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.