On determinant of SME tart p in Ethiopia: A theoretical exploration By Zzana Brixiova 1 African Development Bank, Development Reearch Department, Tni, Tniia Abtract Since coming to power in 1991, the Ethiopian government ha trived to create an environment that pport entreprenerhip. Almot 20 year later, however, the highly prodctive mall and medim-ized enterprie (SME) ector remain limited. Thi paper develop a imple theoretical model of SME tart p with friction in the bine climate and the labor market that characterize the Ethiopian intittional landcape. It find that bidizing entreprener earch may encorage tart-p, bt it need to be accompanied by improvement to the bine environment and fnctioning of the labor market. Wage bidie wold be le effective in timlating SME, bt they cold encorage firm to move from the informal to the formal ector. Since nclear property right contitte potentially the mot evere form of taxation, reforming them i key. Key word: Eqilibrim model of tart p, active policie labor market, informal ector JEL claification: O1, J24, J48, H26 1 The athor thank Jan Babecky, Haile Kibret, Joel Mzima, Arnim Schwidrowki, Andrea Wörgötter, and participant at the Addi Ababa Univerity eminar and the 2009 African Economic Conference for helpfl comment and dicion. inancial pport from the lbright Program for reearch at the Addi Ababa Univerity (2007 08) i grateflly acknowledged. View expreed are thoe of the athor and do not necearily reflect thoe of the African Development Bank. E-mail addre: z.brixiova@afdb.org. 1
1. Introdction Low-income contrie in Sb-Saharan Africa (SSA) are well aware of the poitive role that mall and medim-ized enterprie (SME) can play in their development. SME can innovate, adopt new technology and know-how, create job, broaden the tax bae, and diverify rik. Benefit of SME can extend to the external ector, throgh their lanching of new prodct. The role of the private ector, inclding SME, a engine of growth wa illtrated by the potwar recovery in Atria and Germany and by the diverging path of Central and Eat Eropean and Baltic contrie. In the tranition economie, the prodctivity gain, employment, and the convergence toward the income level of the EU-15 contrie have depended on a dynamic private ector, and epecially new firm. SME now alo receive increaed interet de to the global financial crii, a SSA contrie have earched for way to rebalance their orce of growth from a heavy reliance on export and DI toward dometic private enterprie and demand. When the crrent Ethiopian government came to power in 1991, it inherited a centrally planned economy and faced ome challenge imilar to tranition economie, inclding private ector development. So far, however, hope that the economy wold tranition from being dominated by low-prodctive job in the tate ector to more prodctive one in the private ector remain nflfilled. 2 Thi lack of good (prodctive and well-paid) job dicorage worker from acqiring kill, ot of fear that ch aet wold not be tilized. In trn, the lack of killed worker contrain firm in their activitie. Notwithtanding the recent rapid growth driven motly by pblic infratrctre invetment, the contry eem to be tck in a vicio circle of low prodctivity, lowpaid job and poverty. Deigning and implementing policie that wold help develop the private non-agricltral, and epecially the indtrial ector preent a key policy challenge. Thi paper develop a imple theoretical model of SME tart-p with friction in the rban labor market and the bine environment. It modifie the framework of Brixiova, Li, and Yoef (2009) by conidering imperfect information in the killed worker labor market and allowing firm to operate in the informal ector. The idea that imperfect information and ening negative externalitie lead to boptimal labor market otcome wa emphaized by Snower (1996) in the context of developed economie. Thi paper poit that the concept i even more itable for low-income contrie ch a Ethiopia where exchange in the labor market for killed worker are pare. In ch economie, the large informal ector blr information abot available killed worker and highlyprodctive job. The related nderinvetment in training and carcity of killed worker cold dicorage entreprener to earch for bine opportnitie. The model foce on tart-p of highly-prodctive private firm, a their abence i a key contraint to prodctivity growth and job creation in the formal ector in Ethiopia. The emphai on tart-p and the inclion of the informal ector, which are important 2 Bajona and Locay (2009) develop a model of entreprenerhip nder central planning that accont for the long-rn nderperformance of planned economie relative to market-oriented one. 2
