexpand are shaped by the costs, risks,and bar-riers to competition associated with particularinvestment opportunities.Governments influ-ence those factors through a combination oftheir formal policies in particular areas—sta-bility and security, regulation and taxation,finance and infrastructure,and workers andlabor markets—and their behaviors andbroader governance characteristics.The latterinclude control of rent-seeking,credibility,public trust and legitimacy,and the fitbetween the chosen policy response and localinstitutional conditions.

Formal policies interact with governmentbehaviors and broader governance charac-teristics to shape the investment climateexperienced by firms (see figure). Poor con-trol of rent-seeking can influence both thecontent and the implementation of formalpolicies. Low credibility can undermine theimpact of any policy. Concerns about publictrust and legitimacy can impede the imple-mentation of reforms and undermine thesustainability (and hence credibility) of poli-cies. Policy interventions that are not welladapted to local conditions can have poor oreven perverse results.Tackling these sourcesof potential policy failure is fundamental toefforts to create a better investment climate.

B O X 3 Governance and the investment climate


tial government failure, as well as differ-ences in local conditions. Failure to do socan lead to poor or even perverse results.Approaches that demand capacity beyondthat available will not only fail to meet theirintended objective, but also contribute toinformality and corruption and underminecredibility. Approaches that involve highlevels of discretion expose firms to consid-erable uncertainty and risk when effectivesafeguards against the misuse of that dis-cretion have not yet been developed. Whydo these problems come about? Too often,policy and regulatory approaches havebeen transplanted uncritically from onecountry to another. This phenomenondates back to colonial eras, when develop-ing countries inherited policy approachesthat had little to do with local circum-stances. Many of these museum piecesremain on the books today, many decadeslater. But the tendency persists. Whileapproaches in today’s rich countries canprovide a valuable source of inspiration,care needs to be taken to adapt approachesto local conditions. In some cases this mayinvolve the choice of simpler rules with lessdiscretion and additional measures torestrain arbitrary behavior.

Tackling a broad agendaGovernment policies and behaviors shapingthe investment climate play out over a widefield, from contract enforcement and busi-ness regulation to the provision of infra-structure and labor market policy. Policiesand behaviors in each area can influence theopportunities and incentives for firms. Andthe policy areas often interact, with progressin one area possibly influenced by progressin others. This implies a broad agenda forgovernment.

No country, however, has a perfectinvestment climate. Nor is perfection oneven one dimension required for significantgrowth and poverty reduction. Experienceshows that progress can be made byaddressing important constraints in a waythat gives firms the confidence to invest—and by sustaining a process of ongoingimprovements (box 4).

Early rounds of economic reform weresometimes seen as one-off events. But invest-

ment climate improvements involve an ongo-ing process of policy adjustment and fine-tuning across a wide domain. This is as truein today’s rich countries as it is in developingcountries. Policies need regular review toreflect changes in the conduct of business andlessons from ongoing experience. MichaelPorter has suggested that reforms in this areaare a marathon, not a sprint,12 but even thatassessment may understate the task.

International experience provides insightsinto the essential elements of reformprocesses in this area: setting priorities;managing individual reforms; maintainingmomentum; and strengthening govern-ment capabilities.

Setting prioritiesThe goal is to identify important con-straints that face firms. There are no stan-dard formulas. Instead, it requires an assess-ment in each case of current conditions, thepotential benefits from improvements, links

Overview 9

China, India, and Uganda illustrate somesimple lessons about strategies for makinginvestment climate improvements.

China and India have both grownimpressively in recent years, greatly reduc-ing poverty. China’s growth is officiallyreported at an average of 8 percent a yearfor the past 20 years, and the share of itspopulation living on less than US$1 a dayfell from 64 percent in 1981 to less than 17percent in 2001. India’s growth hasincreased from an average of 2.9 percent ayear in the 1970s to 6.7 percent by the mid-1990s, and the share of its population livingon less than US$1 a day fell from 54 percentin 1980 to 35 percent in 2000.

Yet neither country has an ideal invest-ment climate. China only recently gave con-stitutional recognition to private property,and its banking sector is dragged down bynonperforming loans. Problems in India’spower sector are legendary. Both countriesunleashed growth and reduced povertythrough what appeared to be fairly modestinitial reforms. China began with a rudimen-tary system of property rights that creatednew incentives for a substantial part of itseconomy. India began with early efforts toreduce trade barriers and other distortionsthat covered a significant part of its econ-

omy. In both cases the reforms addressedimportant constraints, and wereimplemented in ways that gave firms confi-dence to invest. And the initial reforms havebeen followed by ongoing improvementsthat addressed constraints that were lessbinding initially, and also reinforced confi-dence in the future path of governmentpolicy.

Such strategies are not limited to largecountries. Uganda launched its program ofinvestment climate improvements in theearly 1990s after a period of civil conflict.Reforms covering many areas of the invest-ment climate provided the basis for grow-ing its economy by an average of more than4 percent a year during 1993–2002 (or8 times the average in Sub-Saharan Africa)and reducing the share of its population liv-ing below the poverty line from 56 percentin 1992 to 35 percent in 2000.Thepersistence of its reform efforts enhancedthe government’s credibility—giving firmsthe confidence to invest.

