License to Sell: The Effect of Business Registration Reform on Entrepreneurial Activity in Mexico

License to Sell: The E¤ect of Business Registration Reform on
Entrepreneurial Activity in Mexico
Miriam Bruhn
MIT
This Version: November 2006
Abstract
The number of procedures for registering a business varies from 2 in Canada to 21 in
the Dominican Republic. Many have argued, on the basis of cross country evidence, that
complex business registration regulation sti‡es economic activity and leads to lower growth.
This paper uses a reform in Mexico that reduced the complexity of business registration
procedures, from 8 on average to less than 3, to bring to bear microeconometric evidence on
the question. The reform was implemented in di¤erent municipalities at di¤erent points in
time, allowing for identi…cation. Using panel data from the Mexican employment survey, I
…nd that the reform increased the number of registered businesses by 5.6 percent in eligible
industries. This increase was due to former wage earners opening businesses. Former
unregistered business owners were not more likely to register their business after the reform.
Moreover, employment in eligible industries went up by 2.6 percent, and people who were
previously unemployed or out of the labor force were more likely to work as wage earners
after the reform. Finally, the results imply that the competition from new entrants lowered
prices by 1 percent and decreased the income of incumbent businesses by 3.5 percent.
Email: mbruhn@mit.edu. I am very grateful to Abhijit Banerjee, Esther Du‡o, and David Autor for their
advice and support. I thank Josh Angrist, Simeon Djankov, Jin Li, Ben Olken, Filipa Sa, Olga Shurchkov,
Tavneet Suri, and participants in the …eld lunches at MIT for valuable comments. I am also grateful to Roberto
Villarreal from the Presidential O¢ ce for Public Policy for his help during my stay in Mexico City and to the
sta¤ of the COFEMER for taking the time to tell me about the motivation and implementation of the reform.

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1
Introduction
According to Djankov et al (2002), who present data on regulation of entry for 85 countries,
the number of procedures for registering a business varied from 2 in Canada to 21 in the
Dominican Republic in 1999. Finding these large di¤erences in entry regulation around the
world has spurred an interest in studying the e¤ect of entry regulation on economic outcomes.
Bertrand and Kramarz (2002) examine what happens to employment growth in the retail trade
industry in France after the introduction of zoning regulation which restricts the establishment
of large retail stores. Exploiting regional variation in the enforcement of this regulation, they
show that stronger deterrence of entry decreased employment growth.
Building on the Djankov et al data, some cross-country studies have also established that
countries with less regulation grow faster, suggesting that simplifying business registration may
increase output1. Along similar lines, Hernando de Soto claims, based on anecdotal evidence,
that complicated and costly business registration procedures have caused “two thirds of the
world’s population [to be] locked out of the global economy: forced to operate outside the rule
of law, they have no legal identity, no credit, no capital, and thus no way to prosper.”
A concern with cross-country studies is that they cannot rule out that causality goes the
other way, such that increases in entry or output lead to reforms. It is also possible that
both simpler regulation and higher entry or growth are caused by a third variable. Klapper,
Laeven and Rajan (2006), as well as Fisman and Sarria-Allende (2004), convincingly address
the reverse causality and omitted variable problems by performing cross-country, cross-industry
analyses. They show that countries with heavier entry regulation have lower …rm entry and
lower growth in value added in naturally high-entry industries. However, these cross-country,
cross-industry studies cannot quantify the overall e¤ect of di¤erences in entry regulation. They
can only quantify this e¤ect relative to the United States, which is the country they use to
obtain the benchmark values of the “natural” rates of entry within industries.
Based on De Soto’s argument and the cross-country evidence, some policy institutions,
such as the World Bank, promote simpli…cation of business registration regulation as a vehicle
to foster growth. However, there is very little evidence on the actual e¤ects of a business
registration reform. This paper exploits cross-municipality and cross-time variation in a recent
business registration reform in Mexico to measure the e¤ect of this reform on registration,
employment, and income2. The reform in Mexico reduced registration procedures from 8
1 For example, Loayza, Oviedo and Servén (2005) and Djankov, McLiesh and Ramalho (2006).
2 To my knowledge, only two other studies present evidence on the consequences of entry regulation reform.
First, the World Bank’s Doing Business in 2005 report states that the top 5 reformers in 2003 - Ethiopia,
France, Morocco, Slovakia and Turkey - have experienced higher increases in new registrations than the OECD
average. Second, concurrently to this paper, Kaplan, Piedra, and Seira (2006) analyze the e¤ect of the business
registration reform in Mexico on …rm creation. Using data from the Mexican Social Security Institute (IMSS),
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on average to less than 3. To give a sense of the magnitude of this reform, the reduction
corresponds to going from the 30th percentile in registration procedures to the 2nd percentile,
or equivalently it corresponds to going from Peru or Pakistan to New Zealand or Australia.