in low-income contrie, ditingihe thi framework from that of Snower (1996) who examined the nmber of vacancie in exiting firm in the formal ector in advanced economie. The framework differ from that of Gelb et al. (2008) a it conider how difference in reglation, inclding nclear property right, and other element of the bine environment (tax rate, monitoring) inflence firm choice between formality and informality. The model matche everal tylized fact of the Ethiopian rban labor market, and i ed to analyze the effect of incentive to develop the SME ector. The paper i organized a follow. Section 2 provide tylized fact on the private ector, SME and the rban labor market in Ethiopia, inclding the informal ector. Section 3 preent the benchmark model. It how that the benchmark eqilibrim i boptimal compared to the one with improved bine environment. Section 4 extend the baic model to allow the firm to chooe to operate in the informal ector and condct frther policy analyi. In particlar, it examine the impact of bidie to entreprener earch with thoe for employing killed worker in SME tart p and their deciion to work in the formal ector. It alo dice factor that may drive firm into the informal ector, with a pecial attention to weak property right. Section 5 conclde. 2. Stylized fact on SME and the rban labor market 3 Since Ethiopia departre from the centrally planned ytem, it economy ha had a niqe mixtre of featre. It lowly declining hare of the tate ector in indtrial otpt, low private job creation, and high nemployment make it akin to an early-tage tranition economy. At the ame time, Ethiopia i one of the pooret contrie in the world, with: (i) a large and dalitic informal ector; (ii) high and almot contant hare of agricltre in otpt; (iii) labor market friction, inclding imperfect information; (iv) bine environment with heavy reglation; and (v) low adoption of new technologie. The ection below highlight main tylized fact abot SME and the rban labor market. 2.1 Limited formal private ector 4 The role of the private ector in the Ethiopian economy ha evolved throgh everal tage. Between the 1950 and early 1970, the Imperial government pred marketbaed policie. When the Derg regime came to power in 1974, it economic policy wa gided motly by principle of central planning. Private property wa ppreed throgh nationalization and private ector indtrial activitie, coniting mainly of SME, were dicoraged throgh policie that prevented firm to acce credit and import inpt. When taking over in 1991, the crrent government aimed to redce breacratic procedre while encoraging private ector development. (Geda and Degefe, 2002). 3 Thi ection draw epecially on World Bank (2007a and 2007b), the Ethiopian Labor orce Srvey (2005), the Urban Labor orce Srvey (2006) and the National Informal Sector Srvey (2003) of the Ethiopian Central Statitical Athority. The paper foce on rban labor market, bt rral development i eqally important a agricltre accont for 80 percent of employment and 50 percent of GDP. 4 The private ector inclde all agent in the economy not formally claified a in the pblic ector, that i agent involved in the government, tate-owned enterprie or paratatal, and independent pblic agencie. 3
Almot twenty year later, however, the role of the private ector in the Ethiopian economy remain limited. A in the tranition economie of Eatern Erope and the CIS, privatization of SME proceeded wiftly. However, the medim-large-cale privatization progreed lowly in 2000, and the hare of the tate ector in indtrial otpt ha been arond 50 percent ince 2000, after a decline from 80 percent in the mid-1990. In manfactring, it amont to only 40 percent (World Bank, 2007b). While the majority of SME are now private, very mall firm predominate. Scce torie in pecific ector notwithtanding, the formal private ector in rban area i nderdeveloped. Poibly only abot 30 percent of total rban employed poplation wa in the formal ector in mid-2000, and only half of thoe in the private ector (igre 1). 5 The private ector i concentrated motly in Addi Ababa and the rronding region (UNCTAD, 2002). To pt the pace of private ector growth into perpective, a comparion with other contrie i efl. Until now, Ethiopia privatization program ha not progreed mch beyond the SME tage. In contrat, in Tanzania, where the private ector ha been the main driver of growth, inclding in indtry and ocial ervice, it crrently accont for abot 70 percent of GDP (World Bank, 2002). In mot tranition contrie, which alo tarted changing from plan to market in early 1990, the private ector acconted for mot of otpt, inclding in indtry, already by the mid-2000. igre 1. Ethiopia: Ditribtion of employed poplation in rban area, 2005 (% of total) 45 40 35 30 25 20 15 10 5 0 NGO Other Dometic employee Unpaid family worker Private ector Pblic ector employee Self-employed Sorce: Central Statitical Athority, Labor orce Srvey, 2005. 5 Other rvey fond that the informal ector accont for 45-50 percent of employment in all rban area and abot 30 percent in rban center, bt tdie on rban center exclde dometic employee. World Bank (2009) tate that informal ector repreent 71 percent of rban employment. 4
2.2 High nemployment, infficient private job creation The rban labor market ha been characterized by peritently high nemployment, with regional rate ranging from 18 to 35 percent of the labor force. Unemployment ha diproportionately affected yong people (igre 2). 6 igre 2a. Employment rate and yoth nemployment rate by rban center, 2005 55 yoth nemployment rate (% of relevant L) 50 45 40 35 30 25 Addi Ababa Correl. Coef.= -0.74 20 30 35 40 45 50 55 60 employment rate (% of working age poplation) igre 2b. Total and yoth nemployment rate by rban center, 2005 55 yoth nemployment rate (% of relevant L) 50 45 40 35 30 25 Correl. Coef. = 0.82 Addi Ababa 20 15 20 25 30 35 40 nemployment rate (% of L) Sorce: Central tatitical office and athor calclation. 1/ Urban center have above 2000 inhabitant. 6 Bigten, Mengitae, and Shimele (2007) tdied the Ethiopian rban labor market dring 1994 2004 and fond that while the nemployment rate declined dring thi period, it tayed well in the doble-digit. 5