Source: China: Chen and Wang (2001), Qian(2003), and Young (2000); India: Aghion and oth-ers (2002), Ahluwalia (2002), De Long (2003),Rodrik and Subramanian (2004),Varshney(1998), and Panagariya (2003); Uganda: Holm-gren and others (2001) and World Bank (2001).

B O X 4 Tackling a broad agenda: Lessons from China,India, and Uganda


with national or regional goals, and imple-mentation constraints.

Current conditions. The most importantconstraint can differ widely across coun-tries, even within a single region (figure 13).Governments can identify them by survey-ing and consulting with firms, with thecaveat that existing firms will not alwaysreflect the perspectives of future entrants.New sources of data also allow the bench-marking of current policy performanceagainst international comparators in agrowing number of areas—highlighting thescope for improvement.

Potential benefits. When the goal is toaccelerate growth, an improvement thataffects a large part of the economy will usu-ally have a bigger impact than reforms thataffect a smaller part. Progress in achieving areasonable level of political and macroeco-nomic stability is thus fundamental—with-out it reforms in other areas will gain littletraction. Enhancing policy credibility canalso leverage the investment response toreforms in any particular policy area. A keyconsideration will be the impact ofimprovements on opportunities for poorpeople—including as employees, entrepre-neurs, or consumers.

Governments should also considerbenefits that may extend beyond the firmsand activities affected most directly. These

may include spillovers to other firms (forexample, from foreign direct investmentto local firms), to other policy areas (forexample, from rights to land to access tofinance), or to broader social goals (forexample, infrastructure improvementsbenefiting the broader community, notjust firms). There can also be spillovers togovernment capabilities, credibility, orconstituency building.

Links with national or regional goals. Invest-ment climate improvements can affect firmsand activities differently. Because of this,priority-setting will often be influenced bythe weight governments place on a subset ofthe goals a good investment climate candeliver: integrating the informal and ruraleconomies; unleashing the growth potentialof smaller firms; taking advantage of inter-national openness; and enabling firms toclimb the technology ladder.

• Integrating informal firms. The informaleconomy produces more than 50 percentof GDP in many developing countries.While less constrained by taxes and reg-ulations, firms in the informal economyusually have less secure property rightsand more difficulty getting public ser-vices and finance. Integrating them intothe formal economy involves addressingthe constraints they find most binding—and reducing obstacles to going formal.

• Integrating rural firms. Firms in rural areasusually face less hospitable investment cli-mates than those in urban areas—due tolower population densities, greater dis-tances to large markets, and fewer publicservices. Improving infrastructure canmake a big difference, and deliver benefitsto broader communities as well as firms.

• Unleashing the growth potential of smallerfirms. Small firms tend to face dispropor-tionate burdens in coping with poorinvestment climates due to the impact offixed costs and greater difficulty obtain-ing financing. Addressing constraintsthat place a particularly heavy burden onsmall firms can help to unlock theirgrowth potential.

• Taking advantage of international open-ness. Most countries have made a decisive


Figure 13 Constraints reported by firms—comparing Bulgaria, Georgia, and Ukraine

Finance

1

0.5

Taxation

Regulation

Security & stability

Labor

Infrastructure

Ukraine

Georgia

Bulgaria

Note: Resulting indicators range from 0 (best) to 1 (worst). Indicesare based on surveys of formal firms. Values are normalized byregional maxima and minima for each indicator. Countries selectedto highlight differences.Source: World Bank Investment Climate Surveys.


shift toward more open economies—andfirm-level evidence confirms that they arereaping the benefits of higher productiv-ity. Beyond reducing remaining trade andinvestment barriers, progress oftenrequires tackling constraints in such areasas ports and customs administration.

• Climbing the technology ladder. Techno-logical progress underpins productivityimprovements and growth. But countriesdo not need to invent everything afresh.Firm surveys show that knowledgeembedded in new machinery and equip-ment is the main source of technologicalinnovation in developing countries.Reducing policy barriers to the adoptionor adaptation of technologies developedelsewhere is thus a first step. Securingproperty rights and reducing barriers tocompetition provide the incentives forfirms to pursue these opportunities.

Implementation constraints. At any point intime the range of potential policy improve-ments will usually be constrained byadministrative and political feasibility.Well-designed strategies address these con-straints through effective management ofreforms and the ongoing strengthening ofgovernment capabilities.

Managing individual reformsThere is often resistance to investment cli-mate reforms from those who benefit fromthe status quo. That resistance may comefrom firms or other interest groups benefit-ing from market distortions or other specialprivileges, officials benefiting from bribesor other perquisites of office, or even thewider community when the implications ofreform are not certain. Experience showsthat progress is possible when committedgovernments communicate to build publicsupport, engage stakeholders construc-tively, and (when appropriate) providesome form of compensation to those disad-vantaged by change. Special efforts to helpvulnerable groups cope with change are alsoimportant, particularly when economywidesafety nets are not yet in place.