Studying the impact of a reform by using micro data considerably re…nes and enriches
the analysis based on cross-country studies. (See Pande and Udry, 2005, for a call to move to
research of this type). First, causality can be established more convincingly. Second, the use of
microeconomic data makes it possible not only to quantify the e¤ects of the reform on overall
levels of entry and production, but also to trace its e¤ect on the functioning of the product
and labor markets.
More generally, many economists have argued that barriers to entry harm consumers by
raising prices and thwarting employment growth. The Mexican reform e¤ectively reduced
entry costs for a large fraction of businesses in the economy in many industries, which allows
for analyzing the impact of entry regulation in a general set up. This paper …rst examines
whether the reform led to increased entry or merely relabelling of existing informal businesses3.
Having shown that it led to creation of new businesses, this paper traces out the impact of
this increase in competition on consumer prices, incumbents’income, and employment.
The paper starts by building a simple model describing the expected e¤ects on the product
and labor markets when the registration cost drops. In the model, high cost of registration
prevents individuals with medium range ability from opening a formal business. Therefore, the
reform leads to increased entry. Depending on the assumption about the returns in the informal
business sector, the increase in entry comes either from informal business owners registering
their business or from wage earners opening businesses. When returns in the informal sector
are high, it is the informal business owners who register their businesses after a reform, which
corresponds to the De Soto view. When returns in the informal sector are low, it is wage
earners who open businesses after the reform and informal business owners do not register
their businesses. This latter e¤ect is in line with a view where informal business owners are
low ability individuals who operate in a residual sector. The model also predicts that increased
entry leads to a decrease in prices and to a decline in income for incumbent businesses.
The paper then tests the predictions of the model using the Mexican reform. The identi…-
cation strategy used to estimate the e¤ects of the reform relies on the fact that implementation
of the business registration reform in Mexico varied across municipalities and across time. The
reform was organized by a federal agency, the COFEMER. This agency had to coordinate
with municipality governments on implementing the reform since many business registration
they …nd an increase in new …rms that have workers registered with the IMSS of 4 percent in eligible industries.
3 Relabeling of existing informal businesses corresponds to De Soto’s view and may still result in an increase
in production and e¢ ciency even if no new businesses are created due to the bene…ts of formality.
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procedures are set locally in Mexico. COFEMER’s goal was to bring the reform to urban mu-
nicipalities that had the largest volume of economic activity in Mexico. However, due to sta¤
constraints, COFEMER could not implement the reform in all the priority municipalities at
the same time. Moreover, they did not specify a particular pattern of implementation within
the set of priority municipalities. A number of checks suggest that the order of implementa-
tion was indeed exogenous in this set of municipalities. Only …rms in low-risk to society4 and
unregulated industries were eligible for the reform. Approximately 80 percent of pre-reform
…rms operated in eligible industries.
The results show that the reform increased the number of registered businesses by 5.6
percent in eligible industries, supporting the …nding of the cross-country literature that lower
regulation leads to more entry. The increase in the number of new businesses came exclusively
from former wage earners opening businesses. Informal (non-registered) business owners were
not more likely to register their business after the reform. This …nding is contrary to the
De Soto view of informal businesses and suggests that informal business owners are instead
low-ability individuals who operate micro businesses in a residual sector. The results also show
that employment in eligible industries increased by 2.6 percent after the reform. In particular,
people who were previously unemployed or out of the labor force were more likely to work as
wage earners after the reform.
By increasing competition, the reform bene…tted consumers and hurt incumbent businesses.
First, using the Mexican CPI as an outcome variable, I …nd that the reform decreased the
price level by 1 percent. Second, the income of incumbent registered businesses declined by 3.5
percent. The fact that the income decline was concentrated among owners of businesses in the
non-tradable goods sector indicates that this was due to competition. Some of the evidence also
suggests that the income of previous wage earners decreased after the reform, possibly because
business owners passed on the decline in prices to their workers. Interestingly, the results do
not show an increase in income for the wage earners who opened a business. One possible
explanation is that these new entrepreneurs are still paying o¤ the …xed cost of opening their
business during the period of observation. Previous wage earners are observed for a maximum
of 4 quarters after the reform. Finally, the income of the previously unemployed and out of
the labor force increased after the reform, by 5 percent on average.