Both pply and demand factor have contribted to the peritent labor market imbalance. On the pply ide, the rban poplation more than dobled between 1990 and 2007, from abot 6 million in 1990 to 13 in 2007. On the demand ide, with declining pblic ector job, the private ector need to drive job creation. Yet low rban job creation impeded the hift from rral to rban activitie a well a the tranition from plan to market. The inadeqate private job creation in rban area i alo evident in low exit rate from nemployment into the formal private ector. 7 2.3 Obtacle to SME and private ector development A mentioned above, the Ethiopian private ector i motly mall-cale, informal and ervice-oriented. What then are the factor that have been impeding fater job creation in the formal private ector? According to the World Bank firt Aement of the Invetment Climate in 2001/02, high tax rate were the mot common complaint of entreprener. Beide high rate, an inefficient and npredictable tax adminitration wa another freqent complaint. Predictably, the credit contraint wa viewed a important. The lack of killed worker affected 20 percent of entreprener (igre 3). igre 3. Mot cited contraint to SME (in % of total repondent), 2001 80 70 60 50 40 30 20 10 0 Tax rate Tax adminitration Acce to land Acce to foreing credit Acce to dometic credit Corrption Cot of financing Skill and edcation of worker Tranporation Bine licening and admin. Labor reglation Sorce: World Bank (2007a). 7 30 percent of the nemployed in 1994 were nemployed in 2004; another 22 percent left the labor force. Of thoe who fond job 70 percent went to the informal ector, and 17 percent to the formal private ector. 6
To eae the tax brden and increae predictability, all Ethiopian binee with annal trnover of le than US$50,000 were inclded nder a premptive tax, where their income i etimated by the tax athority. Their marginal profit tax rate range from 10 percent to 35 percent v. 30 percent corporate tax rate for other binee. However, the progreive tax ytem cold till dicorage the creation of highly profitable firm, a the income from additional effort wold fall nder the higher taxable income bracket. In comparative perpective, Ethiopia trctral reform effort have weakened after the econd generation market reform ndertaken dring 2002 04; thi wa reflected, for intance, in liding on the Doing Bine ranking. According to the 2009 African Competitivene Report (World Economic orm, World Bank and African Development Bank, 2009), inefficient government breacracy and corrption have become major obtacle to entreprenerhip in Ethiopia, with the tax ytem and kill hortage being perceived a important bt omewhat le contraining. Entreprener contined to raie the lack of acce to credit a a concern 8 2.4 Large and dalitic informal ector 9 Mot SME in Ethiopia operate in the informal ector (Den et al., 2005). The informal ector conit motly of low-prodctive firm concentrated in manfactring and trade (igre 4). Several ector eem exclively informal. Thi lower-tier informal ector conit of competitive and largely ndifferentiated firm. Bt ome ccefl mall binee alo operate in the hadow economy, inclding mall-cale manfactring firm. Thi more dynamic pper-tier employ more edcated worker. While precie figre are nclear, ome etimate gget that the pper tier contitte arond 20 percent of the informal ector firm. 10 The Ethiopian informal ector i th dalitic, coniting of both rvival firm and the prodctive one. Neverthele, it i more tagnant than in, for example, Mexico (World Bank, 2007a). 11 Eqally concerning a the predominance of the informal ector i it low prodctivity, which alo lead to low wage, epecially for nkilled worker. Urban labor market in Ethiopia are th characterized by a btantial wage gap between the formal and informal ector (abot 1/3 in 2004). Women and nedcated poplation tend to be 8 Another freqently mentioned contraint to SME in thi rvey wa their lack of acce to credit, conitently with finding of the African Development Bank and OECD (2005). 9 The rban labor market conit of three egment: (i) the pblic ector where job in mot field pay above the private ector; (ii) the nderdeveloped formal private ector; and (iii) the large informal economy. irm are informal if they have no book of accont; no licene; and fewer than 10 employee. 10 Some firm go ndergrond to avoid reglation or taxation; they typically limit the ize and cope of their operation. OECD (2009) dice the dality of the informal ector in developing contrie in detail. 11 The Srvey confirmed the dal natre of the informal ector, a it contained both private etablihment (motly a ole proprietor) and employee. OECD (2009) dice the dality of the informal ector in developing contrie. A in other developing contrie ome firm chooe to operate go ndergrond to avoid reglation or taxation; in ch itation they typically limit the ize and cope of their operation. 7
