If the private sector is to lead economic growth, incentives must be in place to increase private investment, boost the productivity of private firms, and spur competition. Perhaps even more important is removing constraints to private sector development. Distorted incentive policies call for reforms that address product and factor prices, special tax incentives, trade protection, state subsidies, and preferential access to foreign exchange and other scarce resources.
Real exchange rates, real wages, real interest rates, and relative commodity prices convey vital information about the interaction of the agents in an economy—and that economy's interaction with the rest of the world (table 5.5). Some relative price movements are immutable. For a small, open economy the real exchange rate in the long run is determined by the country's endowments, tastes, and technologies. But policymakers can influence relative prices only in the short run—and whether their policy initiatives stick depends on the behavior of real wages and the accompanying monetary and fiscal policies.
Relative prices also reflect an economy's openness by showing how far domestic prices of traded goods are from international prices. Trade restrictions account for most of the gap between domestic and international prices (table 5.6). They push investment to the wrong projects, and they force consumers to pay higher than world prices.
Openness to trade goes hand in hand with faster economic growth. Many developing economies have been lowering their tariffs and reducing the coverage of nontariff barriers, with further progress expected now that the Uruguay Round is coming into force. But tariffs are still high in many countries, in part because the countries need the revenues tariffs generate. For example, tariffs in South Asia averaged 30 percent after the Uruguay Round, substantially lower than in the 1980s, but still much higher than those in East Asia (around 12 percent). Industrial country tariffs now average around 3 percent (see table 6.4). As countries develop, they usually build up their capacity to tax residents directly, and indirect taxes become less important as a source of revenue. Thus the share of direct taxes in total revenues is one measure of the development of the tax system.
Openness to foreign competition, foreign knowledge, and foreign resources energizes the development process in many ways, and lowering trade taxes enhances openness. The fastest-growing economies over the past 15 years have not relied on tax revenues from exports, and, seeing this pattern, many other countries have pulled down their export taxes. High export taxes—typically levied on primary products, particularly agriculture—are inadvisable because they reduce the incentive to export and encourage a shift to other crops. Similarly, high marginal income taxes tend to penalize work and savings (table 5.8). The progressivity of a tax system—as measured roughly by the highest marginal tax rate on individual and corporate income—can show how the tax system builds or reduces the incentives for succeeding on the job or in business. International investors, for example, use such data as an indicator of the hospitality of governments to their interests. Of course, considerations of equity and incentives need to be balanced in a tax policy geared to socially sustainable development.
The overall incentive framework determines how private investors see risk, perceptions that usually are highly subjective. To get a handle on the reality a country faces in trying to attract private capital, country risk ratings take account of objective indicators as well as policies and prevailing prejudices (table 5.9).
Putting support systems in place
An efficient and vibrant financial system is an important precondition for private sector development. It mobilizes savings and allocates them to investments by private entrepreneurs (table 5.10). It links savers and borrowers, manages risk, and operates the payment and settlement systems. And it helps shift resources from declining to dynamic sectors.
Yet in many developing economies, particularly the poorest, inappropriate policies have hobbled fledgling financial systems. Large budget deficits were monetized, and inflation flowered. To keep nominal rates from rising, governments controlled interest rates. The resulting reduction in real rates reduced incentives for the formal banking system to intermediate savings, encouraging capital flight and overborrowing. This neutralized commercial banks, and credit was allocated by government decree. Banks lost their ability to screen and assess credit risks, and central banks allowed their oversight functions to wither.
The unhappy outcomes? Bad loans accumulated, and the losses were periodically covered by printing money. Weak financial sectors are proving a threat to middle-income countries trying to attract large private capital flows.
Financial reforms are now at the top of the agenda for economic reform in many countries. Measures include stopping the hemorrhaging of public enterprises, privatizing banks when appropriate, improving bank management, and strengthening bank supervision.
Infrastructure is a second key support system for private sector growth. The quality and adequacy of infrastructure services are important determinants of how successful firms are in delivering products and services of high quality at low prices in the shortest possible time (tables 5.11 and 5.12). Poor infrastructure increases private costs by increasing investment and transactions costs and restricting access to domestic and international markets.
Low-income countries have improved their infrastructure but are far behind middle-income countries. In Sub-Saharan Africa telecommunications coverage is among the lowest in the world, averaging 11 lines per 1,000 people compared with 34 in East Asia and the Pacific and 91 in Latin America. Indeed, there are more telephones in Tokyo than in the whole of Sub-Saharan Africa. National transport systems also fail to deliver the logistical support needed by private firms, and poorly maintained roads add to excessive freight costs.
Private sector growth is also enhanced by expediting access to technology (table 5.13). Technology is the knowledge that leads to improved machinery products and processes. It is embodied in imported inputs and capital goods, sold directly through licensing agreements, and transmitted through foreign direct investment. The ability to assimilate technology is a function of the pool of trained manpower and investments in research and development, but public spending on research and development has often been wasteful and misdirected. Information technology is now at the vanguard of technological change, with countries rapidly expanding their use of computers and tapping the World Wide Web (table 5.14).
The shift in emphasis from states to markets constitutes a tall agenda requiring simultaneous and difficult actions in many areas over long periods (figure 5b). Future editions of the World Development Indicators should enrich our capacity to monitor these trends further, as data coverage and quality improve, particularly in the area of institutional development.