Maintaining momentumBecause investment climate improvementsare a process, rather than a one-off event,

many countries are creating specialist insti-tutions to help with specific tasks and tosustain progress even through changes ingovernment. These institutions can per-form one or a combination of several roles:consultation with stakeholders, policycoordination, and the more systematicreview of existing investment climate con-straints. Latvia, Senegal, Turkey, and Viet-nam illustrate possible approaches. Gov-ernments are also creating mechanisms toreview new policy and regulatory proposalsmore systematically to ensure that they donot introduce unwarranted distortions.Experience in countries such as Mexico andSouth Korea is encouraging, but politicalcommitment and good institutional designare fundamental.

Strengthening governmentcapabilitiesStrengthening government capabilities is anessential part of any strategy to improve theinvestment climate. Strengthening capabili-ties in regulation is often a high priority.Traditional models for building capacity arebeing complemented by approaches thatfacilitate peer-to-peer learning. Local capac-ity is also being augmented by contracting-out some specialist functions—a commonstrategy even in developed countries. Gov-ernments also need to improve their abilityto monitor the performance of their privatesectors so that they can identify trends andemerging issues and evaluate the impact oftheir policies. Upgrading the quality ofnational statistical systems is an importantpart of these efforts.

Delivering the basicsIndustrial development is usually a processof discovery, making it difficult to predictwhat a country or region will be good atproducing. This underscores the impor-tance of improving the basic foundations ofthe investment climate to benefit all firmsand activities in the economy. Internationalexperience highlights promising approachesin each of the four core areas of the invest-ment climate:

• Stability and security

• Regulation and taxation

Overview 11


• Finance and infrastructure

• Workers and labor markets.

Stability and securityThe outbreak of war or other widespreadviolence spells the end of almost all produc-tive investment. But firms require morethan peace to commit energy and resourcesto investing productively. A reasonable levelof political and macroeconomic stability isthe threshold requirement for a soundinvestment climate. Unstable or insecureenvironments have their most tangibleeffect on investment through their impacton property rights.

Secure property rights link effort withreward, assuring firms that they will be ableto reap the fruits of their investments. Thebetter protected these rights from govern-ment or third parties, the stronger the linkbetween effort and reward, and thus thegreater the incentives to open new busi-nesses, to invest more in existing ones, andsimply to work harder. Studies in manycountries show that the more secure therights, the faster the growth. Improving thesecurity of property rights requires action infour main areas: verifying rights to land andother property; facilitating contract enforce-ment; reducing crime; and ending theuncompensated expropriation of property.

Verifying rights to land and other property.Providing more secure rights to land and

other property encourages investment andeases access to finance. Experience in Peru,Thailand, and a growing number of othercountries highlights the benefits of clarify-ing ownership of land and maintaining aneffective registration system. Registries forequipment and other forms of moveableproperty also play an important role.

Facilitating contract enforcement. A securecontracting environment reduces the risksand costs associated with transactions andeases access to finance. In many developingcountries more than half the firms surveyedlacked confidence in the courts to upholdtheir property rights (figure 14). According tothe Bank’s Doing Business Project, the timetaken to enforce a simple contract can rangefrom 48 days in the Netherlands and nearly600 days in Bolivia to more than 1,400 days inGuatemala. Strengthening courts is thus ahigh priority. Complementary measuresinclude facilitating the free flow of reputationinformation and removing unjustifiedimpediments to the use of alternative disputeresolution mechanisms.

Reducing crime. Crime imposes large costs onsocieties—approximately a quarter of GDP insome countries in Latin America.13 Firm sur-veys show that crime is also a severe constraintfor many firms in all regions. Promisingstrategies involve efforts to prevent and detercrime, as well to improve enforcement. Com-munity policing strategies along the lines ofthose applied in New York City are being pur-sued in many countries around the world.

Ending the uncompensated expropriation ofproperty. All governments reserve the right toexpropriate private property in some circum-stances. But concerns about the arbitrary exer-cise of this power can chill incentives to invest.The key is to create credible restraints onexpropriation without prompt, adequate, andeffective compensation.

Regulation and taxationThe way governments regulate and taxfirms and transactions—domestically andat the border—plays a big role in shapingthe investment climate. Sound regulationaddresses market failures that inhibit pro-ductive investment and reconciles the inter-


Figure 14 Firms in many countries lack confidence that thecourts will uphold their property rights

Note: Countries selected to illustrate range.Source: World Bank Investment Climate Surveys.

0 20 40 60 80 100

Malaysia

Algeria

Zambia

Brazil

Czech Rep.

Kenya

Kyrgyzstan

Guatemala

Moldova

Bangladesh

Percent of firms


ests of firms with wider social goals. Soundtaxation generates the revenues to financethe delivery of public services that improvethe investment climate and meet other socialobjectives. The challenge all governmentsstruggle with is how to meet these objectiveswithout undermining the opportunities andincentives for firms to invest productively,create jobs, and expand. While there are ten-sions between firms’ preferences and socialgoals in this area, there is huge scope toimprove approaches in most developingcountries without compromising broadersocial interests.