diproportionately repreented in the informal economy (Den et al, 2005). Srvey evidence doe not pport view that for ome worker the informal ector may be a tranition to formal job. When worker leave the informal ector, they typically exit to nemployment, with only very few leaving for formal ector job. igre 4. Informal ector etablihment, by region and indtry (2003) 140,000 120,000 100,000 Manfactring/mining Trade Other ervice Other 80,000 60,000 40,000 20,000 0 Amhara Oromiya Addi Other Sorce: Central Statitical Athority, The National Informal Sector Srvey 2003. 2.5 riction in the rban labor market The kill hortage have been demontrated throgh relatively high retrn to edcation. Specifically, when illiterate worker are taken a the reference grop, edcation raie wage by 26 percent for thoe with grade 1-4 and by 130 percent for the highet killed. Unemployment ha affected the highly-killed worker le, with the notably lower rate for worker with tertiary edcation (9 percent v. 23 percent total rate in 2004). At the ame time, nemployment rate of yong people with high chool and ome higher edcation have been on the rie, pointing to a poible mimatch between kill pplied by the edcational ytem and reqirement of the private ector (Den et al, 2005). The lack of labor market information make matching between firm eeking worker and job eeker challenging. While the employment exchange are formally charged with reponibility to regiter job opening and hare the information with the nemployed, their ervice are ed only poradically. or example, in 1999, only 6 per cent of the job eeker regitered with the employment exchange office. Other preferred to earch throgh relative, top by at work ite, or etablih their own enterprie. In part, the low and declining vacancy-to-nemployment ratio poted by agencie may reflect the redced trt in their ervice, in addition to carcity of job (Den et al, 2005). 12 12 According to the World Bank (2007a), 21 percent of vacancie between 1997/98 and 2001/02 remained nfilled, de to a lack of qalified worker or their nwillingne to relocate from rban to rral area. 8
3. The model To reflect contraint faced by SME in Ethiopia, the model developed below incorporate the following featre: (i) imperfection in the bine climate (inclding government breacracy/reglation); (ii) high tax rate; (iii) hortage of killed worker; and (iv) limited information in the labor market for killed worker. The model i conitent with everal tylized fact on the Ethiopian economy, namely (i) limited formal private ector employment, (ii) the informal ector dominated by elf-employment and mall enterprie, and (iii) the wage and prodctivity gap between the formal and informal ector. The impact of everal government intervention, inclding bidie to earching entreprener and to firm that employ killed worker i then examine, with foc on firm creation and firm deciion to work in the formal ector. 3.1 The environment The poplation ize i normalized to one. There are two type of agent, entreprener and worker, with poplation hare μ and1 μ, repectively. 13 Agent live for one period, are endowed with one nit of time and w amont of conmption good, and have rik netral preference, E (c), where c i conmption of a ingle good, and E denote the expectation agent form at the beginning of the period abot income they will receive either from working or rnning a firm. At the beginning of the period, entreprener earch for opportnitie to open private 2 firm. Thi effort, x, cot them d ( x) = x / 2γ, γ > 0, nit of conmption good, and relt in the probability x of finding a highly-prodctive bine opportnity. In order to rn a firm, each entreprener need to find n killed worker. 14 Specifically, denoting V to be the aggregate killed vacancie, N total nmber of killed worker earching for job, and h nmber of killed-job matche, the matching fnction i decribed a h = min[ N ; V ] (1) Entreprener with high-prodctivity bine opportnity th find killed worker with N probability ρ = min[,1]. If entreprener find both a bine opportnity and killed V 13 Th pply of entreprener i not endogeno. Entreprener tend to be individal with pecific backgrond. or example, Djankov et al (2006) fond that family characteritic had a trong inflence on becoming an entreprener in China. Similar amption i ed in Gelb et al. (2008) for Africa. 14 Thi amption i conitent with the long-acknowledged fact that prodctive firm form relationhip mainly with prodctive worker. afchamp et al., 2006, who examined employee-employer matched data for 11 African contrie, confirmed thi empirically alo for Ethiopia. 9
