## 2. Fostering Growth through Business Dynamism

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### 2.1 Introduction: Productivity shortfall and its nature
- Latin America’s weak productivity performance is a major constraint on income convergence with advanced economies (AEs).
- Dual productivity challenge:
  - Low levels of total factor productivity (TFP).
  - Persistently weak TFP growth.
- Mechanisms:
  - Resource misallocation and sluggish firm-level productivity gains prevent high-productivity firms from scaling to efficient size and allow low-productivity firms to remain active for too long.
  - These factors inhibit resource shifts across firms and thereby slow aggregate productivity growth.
- Key aggregate indicator:
  - TFP gap estimated at 43 percent (Figure 2.1, panel 1).

### 2.2 A deeper understanding of the dual productivity challenge
- Analytical approach:
  - Decomposes TFP levels and TFP growth using firm-level data and the Hsieh and Klenow (2009) framework.
  - Allocative efficiency measured as ratio of actual TFP to benchmark without variation in revenue-to-input ratios; TFP loss from misallocation computed accordingly.
- Empirical findings on misallocation:
  - Misallocation in manufacturing reduces TFP in LA3 (Brazil, Colombia, Mexico) by 18 percent below potential.
  - The 18 percent reduction exceeds the 12 percent gap estimated for emerging Asia and Europe and is substantially larger than the benchmark for AEs.
  - Misallocation is consistently higher than in AEs across all sectors.
  - From 2005 to 2021, misallocation increased in EMs but declined slightly in AEs.
  - Misallocation of variable inputs—such as labor and intermediate goods—accounts for over 95 percent of the overall TFP loss in LA and other EMs.
  - Addressing misallocation to AE levels (increasing the region’s TFP by 16 percent in Figure 2.2, panel 3) would close 37 percent of the region’s current productivity gap with AEs.
  - Frictions are particularly severe for high-productivity firms; regression evidence shows more productive firms are more constrained by frictions (Figure 2.2, panel 6).
- Findings on TFP growth decomposition (2005–19; LA3 focus):
  - Average TFP growth in LA3 was −0.7 percent.
  - Contribution from firm entry and exit: 0.9 percent.
  - Contribution from surviving firms: −1.5 percent.
  - The entry and exit margin contributed equally; low rates of entry and exit suggest higher barriers to entry and exit.
  - If LA’s survivor margin had matched AEs, TFP growth could have matched the highest regional rate at 0.9 percent annually observed in emerging Asia.
  - The negative survivor margin stems mainly from weak within-firm productivity growth and limited reallocation toward more productive firms.
  - Surviving firms in LA show deteriorating performance over time, reflecting constrained investment and weak upgrading (including in R&D).

### 2.3 From diagnosis to reforms: Linking productivity to underlying frictions
- Core structural frictions driving misallocation and stagnation:
  - a. Size-Based Frictions
    - Dual-track regulatory regimes grant lighter compliance burdens to firms below size thresholds (taxation, labor, social security).
    - These regimes create disincentives to grow; firms cluster just below thresholds to avoid higher taxation and compliance costs.
    - Result: compressed firm size distribution and reduced allocative efficiency (Figure 2.4, panels 1 and 2).
  - b. Financial Frictions
    - Credit-to-GDP ratios in LA remain well below EM averages.
    - Constraints compounded by concentrated banking sectors, weak creditor protection, and underdeveloped risk assessment tools.
    - Financial frictions restrict surviving firms’ expansion and startups’ ability to enter markets.
  - c. Limited Competition
    - Weak enforcement of antitrust rules, high market entry costs, and regulatory capture undermine competition.
    - LA characterized by high market concentration and dominant conglomerates (Figure 2.4, panel 4).
    - Weak competition reduces incentives for innovation and weakens reallocation toward more efficient producers.
- Broader mechanism:
  - Frictions generate “wedges” between firms’ marginal benefits and costs from additional inputs, preventing efficient reallocation.
  - High-productivity firms face disproportionately high barriers (financing, market access, regulatory burdens), limiting their growth and contribution to aggregate productivity.

### Policy levers to lift constraints
- Reform objectives:
  - Boost business dynamism, investment, and growth by reducing misallocation and enabling firm upgrading.
- Reform areas and illustrative measures:
  - Size-based regulation reforms:
    - Gradual phasing out of hard size-based thresholds.
    - Introduction of smoother compliance regimes to eliminate discontinuities that discourage growth.
  - Financial sector reforms:
    - Expand credit information systems.
    - Improve legal frameworks for creditor rights.
    - Develop risk assessment tools to expand access to financing for productive firms.
  - Competition and market structure:
    - Strengthen antitrust enforcement and reduce market entry costs.
    - Address regulatory capture to lower market concentration and encourage reallocation toward efficient firms.
- Expected impacts:
  - Reducing misallocation to AE levels (TFP +16 percent) could close 37 percent of the TFP gap with AEs.
  - Relaxing financial and regulatory frictions could enable high-productivity firms to expand, improve within-firm productivity growth, and increase entry and exit dynamics.

