MIT Sloan School of Management Working Paper 4538 - 04 March 2005 Are Foreign Firms

This draft is very preliminary and incomplete. Please do not quote or circulate without permission. Comments are welcome. Abstract Using the data from World Business Environment Survey (WBES) on over 10,000 firms across eighty one countries, this paper finds preliminary evidence that foreign firms enjoy significant regulatory advantages—as perceived by the firms themselves—over domestic firms. The findings on regulatory advantages of foreign firms hold with a variety of alternative measures of regulations and with or without firm-and country-level attributes and industry and country controls. There is also evidence that foreign firms' regulatory advantages are especially substantial vis-à-vis the politically weak domestic firms. Furthermore, the regulatory advantages of foreign firms appear stronger in corrupt countries than in non-corrupt countries. Soto documented the extremely difficult regulatory environment facing small businesses in Peru. In a real social science experiment, de Soto assembled a research team and instructed the team to follow all the required bureaucratic procedures in setting up a one-employee garment factory. The process took the team members 289 days and cost them $1,231 altogether, an equivalent of three years in average Peruvian wage (De Soto 1989). De Soto's social science experiment was conducted in 1983 and we should note the broad policy context of his accounts of the business on the ground at the time. The early 1980s in Peru, in fact, coincided with a move away from the state-led development strategy Peru adopted since 1968. As a number of Latin American specialists noted, the administration of Fernando Belaunde (1980-1985) undertook a privatization program, promoted primary exports and, above all, aggressively pursued foreign direct investment (FDI) by conferring substantial tax and other benefits on foreign firms (Pastor and Wise 1992; Wise 1994). This paper will show that this juxtaposition of regulatory constraints imposed on domestic firms on the one hand with an active FDI promotion stance on the other is by no means limited to Peru in the 1980s. The other dynamic de Soto noted in his book also runs through this paper. The kind of regulatory constraints documented in The Other Path did not fall on all domestic firms in Peru but fell disproportionately on the small and politically powerless domestic firms. In fact, the cumbersome regulatory procedures and requirements benefited the small group of political and economic elites, who could circumvent these constraints easily with their political power and connections. One could argue further, as (Shleifer 1993) did, that …