Business Red Tape and the Economy

How much does bureaucracy hurt incomes? A lot.

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Source: World Bank, Comparing Business Regulation in 190 Economies, 2019

But how exactly does bureaucracy distort the economy, and how much?

Unnecessary bureaucracy and red tape require businesses to put additional labour and capital towards tasks that are, in effect, “unproductive” for the economy. Time spent dealing with paperwork cannot be spent on creating goods and services for customers. Weaker property rights and higher taxes discourage investment.

When we compare two economies with similar levels of labour and capital, the difference in output and incomes that cannot be explained by differences in the levels of capital and labour is measured in total factor productivity (TFP) – a measure that captures how efficient an economy is at using its productive resources.

In a cross country comparison, differences in red tape will show up in disparities between economies’ TFP. Of course, business regulation is not the only element that will capture the difference in efficiency across countries. A country with better-educated workers, better use of new technology, or a higher natural resource endowment will have a higher TFP than a country with a similar level of labour and capital.

Nevertheless, there is still a definite trend between GDP per worker, well-being and the World Bank Doing Business Index. For example, researchers at the World Bank estimate that a 10% increase in the Ease of Doing Business Index is associated with a 2% reduction in poverty.

Using a random-effects panel data model that includes 184 countries across 5 years that takes into account the total labour force, gross capital formation, the percentage of the labour force with an advanced education and country-specific effects, I find that for each 1 percent improvement in a country’s Ease of Doing Business Index, GDP grows by 0.9%.

Source: GRETL output using a random-effects panel data model that includes total labour force, gross capital formation, and the percentage of the labour force with an advanced education.

The implications for GDP per capita and incomes are potentially enormous. For some smaller, poorer countries, they could more than double GDP by improving institutions and bureaucracy. Canada, which languishes in 23rd place in the World Bank Doing Business Index, could increase income by 8% if it were to adopted procedures like those found in New Zealand. Of course, this model is limited because it does not capture institutional or cultural factors that might drive both bureaucratic and economic efficiency.