Improving domestic regulation. Too often,governments pursue regulatory approachesthat fail to meet the intended social objec-tives, yet harm the investment climate byimposing unnecessary costs and delays (fig-ure 15), inviting corruption, increasinguncertainty and risk, and creating unjusti-fied barriers to competition. Why? Problemsflow from two main sources. First, regula-tory systems in all countries are vulnerableto rent-seeking by firms, officials, and otherinterests, often reflected in unjustifiedrestrictions on competition or red tape. Sec-ond, many regulatory systems in developingcountries have been uncritically trans-planted from other countries withoutenough consideration of differences in localconditions.

The key is to strike a better balancebetween market failures and governmentfailures, including by tailoring approaches toreflect local conditions and by enhancingtransparency. Successful reforms reducecosts by removing unjustified burdens andstreamlining procedures, as with reforms tobusiness registration requirements inBolivia, Uganda, and Vietnam. They reduceregulatory uncertainty and risk, by curbingunnecessary discretion and expanding con-sultation. And they remove unjustified bar-riers to competition by reducing regulatorybarriers to entry and exit and by tacklinganticompetitive behavior by firms.

Improving domestic taxation. Everyonecomplains about taxes, and firms in develop-ing countries are no exception. Tax rates indeveloping countries are similar to those indeveloped countries. But a high level of

informality, coupled with poor administra-tion and corruption, reduces revenue collec-tions, puts a disproportionate burden onthose who do comply, and distorts competi-tion. Keeping the size of government incheck and spending public money efficientlyhelps to ease the pressure on revenue collec-tion. Beyond this, promising strategiesinvolve efforts to broaden the tax base andsimplify tax structures. Increasing the auton-omy of tax agencies has also improved per-formance in Peru and many other countries.

Improving regulation and taxation at theborder. Most countries have reduced barriersto international trade and investment inrecent years, but many barriers remain.Improving customs administrations can alsooffer big benefits, with successful approachesexploiting new information technologies toreduce delays and corruption, as in Ghana,Morocco, and Singapore.

Finance and infrastructureFinancial markets, when functioning well,connect firms to lenders and investors will-ing to fund their ventures and share some ofthe risks. Good infrastructure connects firmsto their customers and suppliers and helpsthem take advantage of modern productiontechniques. Conversely, inadequacies infinance and infrastructure create barriers toopportunities and increase costs for micro-entrepreneurs as well as multinationals. Byimpeding new entry into markets, inadequa-cies also limit the competitive discipline fac-ing incumbent firms, dulling their incentives

Overview 13

Figure 15 Number of days to register a new business—from 2 days in Australia to 203 days in Haiti

0 50 100 150 200

Haiti

El Salvador

India

China

Uganda

Bangladesh

Australia

Latvia

Note: Countries selected to illustrate range.Source: World Bank (2004c).


to innovate and improve their productivity.Such inadequacies can be severe in develop-ing countries (figure 16).

Finance. The underlying challenge withfinance flows from information problems,which are often exacerbated by insecureproperty rights. But too often governmentinterventions make matters worse. Financialmarkets have been repressed and distorted bystate ownership, barriers to competition,directed or subsidized credit, and other mea-sures. The resulting problems usually hitsmaller firms and those without politicalconnections the hardest.

Governments are confronting theseissues. New approaches recognize thatfinancial markets are not only part of theinvestment climate for firms, but are alsoprofoundly shaped by the investment cli-mate facing providers of financial services.That is why more governments are reducingbarriers to competition, strengthening cred-itor and shareholder rights, establishingcredit bureaus and other mechanisms toaddress information problems, and improv-ing bank regulation.

Infrastructure. The underlying challenge withinfrastructure flows from market power asso-ciated with economies of scale. But responsesfocusing on provision by public sectormonopolies have often made matters worse.

Public ownership and regulation have oftenbeen used to pursue objectives unrelated toefficient service delivery—typically favoringsome groups over broader interests and intro-ducing new sources of inefficiency. Smallerfirms and poor communities are usually hitthe hardest by such approaches.

As with finance, the key is to create a bet-ter investment climate for providers of infra-structure services. Competition, improvedregulation, and private participation havetransformed telecommunications and areplaying a bigger role in improving electricitysupply and ports. For roads, many countriesare getting better results by contracting outservices and improving funding mecha-nisms. Governments are also working toimprove management of public resources—to get more for their money when theyfinance or subsidize infrastructure services.

Workers and labor marketsOne of the main motivations for pursuinginvestment climate improvements is to createmore and better jobs. Government policiesaffecting the labor market play a critical rolein the investment climate by helping to con-nect people to decent jobs. Improving policyperformance requires action on three relatedfronts: fostering a skilled workforce, craftinglabor market interventions to benefit allworkers, and helping workers cope withchange.

