# **1. Introduction**

Recently, policy makers and multinational organizations have increasingly focused on a sound investment environment as a strategy for economic development (Stern 2002; World Bank 2005). It is difficult to define “investment climate,” or business environment, precisely,<sup>2</sup> but Stern (2002) notes that it is the “policy, institutional, and behavioral environment, both present and expected, that influences the returns, and risks, associated with investment” in a specific location. In other words, the business environment covers whatever external environment that affects the returns and risks faced by investors. This general definition includes three broad categories.<sup>3</sup> The first category covers macroeconomic aspects such as fiscal, monetary, and exchange rate policies, which clearly affects investors’ returns—high tax rates, for example, would lower return, while inflation would increase variability of returns. The second category includes governance, institutions, and political stability. Take, for instance, rule of law, which affects investors’ decisions about how much to invest and what organizational form to take. Institutions also include informal ones, such as the general level of trust, social capital, and social network (Knack and Keefer 1997; North 1990; Shirley 2008; Zak and Knack 2001), which would facilitate new transaction relationships and, therefore, firm expansion. The final category includes infrastructure necessary for productive investment, such as transportation, electricity, and communications. This paper discusses the effects of the second and third categories of the business environment, which include government policies and behaviors related to the provision of infrastructure, tax burdens, protection of property rights, labor, and entry regulations (World Bank 2005).

Identifying the effects of the business environment is difficult. The first difficulty concerns measurement problems (e.g., eliciting truthful responses about corruption). For a long time the available data are only at the country level. Since multicollinearity about various aspects of the business environment is particularly severe at the country level—for instance, among the commonlyused cross-country ICRG governance indicators, the correlation coefficient between the rule of law and the control of corruption is 0.62 between 1996 to 2007—identifying the business environment effects at the cross country level becomes particularly difficult. This shortcoming can be partially overcome with firm-level data, which often allow us to go further than cross-country and crossindustry data.<sup>4</sup> Of great help are vast variations within a country. The average tax burden in inland

> 2 The terms “investment climate” and “business environment” are used interchangeably in this paper.

> 3 Other features, such as geography and weather, also belong, but since little can be done to alter them, their effects are not discussed in this paper.

> 4 The touting of micro data here should not be interpreted as discriminating against studies based on sector- or country-level data, which are complementary to those on firm-level data. Some key explanatory variables differ only

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