### LA5: Incentive Gap in Corporate Income Tax and related diagnostics
- Incentive gaps between statutory and simplified tax regimes:
  - Measure reported as "Percentage points; statutory minus simplified tax rate".
  - Simplified regimes included:
    - BRA = Microempreendedor Individual (MEI), Simples Nacional (SIMPLES)
    - CHL = Régimen Tributario enfocado a pequeños y medianos contribuyentes (Pro-Pyme)
    - COL = Régimen Simple de Tributación (RST)
    - MEX = Régimen simplificado de confianza (RESICO), Régimen de Incorporación Fiscal (RIF)
    - PER = Régimen Especial de Renta (RER), Régimen MYPE Tributario (RMT)
  - Methodological specifics preserved:
    - For BRA—SIMPLES, SIMPLES rates bundle multiple taxes, including CIT and social security contributions. For comparability with the general regime’s CIT of 25 percent, after surtax, the SIMPLES CIT is proxied by subtracting the 9 percent social contribution from the median SIMPLES nominal rate across revenue brackets and sector.
    - For MEX—RIF, the year-1 schedule (100 percent CIT discount from the general regime rate) is used to reflect entry incentives; the discount decreases by ten percent each year over ten years.
    - For PER-RER, there is no annual CIT, but a statutory monthly revenue-based quota of 1.5 percent.
  - Definitions:
    - CIT = corporate income tax; STR = simplified tax regime.
- Firm behavior and frictions at thresholds (Peru example):
  - Panel uses "Millions of local currency" to show firm performance and frictions at thresholds across simplified regimes (MEI, RESICO, RST, Pro-Pyme, SIMPLES, RIF, RMT, RER).
  - Labor regulation threshold:
    - Stricter labor regulations apply only to firms with more than 20 salaried workers.
    - Each taxpayer identification number is treated as a separate firm; some firms may split into subunits with different identification numbers to remain below the threshold.
- Financial intermediation and credit:
  - Total Credit to Non-Financial Sector, 2022–24 is shown as "Percent of GDP; quarterly average".
  - Aggregates are purchasing-power-parity GDP-weighted averages.
- Productivity, competition, and market dominance:
  - TFP and Competition, 2019 plotted with x-axis: USA = 1; y-axis: index.
  - Country groups:
    - AEs = advanced economies (AUT, BEL, DEU, DNK, ESP, FIN, FRA, GBR, GRC, ITA, JPN, LUX, SWE)
    - EM = emerging markets
    - EM Asia = CHN, IDN, IND, MYS, THA
    - EM Europe = CZE, EST, HUN, LVA, LTU, NLD, SVK, SVN
    - LA5 = Latin America 5 (BRA, CHL, COL, MEX, PER)
    - TFP = total factor productivity
  - Market dominance index note:
    - The 2019 market dominance index reflects responses to the Global Competitiveness Index 4.0 survey question: “In your country, how do you characterize corporate activity?” This perception-based indicator should be interpreted with caution, as it may reflect sampling biases, framing, and changes in sentiment.
- Regional policy diagnostics and reform recommendations:
  - Promote stronger bank competition to mitigate financial frictions.
  - Support fintech solutions and digital credit platforms to broaden access while reducing risk premiums.
  - Strengthen antitrust bodies.
  - Streamline business registration.
  - Enhance transparency in public procurement.
- Expected outcomes of tackling core frictions:
  - Unlock firm dynamism and support stronger productivity growth.
  - Foster stronger growth, unlock the full potential of human and capital resources, and support income convergence with AEs.
- Case evidence: Successful reforms
  - New Zealand’s mid-1980s comprehensive reforms improved competition, expanded access to credit, eliminated frictions, and bolstered productivity.
    - Private sector credit increased from about 50 to about 115 percent of GDP after reform.
    - Foreign direct investment inflows rose from 1.3 to 4.5 percent of GDP.
  - Peer lessons:
    - Estonia’s deregulation and digital governance reforms enhanced transparency, reduced red tape, and fostered firm creation.
    - Peru’s 1990s reforms addressed labor rigidities, boosted capital flows, and expanded financial intermediation.

*International Monetary Fund, Regional Economic Outlook — Western Hemisphere, October 2025 (chapter figures and notes).*

### 2. Fostering Growth through Business Dynamism

### 2. Fostering Growth through Business Dynamism

### 2.1 Introduction: Productivity shortfall and its nature
- Latin America’s weak productivity performance is a major constraint on income convergence with advanced economies (AEs).
- The region faces a dual productivity challenge:
  - Low levels of total factor productivity (TFP).
  - Persistently weak TFP growth.
- These challenges reflect resource misallocation and sluggish firm-level productivity gains, which:
  - Prevent high-productivity firms from scaling to efficient size.
  - Allow low-productivity firms to remain active for too long.
  - Inhibit resource shifts across firms and thereby slow aggregate productivity growth.
- Aggregate indicators referenced:
  - TFP gap estimated at 43 percent (Figure 2.1, panel 1).