Fostering a skilled workforce. Improving theinvestment climate goes hand in hand withenhancing human capital. A skilled work-force is essential for firms to adopt new andmore productive technologies, and a betterinvestment climate raises the returns toinvesting in education. Government supportfor education and training affects theprospects for individuals—and the ability offirms to pursue new opportunities. Manyfirms in developing countries rate inade-quate skills and education of workers as amajor or severe obstacle to their operations(figure 17). Governments need to take thelead in making education more inclusive andrelevant to the skill needs of firms, strength-ening quality assurance mechanisms, andcreating a sound investment climate forproviders of education and training services.


Figure 16 The inadequacies of finance and infrastructure are severe in manydeveloping countries

0 10 20 30 40 50 60 70

FinanceInfrastructure

South Asia

Sub-Saharan Africa

Latin America & the Caribbean

Europe & Central Asia

East Asia & Pacific

Middle East & North Africa

Percent of firmsNote: Figure shows the share of firms that report access to finance, and any of electricity, telecom-munications, or transportation as "major" or "severe" obstacles to their business.Source: World Bank Investment Climate Surveys.


Crafting labor market interventions to ben-efit all workers. Regulation of labor marketsis usually intended to help workers. But ill-considered approaches discourage firmsfrom creating more jobs and contribute to aswelling of the informal workforce thatlacks statutory protection. When this is thecase, some workers may benefit, but theunemployed, the low-skilled, and those inthe informal economy will not be amongthem. Policy interventions need to becrafted to reflect this wider range of inter-ests. More countries are reviewing theirlabor market policies to encourage wageadaptability, to ensure workplace regula-tions reflect a good institutional fit, and toensure a reasonable balance between work-ers’ preference for employment stability andfirms’ need to adjust the workforce.

Helping workers cope with change. A goodinvestment climate facilitates the allocationof labor to its most productive use whilehelping workers cope with labor mobility.Technological progress that leads to higherproductivity and economic growth improvesworking conditions and wages, but it canalso involve more rapid changes to firms andindustries. In modern economies manyfirms are created and destroyed each year—about 20 percent in many countries—involving 10 to 20 percent of the workforce.14

Inadequate mechanisms to help workerscope with change restrict entrepreneurshipand the adaptability of workers. The inade-quacies can also increase resistance toreforms that would benefit society as awhole. While a narrow tax base reduces thefeasibility of creating comprehensive socialsafety nets in most developing countries,there are opportunities for improving theinsurance component in income supportschemes and the pooling of risks amongindividuals. Innovative programs can alsoreach out to poor and informal workers whocannot be covered by broader insuranceschemes.

Going beyond the basics?Many governments go beyond the basics justdescribed by making selective interventionsto benefit particular firms or activities, or bydrawing on the growing body of interna-

tional rules and standards dealing withinvestment climate issues. Both can play arole but involve additional challenges.

Selective interventionsBroad improvements to the investment cli-mate expand the pool of beneficiaries, reduceconcerns about rent-seeking, and avoid newdistortions. Given the breadth of that agenda,some firms or activities may benefit fromimprovements earlier than others—as withinfrastructure in a particular location or reg-ulatory reforms affecting a particular activity.But beyond the sequencing of reforms, somegovernments confer special policy privilegeson targeted firms or activities. Those privi-leges take many forms: market restrictions,tax breaks, access to subsidized credit, and arange of other measures.

Some selective interventions have aneconomic rationale, such as the possiblespillovers from foreign direct investment orresearch and development. Some may beregarded as a form of “second-best”response, given slow progress in addressingthe basics. Yet others aim to accelerategrowth by targeting particular industries.

Overview 15

Figure 17 Firms often rate skill shortages and laborregulations as serious constraints

0 20 40Percent

60

Bangladesh

Estonia

Algeria

China

Zambia

Brazil

Algeria

Pakistan

Kenya

Philippines

Poland

Brazil

Skill

s an

d ed

ucat

ion

of a

vaila

ble

wor

kers

Labo

r reg

ulat

ions

Note: Percentage of firms reporting that skills and education ofavailable workers or labor regulations were a major or severeobstacle to the operation and growth of their business.Source: World Bank Investment Climate Surveys.


Whatever the rationale, all such schemes mustnavigate the heterogeneous and self-inter-ested requests of firms, rent-seeking pressures,and other sources of potential policy failure.

While governments have been experi-menting with selective interventions for cen-turies, a review of international experiencereveals no sure-fire strategies. Some countriesin East Asia appear to have made selectiveinterventions successfully, but recent worksuggests that the contribution may have beenrelatively modest. Experience also shows howdifficult it is to replicate similar approacheselsewhere and in what is now a very differentinternational environment. Overall, experi-ence with government efforts to “pick win-ners” is discouraging. Efforts to woo investorsthrough tax holidays or other special incen-tives have also met with mixed success—evenwhen investment expands in the targetedindustry, it is difficult to know whether theinducements were necessary or cost effective.Indeed, there are many examples of selectiveinterventions going spectacularly wrong—atbest wasting public resources, but sometimescreating large distortions that harm theinvestment climate, and distracting attentionfrom broader improvements.