15 worker, they prodce otpt according to y = βzn. The otpt i inflenced by the prodctivity of the opportnity, z, and by the qality of the bine climate, which enter a an efficiency component of the prodction fnction β, 0 β 1. 16 Each entreprener rnning a highly prodctive firm earn profit π = βz n w n ), where w i the wage of killed worker, determined throgh bargaining. ( If entreprener do not find a bine opportnity and/or killed labor, they will open a low-prodctivity firm in the informal ector, employing nkilled worker, n. Their profit then amont toπ = zn wn, where w i the wage in the low-prodctivity firm, which eqal the income of elf-employed, b, alo working in the informal ector. The otpt i prodced by one of the two technologie, which differ in the labor inpt reqired per nit of otpt, where z > z > b > 0 are prodctivity level in highprodctivity firm, low-prodctivity firm, and of elf-employed worker, repectively. 17 Worker acqire kill demanded in the private ector, and incr cot kq ( ) = q 2 / 2θ, where θ > 0. Their learning effort relt in probability q of obtaining kill. 18 Skilled worker then find employment in a high-prodctivity firm in the formal ector with V probability ξ = min[,1]. Worker who either do not obtain kill or do not find killed N job become go into the informal ector, either a elf-employed or a employee of lowprodctivity private firm. In each cae they earn income amonting to b < w, where b i the income from being elf-employed. While the market for nkilled worker i perfectly competitive, the killed worker wage i et throgh decentralized Nah bargaining between the highly-prodctive private firm and the killed worker it employ. If bargaining doe not lead to an agreement, the worker wold exercie it fall-back option, which i the income when elf-employed in the informal ector or wage in the low-prodctivity firm, b. Since the otcome depend on the relative trength of the killed worker v. the firm,α, 0 < α < 1, the relting wage i: 15 In the tandard dynamic earch model of Mortenen and Piaride (2000), the matching fnction take α 1 α Cobb-Dogla form and i decribed by h = AV U, where i the efficiency of matching. Since thi i a tatic model, the matching fnction Snower (1996) i more itable. 16 More generally, β reflect qality of intittion. Amoro (2009) how empirically that difference in intittional qality help explain difference in entreprenerhip acro developed and developing contrie. In Parente and Precott (2000), thi component reflect contry-pecific policie and intittion 17 The amption that more prodctive firm operating in the formal ector employ more worker i conitent with the obervation that growth and development are accompanied by increae in average ize of the enterprie, with elf-employment and mall firm acconting for mot of prodction and employment in pooret contrie. Gollin (2008) how in a calibrated model that thee difference in firm ize and employment trctre acro contrie can be largely explained by difference in prodctivity. 18 x (and q) are retricted to be between 0 and 1. Thi ame that depite their effort, worker (entreprener) occaionally fail to acqire kill (find highly-prodctive bine opportnitie). 10
w = αβ. z + (1 α b (2) ) The wage gap between the killed and nkilled job amont to α ( βz b). 19 The characterization of the environment i completed by market clearing condition. Denoting n = mn to be the total nmber of killed labor employed in the highprodctivity private ector, n = mn total labor employed in the low-prodctivity private ector, and n i total nmber of elf-employed, the market clearing condition for worker i1 μ = n + n + ni. The market clearing condition for the entreprener can be written a μ = m + m, where m are entreprener who rn highly prodctive firm, while m denote thoe who rn low-prodctivity firm. 3.2 Entreprener and worker problem and oltion At the beginning of the period, firm and worker decide how mch effort to pt into earch for bine opportnitie and training, repectively. The entreprener deciion to earch for a bine opportnity and open a firm i:.t. max c, x > 0 E ( c) 2 x c + w + xρπ + x(1 ρ) π (3) 2γ The worker deciion to obtain training can be decribed by: max c, x> 0 E( c).t. 2 q c + w + qξw + q(1 ξ ) b + (1 q) b 2θ (4) Solving the tility maximization problem of worker and entreprener and btitting from the labor market clearing condition yield: x (1 μ ) q = ρ ( π π ) = min ;1 ( π π ) (5) γ μxn q μxn = ξ ( w w ) b = min ;1 w b b q ( ) (6) θ (1 μ) 19 When analyzing data on manfactring firm in Ethiopia Mengitae (2001) fond that both kill and job-matching inflence wage growth. Thee empirical finding pport amption of kill acqiition and matching before prodction in the high-prodctivity private ector take place. 11
Eqation (5) tate that in eqilibrim, the marginal cot of entreprener earch for a bine opportnity, x / γ, i eqal to the profit from earch. According to (6) the worker marginal cot of acqiring kill eqal the net marginal benefit from working, which amont to the killed and nkilled wage over the income from elf-employment. In (5) and (6), nmber of vacancie amont to V = μxn, where μ x i the nmber of entreprener who fond highly prodctive bine opportnity. Similarly, the nmber of killed worker earching for a killed job i ( 1 μ) q. 20 3.3 Policy dicion improving the bine environment Sppoe that in eqilibrim ( E 1 ), ( 1 μ ) q > μxn, the nmber of killed worker looking for job exceed the nmber of killed vacancie. Then with improvement to the bine climate, β, entreprener wold intenify their earch in repone to firm profitability. The relting increaed nmber of killed vacancie encorage worker to acqire kill. Th in the new eqilibrim E 2, both entreprener and worker effort wold be higher de to the improved bine environment (higherγ and β ) (igre 5). When the lack of killed vacancie i the key contraint to job creation, improving the bine environment hold be a priority. 