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Tuesday, November 7, 2017

The Ease of Doing Business Index Is Fraught with Flaws

Every year, the World Bank puts out its Ease of Doing Business Index, and it's incredibly problematic.

Recently, the World Bank released the latest round of its Ease of Doing Business Index. India improved its rank by 30 places, jumping from 130 to 100. While politicians are busy patting themselves on the back for their “achievement”, the ground reality is very different. Growth has slowed significantly due to hare-brained and ham-fisted policies such as demonetization and Goods and Services Tax (GST). There are tens of millions of unemployed youth, and jobs aren’t being created fast enough.

One would think that the Ease of Doing Business Index would reflect these facts. After all, if it is easier to do business in the country, then growth should be higher, not lower, and far more jobs should be created. The plain fact is that the World Bank’s index is fraught with methodological flaws. Let us go through some of the more glaring ones.

Implementation Matters

For instance, instead of looking at whether reforms were actually implemented, and in what manner, the World Bank just takes governments’ words for it. Theoretically, GST was supposed to make it cheaper to do business and boost economic growth by simplifying tax payments. But even the government has admitted that the implementation was poor. GST has hurt business and destroyed jobs, which is the opposite of making business easy. It has made paying taxes not easier, but more difficult. Yet, the World Bank rewards India with a higher score on the basis of intention, not outcome.

Another example is the recent bankruptcy law. While it looks good on paper, it remains to be seen how it is implemented. Yet the World Bank improved India’s score on the basis of a non-implemented reform.

Sample Selection Bias

The index is constructed using only one city for most countries, and two for more highly populated countries like India. It used data from Mumbai and Delhi, which are in no way representative of the entire country. Being the largest and wealthiest cities, they have better infrastructure, legal systems, government services, and so on.

India ranks high on a parameter like getting electricity if we consider Mumbai, which enjoys 24/7 electricity. But a majority of the country gets electricity only for a few hours a day, if at all. Getting a connection outside of big cities is also a huge hassle. If the World Bank were to use the exact same methodology on a sample of randomly selected towns and villages, India’s score would be much lower in every category.

Vital Details

Stemming from the sample selection bias is another big problem. Mumbai and Delhi are mostly service sector economies, as opposed to agriculture or manufacturing. Since there are fewer regulations on the service sector, this makes doing business in Mumbai or Delhi easier.

You’ll go through piles of paperwork or pay loads of bribes if you want to set up a factory. One of the main things required for starting a business is real estate. How easy it is to acquire property influences a country’s score on the index. Acquiring property for a service-oriented business is very easy. Suppose you want to start a software firm or a fast food outlet in Mumbai. You don’t require much space. Just two or three rooms will be enough. Transferring property between two companies is also easier in big cities.

Now suppose you wish to manufacture some product, and want to set up a large factory. It requires a lot of land, which you can only find in a village. First of all, land records are seldom kept properly in Indian villages. Assuming they are, government will probably prevent you from acquiring land. In its infinite wisdom, government has decreed that farmers may not sell their land for non-agricultural purposes, such as manufacturing, without permission from government. Either you’ll go through piles of paperwork or pay loads of bribes if you want to set up a factory. The World Bank’s index fails to reflect this.

This is an important detail because the service sector creates very few jobs, relatively. Software firms and restaurants, while very profitable, cannot employ tens of millions of youth. Only factories can generate gainful employment for these people.

Unrealistic Assumptions

Even if the World Bank were to take a representative sample of towns and villages for its study, it runs into another major problem. In order to standardize data across countries, it makes several assumptions, some of them quite ridiculous.

For example, it assumes that all business is subject to similar tax treatment. That is demonstrably false, especially in larger economies like India. The government imposes additional levies on products government deems “sinful”, such as alcohol, tobacco, and even my beloved aerated drinks.

Next, there are tax breaks for certain sectors, or for doing business in certain areas like Special Economic Zones (SEZs) or in the North-Eastern states. This backdoor central planning is problematic and should result in a lower score from the World Bank. The fact that they’re not results in some bizarre rankings. For example, Russia, where you can’t run a business if Putin doesn’t like it, is ranked much higher than Chile, a thriving economy which is the world’s 10th freest and Latin America’s richest.

Error by Omission

The single largest cost of running a business is typically labor. Regulations such as minimum wage, paid maternity leave, and so on increase the cost of hiring employees. More labor laws mean that business is more difficult. Yet, the Ease of Doing Business Index does not include labor regulations as a component.  If it were included, India would have a much lower score since it has highly restrictive labor laws.

A Better Alternative

Given the long list of problems with the World Bank’s Index, I suggest that we instead follow the Index of Economic Freedom, which is published annually by the Heritage Foundation. While taxpayer-funded organizations such as the World Bank do their best to make big government look good, voluntarily-funded think tanks like Heritage do a more sound analysis.

The Index of Economic Freedom overcomes the flaws I have listed and gives a more accurate picture of the economy. Also, the fact that India has an abysmal ranking of 143 on that index will wipe the smile off politicians’ faces and remind them that there is far more scope for reform than they think.

  • Jairaj Devadiga is an economist. His work mainly deals with public policy and economic history. Apart from FEE, his writings have been published by the Centre for Policy Studies, the Institute of Economic Affairs and Pragati among others. He is on twitter @JairajDevadiga. Readers can also email him at [email protected].