Even in the best of circumstances manyselective interventions seem to be a gamble.The more ambitious the goal and theweaker the governance, the longer the oddsof success. This suggests that selective inter-ventions should be approached with cau-tion and not regarded as a substitute forbroader investment climate improvements.The hazards of such strategies can bereduced by ensuring that schemes have aclear objective and rationale, focus on thesources of problems rather than the symp-toms, match the instrument to the ratio-nale, impose discipline on the beneficiaries,are administered transparently, and arereviewed regularly.

International rules and standardsThe body of international rules and stan-dards dealing with investment climate mat-ters has grown exponentially in recentdecades. There are now more than 2,200bilateral investment treaties and more than200 regional cooperation arrangements.There is also a plethora of new and pro-

posed multilateral instruments on every-thing from trade, bribery, and corporategovernance to taxation and environmentaland labor regulation. International arrange-ments have a clear role to play in reducingbarriers to international trade and invest-ment. But they might also contribute toinvestment climate improvements in threebroader ways: by enhancing credibility toreduce risks, by harmonizing rules andstandards to reduce costs, and by addressinginternational spillovers. All three involvetradeoffs.

Enhancing credibility. By increasing thecosts of policy reversal, entering into inter-national obligations can reinforce the credi-bility of government policy, and sostrengthen the investment responses offirms. But by design the tradeoff is forgonepolicy flexibility, which means that com-mitments need to be considered carefully.Strategies that involve the strongest form ofcommitment—allowing firms to enforcetreaty commitments against governmentdirectly through binding international arbi-tration—can enhance credibility but wouldbenefit from ongoing efforts to improve thetransparency of the arbitration process.Strategies that rest more on the reputationconcerns of governments can also con-tribute to policy credibility, but their impactwill depend on whether participants in thearrangement insist on high levels of mutualcompliance.

Harmonizing international rules and stan-dards. To reduce costs in internationaltransactions, many efforts focus on harmo-nizing particular rules or standards, withexamples ranging from the harmonizationof business laws in West Africa to the devel-opment of uniform accounting standards.These efforts can be beneficial for develop-ing countries. But there can also be trade-offs with adapting approaches to local con-ditions and with allowing a degree ofcompetition between approaches. There arealso tradeoffs among multilateral, regional,and bilateral approaches to harmonization.

Addressing international spillovers. Over thepast two decades, concerted global actionhas been promoted for a growing number of



matters where the effects of policy actionsby one country may spill over onto others.Addressing international spillovers in theenvironmental area is important for sustain-able development. When the suggestedspillover is less tangible, or the benefits lessevenly shared, cooperative action is moredifficult. With taxation, for example, con-cerns have been expressed about the poten-tial for competition between countries forinvestment to lead to a “race to the bottom”in tax collections, to the detriment of globalpublic welfare. Similar concerns are some-times expressed about other areas of invest-ment climate policy, including environmen-tal regulation. Experience so far suggestslittle evidence of the feared collapses in taxesor standards. But there are also practicalissues of trying to find common ground.Proposals in these and other areas need togive due weight to the perspectives of devel-oping countries.

How the internationalcommunity can helpResponsibility for improving their invest-ment climates lies first and foremost withgovernments of developing countries, bothnational and subnational. But the interna-tional community can lend a hand. Helpingto improve investment climate conditionscan provide huge development dividends.The manufacturing value added unleashedby investment climate improvements ineven a single country can far exceed thedevelopment assistance provided world-wide (figure 18). The international commu-nity can help developing countries reapthese benefits in three main ways: byremoving policy distortions in developedcountries that harm the investment cli-mates of developing countries; by providingmore, and more effective, assistance; and bytackling the substantial knowledge agenda.

Removing distortions in developedcountriesDeveloping countries are not alone in grap-pling with investment climate improve-ments. The trade and market distortionscreated by policies in developed countriesimpose large costs on their own economies.These distortions also undermine opportu-

nities and incentives for firms to invest indeveloping countries. It has been estimatedthat removing trade protection and relateddistortions in developed countries couldprovide gains to developing countries ofUS$85 billion by 201515—or more than fourtimes the official development assistancecurrently provided for investment climateimprovements.

Providing more, and more effective,assistanceThe international community has long pro-vided development assistance to supportthe design and implementation of invest-ment climate improvements. Substantialsupport is also provided directly to firms.There is room to do better in both areas.

Development assistance for investment cli-mate improvements. Around one quarter ofofficial development assistance, or aboutUS$21 billion per year, focuses on supportto investment climate improvements, withthe bulk of that directed to infrastructuredevelopment.16 Technical assistance can beone of the most potent ways of helping gov-ernments improve their investment climatesbut accounts for just 13 percent of assistancein this area. There is room to provide moresupport of this kind and to deliver it moreeffectively. Improving effectiveness requiresefforts to curb supply-driven approaches

Overview 17

Figure 18 Manufacturing value added in a single country can far exceed net globalofficial development finance

1970 1975 1980 1985 1990 1995 2000

Billi

ons

of 1

995

dolla

rs

0

100

200

300

400

500

India

China

South Korea

Global net officialdevelopment finance

Note: Data for China, India, and South Korea show manufacturing value added.Source: OECD online database and World Bank (2004a).


and greater efforts to ensure that recom-mended solutions reflect a good fit withlocal conditions. Multidonor technicalassistance facilities are playing a growingrole in several areas of investment climatepolicy and present opportunities to leverageresources and expertise in specialist areasand to improve the overall effectiveness ofassistance.