21 Improving efficiency of entreprener earch wold alo have a poitive impact. While policie redcing training cot wold encorage worker to acqiring more kill, they wold not be effective in raiing killed employment. Given the carcity of killed job opening the killed employment otcome wold not change, only additional killed worker wold end p in low-killed job. Thi example how how policie need to be well-targeted to addre binding contraint. 4. What drive firm into the informal ector? Thi ection extend the baic model to examine the factor that inflence firm deciion whether to operate in the formal or the informal ector. In addition, the ection below explore whether policie bidizing entreprener earch or wage of killed worker wold be effective for encoraging entreprenerhip and in what ector. 20 The eqilibrim i defined a wage rate and an allocation of worker and entreprener ch that (i) agent maximize their tilitie; and (ii) labor and prodct market clear. Depending on the parameter, the model either ha (i) a niqe trivial eqilibrim where worker and entreprener exert zero effort, or (ii) a trivial eqilibrim and a niqe one with poitive effort by worker and entreprener. We foc on the niqe eqilibrim with poitive worker and entreprener effort. 21 The poitive impact of higher earch effort entreprener on worker applie only if the earch crve interect the training crve in the concave part of the latter igre 2. igre 2 ame that μn = 1 μ. 12
igre 5. The impact of improved bine environment on eqilibrim otcome 1 0.9 entreprener' earching crve x: effort or entreprener 0.8 0.7 0.6 0.5 0.4 0.3 weaker bine climate better bine climate E_1 E_2 worker' training crve 0.2 0.1 0 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 q: learning effort of worker With profit taxe and the option for the highly prodctive firm to go ndergrond, entreprener profit from rnning a highly-prodctive firm change I to π = max[ π, π ], where π i the after-tax profit in the formal ector and π I S i profit in the informal ector. Entreprener will operate in the formal ector with probability p. If they do not find a highly prodctive bine opportnity and/or killed labor, they will rn a low-prodctivity firm with nkilled worker, n in the informal ector. The bine climate enter the prodction fnction a an efficiency h component β, h =f, i where f tand for formal and i for informal ector. It i better in f i the formal than in the informal ector, i.e. β > β. Hence the otpt of a highly prodctive firm i prodced according to y h h = β zn. The wage of killed worker now h h alo depend on the ector: w = αβ z + ( 1 α) w, h = f, i. Since the prodctivity of firm decreae when they go ndergrond, wage of killed worker alo fall. The government impoe tax rate τ on profit of highly prodctive firm and monitor their payment. When doing o, it incr K monitoring expenditre and detect tax evading firm with probabilityφ > 0. Aming that the government conficate the firm entire profit if it detect tax evaion, it net revene amont to: I I I p τ ( E z n w n ) m + (1 p ) φ( E z n w n ) m K, where φ i the probability that the firm in the informal ector i caght by the tax athoritie. 13
With the poibility to go ndergrond, the entreprener profit from rnning a highlyprodctive firm now becomeπ I = p ( 1 τ ) π + (1 p )(1 φ) π ; the entreprener take the tax rate and the probability of being monitored a given. The firm will chooe to be in the informal ector, i.e. p = 0, if the after-tax profit in the formal ector i le than the expected profit in the informal ector: 22 ( 1 τ ) π < (1 φ) π. (6) I Table 2 how how different factor inflence the probability that the entreprener will operate in the formal ector, p. Redced profit tax rate wold entice firm to move to the formal ector, provided they are fficiently large. Improving tax monitoring wold alo help, bt cot-benefit of thi meare in particlar need to be conidered relative to reform of the bine environment, epecially given the nderdeveloped private ector in Ethiopia. While better tax monitoring wold encorage firm to move to the formal ector, it cold redce entreprenerhip de to lower expected profit in the informal ector. In contrat, improvement in the bine climate wold raie profit in the formal ector and encorage entreprener to move to the formal ector, th have nambigoly poitive effect on both entreprener earch and formality. Table 2. Comparative tatic On probability to work Effect of increae in in the formal ector Tax rate τ - Monitoring φ + Better bine climate E + I Improved fnctioning in the informal ector E - Worker' bargaining power α - 4.1 Sbidie of entreprener earch v. bidie to killed employment Thi ection foce on timlating entreprener earch effort to create firm and job, a key contraint for private ector development in the Ethiopian economy. In repone to low firm and job creation, active pport to entreprener ha become common in lowincome economie, inclding Ethiopia. Thi ection analyze the impact of partial government financing of the entreprener earch for bine opportnitie and compare it with wage bidie to killed worker. 23 22 Thi i the well-known Sandmo condition (Sandmo, 2005). 23 In both cae, the bidy i financed by the ame amont of lmp-m tax T. Brixiova et al. (2009) dic the impact of bidy financing in detail. 14