### 2.2 A deeper understanding of the dual productivity challenge
- Analytical approach:
  - Decomposes TFP levels and TFP growth into underlying drivers using firm-level data and Hsieh and Klenow (2009) framework.
  - Allocative efficiency measured as ratio of actual TFP to benchmark without variation in revenue-to-input ratios; TFP loss from misallocation computed accordingly.
- Key empirical findings on misallocation:
  - Misallocation in manufacturing reduces TFP in LA3 (Brazil, Colombia, Mexico) by 18 percent below potential.
  - This 18 percent reduction is larger than the 12 percent gap estimated for emerging Asia and Europe and substantially larger than the benchmark for AEs.
  - Misallocation is consistently higher than in AEs across all sectors.
  - From 2005 to 2021, misallocation increased in EMs but declined slightly in AEs.
  - Misallocation of variable inputs—such as labor and intermediate goods—accounts for over 95 percent of the overall TFP loss in LA and other EMs.
  - Addressing misallocation to AE levels (increasing the region’s TFP by 16 percent in Figure 2.2, panel 3) would close 37 percent of the region’s current productivity gap with AEs.
  - Frictions are particularly severe for high-productivity firms; regression evidence shows more productive firms are more constrained by frictions (Figure 2.2, panel 6).
- Findings on TFP growth decomposition (2005–19; LA3 focus):
  - Average TFP growth in LA3 was −0.7 percent.
  - Contribution from firm entry and exit: 0.9 percent.
  - Contribution from surviving firms: −1.5 percent.
  - The entry and exit margin contributed equally; low rates of entry and exit suggest higher barriers to entry and exit.
  - If LA’s survivor margin had matched AEs, TFP growth could have matched the highest regional rate at 0.9 percent annually observed in emerging Asia.
  - The negative survivor margin stems mainly from weak within-firm productivity growth and limited reallocation toward more productive firms.
  - Surviving firms in LA show deteriorating performance over time, reflecting constrained investment and weak upgrading (including in R&D).

### 2.3 From diagnosis to reforms: Linking productivity to underlying frictions
- Core structural frictions identified as driving misallocation and stagnation:
  a. Size-Based Frictions
    - Dual-track regulatory regimes grant lighter compliance burdens to firms below size thresholds (taxation, labor, social security).
    - These regimes create disincentives to grow; firms cluster just below thresholds to avoid higher taxation and compliance costs.
    - Result: compressed firm size distribution and reduced allocative efficiency (Figure 2.4, panels 1 and 2).
  b. Financial Frictions
    - Credit-to-GDP ratios in LA remain well below EM averages.
    - Constraints compounded by concentrated banking sectors, weak creditor protection, and underdeveloped risk assessment tools.
    - Financial frictions restrict surviving firms’ expansion and startups’ ability to enter markets.
  c. Limited Competition
    - Weak enforcement of antitrust rules, high market entry costs, and regulatory capture undermine competition.
    - LA characterized by high market concentration and dominant conglomerates (Figure 2.4, panel 4).
    - Weak competition reduces incentives for innovation and weakens reallocation toward more efficient producers.
- Broader mechanisms:
  - Frictions generate “wedges” between firms’ marginal benefits and costs from additional inputs, preventing efficient reallocation.
  - High-productivity firms face disproportionately high barriers (financing, market access, regulatory burdens), limiting their growth and contribution to aggregate productivity.

### Policy levers to lift constraints
- Targeted, well-sequenced structural reforms can boost business dynamism, investment, and growth (international reform experiences provide guidance).
- Policy areas and illustrative reforms:
  - Size-based regulation reforms:
    - Gradual phasing out of hard size-based thresholds.
    - Introduction of smoother compliance regimes to eliminate discontinuities that discourage growth.
  - Financial sector reforms:
    - Expand credit information systems.
    - Improve legal frameworks for creditor rights.
    - Develop risk assessment tools to expand access to financing for productive firms.
  - Competition and market structure:
    - Strengthen antitrust enforcement and reduce market entry costs.
    - Address regulatory capture to lower market concentration and encourage reallocation toward efficient firms.
- Expected benefits:
  - Reducing misallocation to AE levels (TFP +16 percent) could close 37 percent of the TFP gap with AEs.
  - Relaxing financial and regulatory frictions could enable high-productivity firms to expand, improve within-firm productivity growth, and increase entry and exit dynamics.