Support provided directly to firms andtransactions. Well-designed support of thiskind can complement investment climateimprovements. Development assistance tosupport small firms through credit lines andcapacity building amounts to slightly morethan the value of technical assistance forinvestment climate improvements. Thesemeasures have a mixed track record, however,and would benefit from the same guidelinessuggested for selective interventions made bygovernments. Developed countries and inter-national agencies also provide around US$26billion per year in nonconcessional loans orguarantees to support specific transactions.

While not a form of development assistance,increasing the emphasis on the contributionthese transactions make to the creation ofmore transparent and competitive marketscould expand the development impact of thissupport.

Tackling the substantial knowledgeagendaNew sources of data of the kind drawn on inthis Report add to our understanding of thefoundations of growth and poverty reduc-tion. But a long agenda lies ahead in broaden-ing and deepening this understanding to pro-vide guidance to policymakers. This includesexpanding the development of objective indi-cators of the investment climate and the sys-tematic analysis of country experiences todistill emerging lessons.

By working together on these themes, theinternational community can help create bet-ter investment climates in developing coun-tries and so contribute to a more balanced,inclusive, and peaceful world.


The investment climate is central togrowth and poverty reductionImproving the opportunities and incentives forfirms of all types to invest productively, createjobs, and expand should be a top priority forgovernments. It is not just about increasing thevolume of investment but also spurring produc-tivity improvements that are the key to sustain-able growth.

• The goal is to create a better investment cli-mate for everyone. A good investmentclimate benefits society as a whole, not justfirms. And it embraces all firms, not just largeor politically connected firms.

• Expanding opportunities for young people isa pressing concern for developing countries,where 53 percent of people live on less thanUS$2 a day, youths have more than doublethe average unemployment rate, and popula-tions are growing rapidly.

Reducing unjustified costs is critical, butpolicy-related risks and barriers tocompetition also need to be tackledAll three matter for firms and thus for growthand poverty reduction.

• Costs associated with weak contract enforce-ment, inadequate infrastructure, crime, cor-

ruption, and regulation can amount to over25 percent of sales—or more than threetimes what firms typically pay in taxes.

• Firms in developing countries rate policyuncertainty as their top concern.This andother sources of policy-related risk—such asinsecure property rights, macroeconomicinstability, and arbitrary regulation—chillincentives to invest. Improving policypredictability can increase the likelihood ofnew investment by over 30 percent.

• Barriers to competition benefit some firmsbut deny opportunities and increase costs toother firms and to consumers.They alsoweaken incentives for protected firms toinnovate and improve their productivity.Increasing competitive pressure can increasethe probability of firm innovation by morethan 50 percent.

Progress requires more than changes toformal policiesOver 90 percent of firms claim gaps betweenformal rules and what happens in practice, andthe informal economy accounts for more thanhalf of output in many developing countries.Creating a better investment climate requiresgovernments to bridge these gaps and totackle deeper sources of policy failure that

undermine a sound investment climate. Thisrequires efforts to:

• Restrain corruption and other forms of rent-seeking that increase costs and distort policies;

• Build policy credibility to give firms the confi-dence to invest;

• Foster the public trust required to enable andsustain policy improvements; and

• Ensure policy responses are crafted to fit localconditions.

Investment climate improvements are aprocess, not an eventGovernment policies and behaviors influencingthe investment climate cover a wide field. Buteverything does not have to be fixed at once,and perfection on even a single policy dimen-sion is not required. Significant progress can bemade by addressing important constraints fac-ing firms in a way that gives them theconfidence to invest—and by sustaining aprocess of ongoing improvements.

• Because constraints differ widely across andeven within countries, priorities need to beassessed in each case. Reform processes ben-efit from effective public communication andother measures to build consensus and main-tain momentum.

B O X 5 Main messages from World Development Report 2005


Overview 19

Endnotes1. Johnson, McMillan, and Woodruff (2002).2. Feder and others (1988).3. Hall and Jones (1999); Parente and Prescott (2000); Easterly

and Levine (2001); and Bosworth and Collins (2003).4. Schumpeter (1942).5. ILO (2004).6. OECD (2002) and Carlson and Payne (2003).7. Dollar, Hallward-Driemeier, and Mengistae (2003) and

Hallward-Driemeier, Iarossi, and Sokoloff (2002).8. Minot and Goletti (2000) and Winters, McCulloch, and

McKay (2004).