The results suggest that the e¤ect of the reform on average income was zero or slightly
negative. This may be due to that fact that total employment did not increase after the reform.
Employment increased in eligible (low-risk) industries, but decreased in ineligible (high-risk to
society) industries. This shift could imply that welfare went up, even if income did not go up.
4 Low-risk industries are industries that do not present a serious risk to public health, public security, or the
environment. An example of a high-risk industry is chemical production.
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Employees may prefer to work in low-risk industries and may therefore be willing to accept a
lower wage in these industries than in high-risk industries.
Overall, this paper con…rms that the e¤ects of a business registration reform are positive
and potentially important. However, it underestimates the e¤ect of a nationwide reform since
the general equilibrium e¤ects would be larger.
The rest of this paper is organized as follows. Section 2 describes the business registration
reform. Section 3 develops a simple occupational choice model which provides the framework
for analyzing the e¤ects of the registration reform. Section 4 discusses the identi…cation strat-
egy and Section 5 describes the Mexican employment survey data. Section 6 presents the
empirical results. Section 7 concludes.
2
The Mexican Rapid Business Opening System Reform
According to Djankov et al (2002), in 1999, the number of procedures required to register a
business in Mexico was 15 and the number of days was 67. Both numbers were above the cross-
country average (10 and 48 respectively)5. Realizing that Mexico had rather heavy regulations
by international comparison, in 2000, the Mexican government created the Federal Commission
for Improving Regulation (COFEMER), charged with providing information about the state
of regulation across Mexico and implementing possible reforms.
The COFEMER suggested a reform to simplify business registration procedures with the
goal of stimulating investment and economic growth. Following this proposal, on March 1,
2002, the Mexican government passed a federal law stating that the number of federal pro-
cedures required for starting operation of most businesses should be reduced to a maximum
of two procedures that could be administered within 72 hours. These two procedures are ob-
taining a tax payer number and incorporating the business in case it is a corporation. Once a
…rm starts operating, it has three months to take care of the other federal requirements that
may apply, such as registering workers for medical insurance. This reform applied only to
non-governmental …rms in industries which do not require special permits or concessions and
which do not present a serious risk to public health, public security, or the environment. These
eligible “low-risk” industries made up 55 percent of all industries and 80 percent of operat-
ing …rms, typically micro, small or medium size businesses. Another 10 percent of industries
were governmental and 35 percent were classi…ed as “high-risk”or regulated. Appendix A lists
examples of low-risk and high-risk/regulated industries as classi…ed by the COFEMER. Exam-
ples of low-risk industries are commerce and restaurants. Examples of high-risk or regulated
5 The minimum number of procedures (days) was 2 (2) both in Canada and Australia. The maximum number
of procedures (days) was 21 in the Dominican Republic (152 in Madagascar). These numbers refer to business
registration in the largest city of each country. For Mexico, this is Mexico City.
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industries are chemical production and transportation (including taxis).
However, simplifying federal regulations was not enough, since there were additional state
and municipal procedures required for starting a business. These procedures typically varied
from state to state and municipality to municipality. Having simpli…ed federal regulations, the
COFEMER then approached state and municipal governments to suggest that they cut down
on local regulations and that they implement one-stop-shop centers where entrepreneurs could
take care of federal, state, and municipal procedures at the same time. The COFEMER’s
goal was to create a Rapid Business Opening System (SARE) in Mexico’s most populous and
economically important urban municipalities in order to quickly reach a large number of people
and a large fraction of economic activity with the reform. However, the COFEMER was not
able to bring a SARE to all those municipalities at the same time since it had limited resources.
There were only four people within the COFEMER working on spreading the reform to local
governments. Consequently, the SARE was implemented in di¤erent municipalities at di¤erent
times, staring in May 2002. By September 2006, 103 municipalities had a SARE and another
13 municipalities were in the process of setting up a SARE6.
The SARE was successful in simplifying local business registration procedures. Table 1
shows summary statistics for business registration procedures before and after the reform for
a sample of 32 municipalities from 17 di¤erent states. The averages for the number of days,
procedures and o¢ ce visits required to register a business all decreased signi…cantly, falling
from 30.1 to 1.4, from 7.9 to 2.7 and from 4.2 to 1, respectively7. The standard deviations of
all three measures also became much smaller, implying relatively small di¤erences in business
registration procedures across municipalities after the reform.