4.1.1 Sbidizing entreprener earch In cae of bidy to earching entreprener, x, the entreprener bdget contraint 2 x change to: c + x w + xρπ + x(1 ρ) π. Profit of an entreprener rnning a 2γ high prodctive binee (and employing killed labor) amont again to I π = p ( 1 τ ) π + (1 p )(1 φ) π, where π = 1 τ )( β z n w n ) i after-tax ( I I I profit of a firm in the formal ector and π = β z n w n ). (3) now change to: ( x (1 μ ) q = ρ ( π π ) = min ;1 ( π π ) γ μxn + (7) The worker training crve, mmarizing their deciion to obtain training, i a in (4). rom (6) and (7) it i clear that while bidizing entreprener earch will raie their effort, it will not impact their deciion whether to operate in the formal ector or not. Sch deciion, a hown above, wold depend on change in profit tax rate, τ, and/or in I the bine environment relative to condition in the informal ector, β / β. 4.1.2 Sbidizing employment of killed worker 24 In cae of the wage bidy per killed worker amonting to ω, entreprener bdget 2 x contraint change to c + x w + xρπ ( ω) + x(1 ρ) π ; where profit of an 2γ entreprener who work in the formal ector and receive wage ω bidy per killed worker hired i: π ( ω) = (1 τ )[ β zn ( w ( ω) ω) n ]. Profit of the entreprener I I I working in the informal ector i nchanged, that i π = β z n w n. Worker captre part of the bidy in proportion to their bargaining power,α. The wage of killed worker working for a firm in the formal ector then increae to: w ( ω) = α( β z + ω) + (1 α) w, while the wage of a killed worker working for a firm I I in the informal ector i nchanged, w = αβ z + ( 1 α) w, and I w ( ω ) = pw ( ω) + (1 p ) w.with higher expected wage of killed worker de to the bidy, the worker training effort increae according to: q μxn = ξ[ w ( ω) w ] b = min ;1 w w b q [ ( ω) ] θ (1 μ) (8) 24 Thi concept of bidie differ from that of Rijker, Ladarchi and Teal (2008) who examined whether the bidized SME adopted more labor-intenive technology and hence increaed employment. 15
Entreprener profit in the formal ector alo increae a they receive part of the bidy. Eqation (3) th change to: x (1 μ ) q = ρ[ π ( ω ) π ] = min ;1 [ π ( ω ) π ( ω )] (9) γ μxn The impact of wage bidy on entreprener earch i more nanced in thi cae than nder the earch bidy. irt, if in the abence of bidy the firm wold opt for the informal ector and if the bidy i not large enogh to entice it to move to the formal ector, the entreprener earch effort wold not change. So the wage bidy can raie entreprener earch effort only if the firm end p working in the formal ector. Second, in addition to timlating entreprener earch, by changing net profit the wage bidy can alo inflence in which ector formal or informal the entreprener operate. Third, when = ωn, that i when amont paid to firm are eqal nder both bidie, the wage bidie will have lower impact on entreprener earch. Thi i becae entreprener captre only ( 1 α)ωn of the bidy; the ret accre to worker. Correpondingly, worker alo raie their effort in repone to higher wage (igre 7). The conditionality on the ector in which the firm end p operating contitte a key difference in how bidie impact the entreprener effort. Search bidie, which are paid before entreprener find their bine opportnitie, impact only their earch effort deciion, bt not whether to operate in the formal or the informal ector. With wage bidie, forward-looking entreprener increae their effort only when they work in the formal ector pon finding a bine opportnity and killed worker. inally, when deciding between thee two intrment, policymaker need to conider the binding condition that the economy face. If the initial eqilibrim i low becae of the lack of killed job opening (a i the cae in Ethiopia), in the new eqilibrim nmber of firm earching for killed worker wold rie more in repone to earch than wage bidie. In contrat, the nmber of killed worker eeking employment in highlyprodctive firm i higher nder wage bidie. Bt, a igre 7 how, ince the key contraint to the private job expanion i the lack of job opening and not killed worker, wage bidie wold lead to a larger hare of killed worker the informal ector than nder the earch bidy. A thi example illtrate, for policie to be effective, they need to addre the biding contraint and not to fall on nintended recipient. 4.2 Unclear property right Thi ection dice the bine environment and in particlar the impact of nclear property right that alo characterize the Ethiopian economy. In general, nclear property right preent a poibility of expropriation and th an extreme form of taxation on bine capital. In ch a itation, the efficiency coefficient become 0, β = 0. Denoting probability of expropriation a ψ, the entreprener efficiency coefficient in 16