*Prepared by Olusegun A. Akanbi, Armine Khachatryan (co-lead), Nils H. Lehr (co-lead), and Nicolás Gómez Parra.*

### 1. LA5: Incentive Gap in Corporate Income Tax

### ch2 - 1. LA5: Incentive Gap in Corporate Income Tax

### Incentive gaps between statutory and simplified tax regimes
- The exhibit reports "Percentage points; statutory minus simplified tax rate" as the measure of incentive gaps.
- Simplified regimes included (country → regime):
  - BRA = Microempreendedor Individual (MEI), Simples Nacional (SIMPLES)
  - CHL = Régimen Tributario enfocado a pequeños y medianos contribuyentes (Pro-Pyme)
  - COL = Régimen Simple de Tributación (RST)
  - MEX = Régimen simplificado de confianza (RESICO), Régimen de Incorporación Fiscal (RIF)
  - PER = Régimen Especial de Renta (RER), Régimen MYPE Tributario (RMT)
- Methodological adjustments and specific regime features preserved exactly:
  - For BRA—SIMPLES, SIMPLES rates bundle multiple taxes, including CIT and social security contributions. For comparability with the general regime’s CIT of 25 percent, after surtax, the SIMPLES CIT is proxied by subtracting the 9 percent social contribution from the median SIMPLES nominal rate across revenue brackets and sector.
  - For MEX—RIF, the year-1 schedule (100 percent CIT discount from the general regime rate) is used to reflect entry incentives; the discount decreases by ten percent each year over ten years.
  - For PER-RER, there is no annual CIT, but a statutory monthly revenue-based quota of 1.5 percent.
  - CIT = corporate income tax; STR = simplified tax regime.

### Firm behavior and frictions at thresholds (Peru example)
- The Peru panel uses "Millions of local currency" to show firm performance and frictions at thresholds across simplified regimes (MEI, RESICO, RST, Pro-Pyme, SIMPLES, RIF, RMT, RER).
- Labor regulation threshold:
  - Stricter labor regulations apply only to firms with more than 20 salaried workers.
  - Each taxpayer identification number is treated as a separate firm; some firms may split into subunits with different identification numbers to remain below the threshold.

### Financial intermediation and credit
- Total Credit to Non-Financial Sector, 2022–24 is shown as "Percent of GDP; quarterly average".
- Aggregates are purchasing-power-parity GDP-weighted averages.

### Productivity, competition, and market dominance
- TFP and Competition, 2019 plotted with x-axis: USA = 1; y-axis: index.
- Country labels refer to ISO country codes. Definitions:
  - AEs = advanced economies (AUT, BEL, DEU, DNK, ESP, FIN, FRA, GBR, GRC, ITA, JPN, LUX, SWE)
  - EM = emerging markets
  - EM Asia = CHN, IDN, IND, MYS, THA
  - EM Europe = CZE, EST, HUN, LVA, LTU, NLD, SVK, SVN
  - LA5 = Latin America 5 (BRA, CHL, COL, MEX, PER)
  - TFP = total factor productivity
- The 2019 market dominance index reflects responses to the Global Competitiveness Index 4.0 survey question: “In your country, how do you characterize corporate activity?” This perception-based indicator should be interpreted with caution, as it may reflect sampling biases, framing, and changes in sentiment.

### Policy diagnostics and reform recommendations (regional)
- Identified policy levers to mitigate frictions and unlock firm dynamism:
  - Promote stronger bank competition to mitigate financial frictions.
  - Support fintech solutions and digital credit platforms to broaden access while reducing risk premiums.
  - Strengthen antitrust bodies.
  - Streamline business registration.
  - Enhance transparency in public procurement.
- Expected outcomes of tackling core frictions:
  - Unlock firm dynamism and support stronger productivity growth.
  - Foster stronger growth, unlock the full potential of human and capital resources, and support income convergence with AEs.

### Case evidence: Successful reforms (New Zealand and peers)
- New Zealand’s mid-1980s comprehensive reforms (trade policy, financial markets, taxation, labor policies) improved competition, expanded access to credit, eliminated frictions, and bolstered productivity.
- Key magnitudes reported for New Zealand:
  - Private sector credit increased from about 50 to about 115 percent of GDP after reform.
  - Foreign direct investment inflows rose from 1.3 to 4.5 percent of GDP.
- Peer lessons:
  - Estonia’s deregulation and digital governance reforms enhanced transparency, reduced red tape, and fostered firm creation.
  - Peru’s 1990s reforms addressed labor rigidities, boosted capital flows, and expanded financial intermediation.

*International Monetary Fund, Regional Economic Outlook — Western Hemisphere, October 2025 (chapter figures and notes).*

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_Source: https://www.imf.org/-/media/files/publications/reo/whd/2025/october/english/ch2.pdf_