Business Environment and the Incorporation Decision Asli Demirguc-Kunt Inessa Love Vojislav Maksimovic

Motivation Without transaction costs corporate form is irrelevant - all benefits can be obtained by private contracting (Easterbrook and Fischel, 1985) With transaction costs and some property rights protection the corporate form may be important Corporate form followed industrialization and economic development; –Form affects legal transactions and raising capital.

Potential advantages of incorporation Corporations can derive advantage from: –More efficient contracting (separate legal identity) –Limited liability –Freer transferability of shares –Regulatory and tax structure These advantages will depend on the business environment

The Adaptive View Firms will choose corporate form to adapt to their environment (and minimize costs) –Corporations may be better adapted when disputes are mediated by courts (well functioning legal system) –Businesses incorporate until the benefits equal costs for the marginal firm In better legal systems this will result in more incorporated businesses

Questions How business environment affects the choice of corporate form? Does the corporate form affect the firm’s operation and growth? Does business environment affect the relative benefits that firms derive from incorporation?

Our tests 1. Predict the probability that the business incorporates as a function of firm characteristics and business environment 2. Test for differences in obstacles faced by firms –As function of corporate form, function of business environment and interactions 3. Test for differences in growth rates

Data WBES –52 countries, 4200 firms, 1999 (cross-section) –Corporation / non-corporation (partnership, sole proprietorship) –Legal, financial, corruption and regulatory obstacles Business environment: –Law and order, financial development, GDPPC, creditor and shareholder rights, duration of entry, bankruptcy process (absolute priority, time in bankruptcy, percent of bankruptcies), tax disadvantage (corp. tax- income tax)

Results/Choice of incorporation Firm-level: more likely to incorporate if: –Foreign owned, large, non-service Business environment: –Financial and legal development increases incorporation –More efficient bankruptcy process (time, number, absolute priority) increases incorporation –High costs of incorporation decrease incidence: Longer incorporation process, higher taxes

Results/Obstacles Corporations report lower obstacles This is especially so in an environment where these effects are likely to be material –Lower financing obstacles in countries with more developed financial systems –Lower legal obstacles in countries with stronger law and order traditions –Lower corruption obstacles in countries with less corruption –Lower tax and regulation obstacles in countries with lower tax disadvantage and lower regulatory burden

Results/Growth On average growth rates are not different However, in countries with better business environment corporations grow faster. –Consistent with previous findings that corporations have less obstacles in countries with better business environment

Conclusions Corporations are better adapted in countries where formal legal system is used in conflict resolution. Partnership and Sole Proprietorships are better in a reputation-based environment. Advantages of corporate form only manifest in countries with better business environment.