9. Hoekman, Kee, and Olarreaga (2001).10. World Bank (1996).11. Field (2002).12. World Economic Forum (2004).13. Londoño and Guerrero (2000).14. Bartelsman and others (2004).15. World Bank (2004a).16. Migliorisi and Galmarini (2004).

Aghion, Philipe, Robin Burgess, Stephen Redding, and FabrizioZilibotti. 2002. “Liberalization, Institutions, and Industrial Per-formance: Evidence from India.” Paper presented at the Interna-tional Trade and Investment Conference. Cambridge, Mass.August 5.

Ahluwalia, Montek. 2002. “Economic Reforms in India Since 1991:Has Gradualism Worked?” Journal of Economic Perspectives16(3):67–88.

Ayyagari, Meghana, Thorsten Beck, and Asli Demirgüç-Kunt. 2002.“Small and Medium Enterprises across the Globe: A New Data-base.” Washington, D.C.: World Bank Policy Research WorkingPaper Series 3127.

Bartelsman, Eric, John Haltiwanger, and Stefano Scarpetta. 2004.“Microeconomic Evidence of Creative Destruction in Industrialand Developing Countries.” Background paper for the WDR2005.

Bosworth, Barry, and Susan M. Collins. 2003. “The Empirics ofGrowth: An Update.” The Brookings Institution. Washington,D.C. Processed.

Burgess, Robin, and Tony Venables. 2003. “Towards a Microeco-nomics of Growth.” London School of Economics. London.Processed.

Carlson, Ingrid, and Mark J. Payne. 2003. “Estudio Comparativo deEstadisticas de Empleo Publico en 26 Paises de America Latina yel Caribe.” In Koldo Echebarria, eds., Red de Gestion y Trans-parencia de la Politica Publica. Servicio Civil: Temas para un Dial-ogo. Washington, D.C.: Banco Interamericano de Desarrollo.

Chen, Shaohua, and Yan Wang. 2001. “China’s Growth and PovertyReduction: Trends between 1990 and 1999.” Washington, D.C.:World Bank Policy Research Working Paper Series 2651.

De Long, J. Bradford. 2003. “India since Independence: An AnalyticGrowth Narrative.” In Dani Rodrik, eds., In Search of Prosperity.Princeton: Princeton University Press.

Dollar, David, Mary Hallward-Driemeier, and Taye Mengistae.2003. “Investment Climate and Firm Performance in DevelopingCountries.” World Bank. Washington D.C. Processed.

Easterly, William, and Ross Levine. 2001. “It’s Not Factor Accumu-lation: Stylized Facts and Growth Models.” World Bank Eco-nomic Review 15(2):177–219.

Feder, Gershon, Tongroj Onchan, Yongyuth Chalamwong, andChira Hongladarom. 1988. Land Policies and Farm Productivityin Thailand. Baltimore: John Hopkins University Press.

Field, Erica. 2002. “Entitled to Work: Urban Property Rights andLabor Supply in Peru.” Princenton, N.J.: Princeton University,Princeton Law and Public Affairs Working Paper 02-1.

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Hallward-Driemeier, Mary, Giuseppe Iarossi, and Kenneth L.Sokoloff. 2002. “Exports and Manufacturing Productivity in EastAsia: A Comparative Analysis with Firm-Level Data.” Cam-bridge, Mass.: National Bureau of Economic Research WorkingPaper Series 8894.

Hoekman, Bernard, Hiau Looi Kee, and Marcelo Olarreaga. 2001.“Markups, Entry Regulations, and Trade: Does Country SizeMatter?” Washington, D.C.: World Bank Policy Research Work-ing Paper Series 2662.

Holmgren, Torgny, Louis Kasekende, Michael Atingi-Ego, andDaniel Ddamulira. 2001. “Uganda.” In Shantayanan Devarajan,David Dollar, and Torgny Holmgren, eds., Aid and Reform inAfrica: Lessons from the Case Studies. Washington, D.C.: WorldBank.

ILO (International Labour Organisation). 2004. Global Employ-ment Trends. Geneva: International Labor Organization.

Johnson, Simon, John McMillan, and Christopher Woodruff. 2002.“Property Rights and Finance.” American Economic Review92(5):1335–56.

Kaufmann, Daniel, Aart Kraay, and Massimo Mastruzzi. 2003. “Gov-ernance Matters III: Governance Indicators for 1996-2002.” Wash-ington, D.C.: World Bank Policy Research Report Series 3106.

Londoño, Juan Luis, and Rodrigo Guerrero. 2000. “Violencia enAmerica Latina: Epidemiología y Costos.” In Rodrigo Guerrero,Alejandro Gaviria, and Juan Luis Londoño, eds., Asalto al Desar-rollo: Violencia en América Latina. Washington, D.C.: Inter-American Development Bank.

Migliorisi, Stefano, and Marco Galmarini. 2004. “Donor Assistanceto Investment Climate Reforms.” Background paper for theWDR 2005.

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World Development Report 2005 looks at what governments can do to improve the investment climates of their societies to increase growth and reduce poverty. The Report identifies the opportunities and challenges governments face in making investment climate

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