the prodction fnction in the formal economy change to E = ( 1 ψ ) E + ψ 0. The entreprener will now be more likely to opt for the informal ector, ince p = 0 (1 π (10), τ )( E zn w n) < (1 φ) I and the expected profit in the formal ector i redced by the poibility of expropriation. Even if they do not opt for the informal ector, the entreprener will lower their earch effort. The revere i alo tre if improvement to property right are fficiently large, entreprener who wold otherwie opt for the informal ector will increae their earch effort and opt for the formal ector. In that ene, improving bine environment eem to reemble providing wage bidie and tax incentive. igre 7. Comparion of the impact of wage and earch bidie x: effort or entreprener 1 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 earch crve with wage bidy baeline earch crve E_1 (earch bidy eqilibrim) earch crve with earch bidy E_2 (wage bidy eqilibrim) training crve with wage bidy baeline training crve/training crve with earch bidy 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 q: learning effort of worker However, it need to be emphaized that wage bidie are inferior to improvement in the bine environment, and epecially to trengthening the property right, a a way to encorage entreprener to move to the formal ector. In addition to encoraging entreprener to earch and operate in the formal ector, trengthened property right raie firm prodctivity and wage of killed worker. Wage bidie or tax incentive hold th be ed catioly, and only when improvement to the bine climate are particlarly cotly. 25 25 At the ame time, when policymaker conider incentive that wold move firm to the formal ector, wage bidie (or tax incentive in the form of lower rate) may be preferable to extra expenditre on tax monitoring. Unle the revene from enhanced tax monitoring are pent in a way that benefit entreprener, the profitability of rnning a firm may decreae, dicoraging entreprenerhip. 17
5. Conclion Are bidie the bet way to pport SME tart p and killed employment in lowincome contrie with a largely nderdeveloped private ector ch a Ethiopia? Or analyi how that bidie may help, bt the government choice of the type of bidy mt addre the main contraint that the private ector face. In contrie ch a Ethiopia, where entreprenerhip i limited and prodctivity i low, the key objective hold be to help entreprener open high-prodctivity firm and employ killed worker, regardle of the ector. In ch a itation, the earch (or tart-p) bidy may be itable, a it wold encorage entreprener to earch for bine opportnitie. In contrat, tax incentive or wage bidie wold be mch le effective to encorage tart p a they do not affect firm in the informal ector, where mot SME in Ethiopia operate. And wage bidie wold be le effective than earch bidie even for firm in the formal ector, a it wold partly accre to worker. 26 On the poitive ide thogh, tax ct may facilitate SME formalization and a broadening of the tax bae. To accelerate tart p of highly prodctive SME and encorage killed employment, the nderlying inefficiencie in the factor market wold alo need to be addreed. Hence both type of bidie hold be accompanied by frther reform of the bine climate and fnctioning of the labor market. The key among them i a trengthening of property right. In addition to encoraging entreprenerhip -- throgh higher firm creation and increaed rate of formalization -- clearer property right raie firm prodctivity and th wage of killed worker. Thi, in trn, wold encorage worker to acqire kill withot creating an exceive pply of edcated labor. The gap in the fnctioning of the rban labor market, ch a the lack of information abot killed job and worker, cold be alo tackled by bilding p the employment exchange office. Taking a broader view, the global financial and economic crii ha ndercored the importance of the diverified private ector, inclding SME. or policymaker, the crii ha th triggered a rethinking of their growth trategie. Before the crii, many SSA mall open economie relied almot exclively on DI and export a the main driver of growth. However, in light of the crii, contrie are trying to achieve a more broadbaed growth by hifting ome of their reorce to dometic private enterprie and demand. 27 In thi context, enhanced efficiency of the financial ector wold help channel aving to their mot prodctive e. In addition, in reorce-poor landlocked contrie ch a Ethiopia, dometic reorce wold likely need to be pplemented by external financing to eae credit contraint and hortage of foreign exchange. Magnitde of ch contraint and a deign of mitigating intervention a well a application of thi framework to other contrie in SSA cold be bject of frther reearch. 26 Thi conclion i conitent with Ayele (2005), who fond invetment incentive (i.e. import and income tax exemption) to be relatively weak policy intrment of indigeno SME in Ethiopia. Enterprie tart p were more pported by better infratrctre and overall environment. 27 Even before the crii, ome economit pointed ot that an otward orientation in general, and exportoriented manfactring in particlar, may not be itable development path for b-saharan Africa becae of a trong competition from China and India on the global market (Kaplinky and Morri, 2007). 18
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