I have fairly detailed administrative data on licenses issued in 2004 from the registration
center in one of the municipalities which adopted the reform in 2003, Guadalajara. Looking
at these data provides an insight into what types of businesses registered after the reform.
Guadalajara reports that a total of 16,631 businesses were created in 2004, corresponding to
an investment of US$ 90,997,003 and to 21,170 new jobs created. The average investment was
thus US$ 5,471 and the average employment per …rm was 1.27. The most frequent business
types were video game console rental, computer rental, small grocery stores, clothing stores,
home-style food-to-go vendors, and beauty salons.
6 There are 2454 counties in Mexico, but 94 percent of the population and 98 percent of economic activity
are concentrated in 450 counties. These 450 counties include 99 of the 103 counties which had a SARE by
September 2006. The SARE counties contain 33 percent of the population and 47 percent of economic activity.
The four counties which are not part of the 450 biggest counties, but have a SARE, implemented the reform
when other counties in the same state implemented it.
7 These pre-reform data are di¤erent from the data in Djankov et al since the latter are for Mexico City
only. The 32 counties for which COFEMER reports data don’t include any county from Mexico City since these
counties have not implemented reforms.
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3
A Simple Occupational Choice Model
To have a framework for analyzing the e¤ects of the business registration reform, I develop
a simple occupational choice model. The model generates a division of the population into
three occupational groups: wage earners, informal (non-registered) business owners and formal
(registered) business owners. An important issue is how we should model informal business
owners. There are two di¤erent views in the literature. One view is that informal business
owners are people who can not be wage earners since their ability is too low. Therefore, they
set up a micro …rm in the informal sector. Under this view, the informal sector is a residual
sector (See for example Loayza, 1994). The other view says that informal business owners
are and have relatively high ability. However, their ability is lower than the ability of formal
business owners, and they operate in an unregulated environment since the costs of formality
are high (See Levenson and Maloney, 1998, and Maloney, 2004). The latter is also largely
consistent with Hernando de Soto’s view.
The model considers two alternative assumptions about returns in the informal sector,
which generate occupation divisions corresponding to each of the two views. Both assump-
tions give the same predictions about the overall e¤ects of the business registration reform.
However, the predictions about the e¤ects on wage earners and informal business owners are
di¤erent across the two models. I test these predictions in Section 6. The reform thus helps
to discriminate between the two views described above.
3.1
The Environment
The economy lasts for one period and is populated by a continuum of individuals of mass one.
Individuals have strictly increasing preferences over consumption, u(c). They have one unit of
labor they can supply, and they have to choose between becoming a wage earner, setting up a
formal (registered) …rm, or setting up an informal (unregistered) …rm.
Each individual is endowed with an ability level, x, drawn from a uniform distribution
H(x) with support [0; 1]. Wage earners are employed by formal …rms and get a wage w(x).
Each formal …rm employes exactly one worker. The production function for formal …rms,
y(x; xw), depends on the ability level of the owner, x, and the ability level of the worker, xw.
In particular, I assume
y = x + xw,
where
> 1. Formal …rms face a downward sloping demand curve for the good they pro-
duce, such that the price of this good is a function, P (Y ), of the aggregate quantity produced,
Y , where dP (Y ) < 0. Note that the assumption that prices decrease with aggregate output
dY
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should be true only for non-tradable goods, but not for tradable goods. I assume that the
price is measured in terms of a second good that all agents produce at home and that plays
no role in the labor market or in …rm production. The home good is thus the numeraire.
There is a …xed cost, F , of registering a formal …rm, implying that formal …rms’pro…ts are
(x; xw; P (Y ); F ) = P (Y )[ x + xw]
w(xw)
F .
Since formal …rms are relatively small, they do not consider the impact their output has
on aggregate output and the price in their decision to produce.
Pro…t maximization implies that
w0(xw) = P (Y ),
such that the marginal increase in wage for an additional unit of ability is equal to the price.
This implies that the wage of a worker of ability x, w(x), is of the form P (Y )x
k, where is a
k constant that clears the labor market.
Informal business owners produce the same good as formal …rms, but they have a di¤erent
production function, y = x, where 0 <
< . In this model, informal business owners work
alone. This fact generally matches my data. In the pre-reform period, 79 percent of informal
business owners work alone, another 20 percent have one employee and only 1 percent have
more than one employee. In contrast, only 40 percent of formal business owners work alone,
50 percent have one employee and another 10 percent have more than one employee.
