# **_IV.1 Spurring entrepreneurial experimentation_**

Policymakers have an important role to play in creating an enabling environment for entrepreneurs to take risks, experiment and learn. Possibly the highest risk to the enterprise sector in any country is maintaining a business environment with high exit costs and low levels of risk-taking, as there is then no impetus for rapid reallocation and innovation. Key policy imperatives are to set the appropriate rules of the game for the allocation of entrepreneurial talent towards innovation, including reducing distortionary “costs of success” and “costs of failure”, and ensuring sufficiently flexible and competitive product and factor markets with as much policy certainty and as little policy arbitrariness as possible.

Policy can influence the allocation of entrepreneurship more effectively than it can influence its total supply. By establishing or altering the prevailing “rules of the game”, policy plays a key role in specifying the relative payoffs to different entrepreneurial activities that determine whether these people develop and use these talents and most critically how they allocate their entrepreneurial talent and effort: whether entrepreneurship will be directed to destructive activities (e.g. war lords or drug barons), to unproductive activities (e.g. public sector rent-seeking by creating and taking advantage of protection from competition and monopoly rents, and private sector rent-seeking including through insider dealing, unproductive tax evasion, litigation and societally-inefficient corporate takeovers), or to socially productive activities, namely efficiency-enhancing reallocation and innovation (Baumol 2010).

Distortionary “costs of success” inhibiting risk-taking and growth include a high likelihood of expropriation of the rewards of innovation and a range of related policy barriers. One of the most important sets of rules to stimulate the allocation of entrepreneurial talent toward innovation activities is to ensure, through contract enforcement and rule of law, that successful innovators are allowed to reap generous rewards commensurate with the risk undertaken, that entrepreneurs are permitted to grow and accumulate wealth without a high risk of expropriation by other firms or by the state (including through excessive taxation, various forms of corruption, or dominant firms denying expansion opportunities through illegal means if the young growing firms are too successful), and that the respect for such rules is widely followed and trusted throughout society. Based on evidence from India and Mexico, Hsieh and Klenow (2013) suggest that the return on investments in plant-specific intangible capital (KBC) to boost within-firm TFP may be lower in Mexico and India than in the US due a range of market and government distortions punishing enterprise expansion — such as higher tax enforcement and/or corruption,<sup>48</sup> difficulties in obtaining skilled managers and/or bigger contractual frictions in hiring non-family labor,<sup>49</sup>

> 48 In Mexico, Levy (2008) argues that payroll taxes (roughly 32% of the wage bill) are more stringently enforced on large plants, as are other taxes (Anton, Hernandez and Levy, 2012). Indian labor regulations, applying more strictly to larger firms (or that small formal and informal firms find easier to evade), are emphasized by Besley and Burgess (2004). La Porta and Shleifer (2008) document that larger formal plants spend more on bribes (as a share of revenue) than do smaller formal and informal plants.

> 49 Bloom et al. (2013a) argue that delegation costs raise the costs of managers in India, supported by models where managerial inputs are important for large plants but less important for smaller formal or informal plants (see the appendix in Hsieh and Klenow 2013). The fact that the gap in average wages between large and small plants in Mexico and India is almost twice that observed in the US also suggests that larger plants in Mexico and India may pay higher efficiency wages due to monitoring costs or that the cost of skilled managers is higher there.

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