Agents choose their occupation by maximizing utility subject to their ability constraint.
In this economy, utility maximization is equivalent to income maximization, where the income
from the di¤erent types of occupations, I(x; P (Y ); F ), is given by
P (Y ) x for informal business owners,
I(x; P (Y ); F ) = P (Y )x
k for wage earners,
P (Y ) x + k
F for formal business owners.
Depending on the size of returns in the informal sector, , the resulting occupation division
matches one of the two di¤erent views of informal businesses mentioned above. If returns in the
informal sector are low, such that
< 1, then the resulting occupation division is consistent
with the residual sector view. If returns in the informal sector are high, such that 1 <
< ,
then the resulting occupation division matches the De Soto view.
The following subsections discuss the occupation divisions and equilibria under the di¤erent
assumptions about productivity in the informal sector.
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3.2
Occupational Choice with a Low Productivity Informal Sector
If
< 1, then income from wage work exceeds income from informal businesses for levels of
x higher than a cuto¤, xw. This threshold level is de…ned by P (Y ) xw = P (Y )xw
k, and
agents with ability lower than xw become informal business owners.
Agents with ability higher than xw have to choose between becoming wage earners and
formal business owners. Holding the price …xed, a …rm’s pro…ts are strictly increasing in x,
which implies that only agents with relatively high ability, x, choose to become formal business
owners. In particular, there exists a threshold level, x, such that for values of ability above
this level pro…ts exceed the income of wage earners. This threshold level x is de…ned by
P (Y ) x + k
F = P (Y )x
k. Given this threshold level, the occupation division is as follows
1. Agents with ability above x become formal business owners.
2. Agents with ability between x and xw become wage earners.
3. Agents with ability below xw become informal business owners.
Figure 1 depicts income and the occupation division as a function of ability under the
assumption that …rms in the informal sector have low productivity.
3.3
Equilibrium with a Low Productivity Informal Sector
Aggregate labor demand is given by
L(P (Y ); F ) = Z 1
h(x)dx.
x(P (Y );F )
Labor supply has to equal demand, such that
Z x(P(Y);F)h(x)dx=Z 1 h(x)dx.
xw(P (Y ))
x(P (Y );F )
This condition closes the model since it determines the value of the constant k that clears
the labor market.
Aggregate output is given by
Y (P (Y ); F ) = Z 1
xh(x)dx + Z x(P(Y);F)xh(x)dx+Z xw(P(Y)) xh(x)dx.
x(P (Y );F )
xw(P (Y ))
0
Note that both labor demand and aggregate output depend on the price level and the …xed
cost of registration.
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3.4
Occupational Choice with a High Productivity Informal Sector
If 1 <
<
, then income from an informal business exceeds the income from wage work.
Therefore, the cuto¤ level of ability x is now the cuto¤ between formal business owners and
informal business owners. This cuto¤ level, x, is de…ned by P (Y ) x + k
F = P (Y ) x.
Note that, under the assumption that 1 <
<
, formal …rms need to share more of
their revenues with their workers than they do when
< 1, such that k becomes negative in
equilibrium. Otherwise, all agents with x smaller than x would prefer to be informal business
owners since x > x
k would be true for each level of x if k were positive. The threshold level,
xw, now represents the cuto¤ level of ability between workers and informal business owners.
This threshold level is given by P (Y ) xw = P (Y )xw
k.
The occupation division is a follows
1. Agents with ability above x become formal business owners.
2. Agents with ability between x and xw become informal business owners.
3. Agents with ability below xw become wage earners.
Figure 2 depicts income and the occupation division as a function of ability under the
assumption that …rms in the informal sector have high productivity.
3.5
Equilibrium with a High Productivity Informal Sector
In equilibrium, labor demand is again given by
L(P (Y ); F ) = Z 1
h(x)dx.
x(P (Y );F )
Labor supply has to equal demand, such that
Z xw(P(Y))h(x)dx=Z 1 h(x)dx.
0
x(P (Y );F )
This condition again determines the value of the constant k that clears the labor market.
Aggregate output is now given by
Y (P (Y ); F ) = Z 1
xh(x)dx + Z x(P(Y);F) xh(x)dx+Z xw(P(Y))xh(x)dx.
x(P (Y );F )
xw(P (Y ))
0
Both labor demand and aggregate output depend on the price level and the …xed cost of
registration.
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