African Development Bank, Working Paper No. 116, November, Zuzana Brixiova and Emerta Asaminew (2010)

This study examines the state of small and medium sized enterprises in Ethiopia and recommends search subsidies to encourage their development.

The new Ethiopian government came to power in 1991 and implemented sweeping economic reforms.  In a marked departure from the 1974-1990 Derg regime’s legacy of central planning, the new government aimed to stimulate private sector growth and the development of small and medium sized enterprises.  Yet despite twenty years of liberalization, friction in the product and labour markets and a large informal sector remain pervasive.  Small and medium sized enterprises have gained little ground.  Private sector productivity gains have been limited to the leather and cut flowers industries.  Manufacturing in particular has failed to gained ground.  In a vicious circle, workers have had few incentives to upgrade their skills due to the lack of high paying jobs, but the dearth of high skill workers has hampered the development of firms.  Most small and medium sized enterprises are in the informal sector.  Overall, productive private firms in the formal sector are rare, and their absence “is a key constraint to productivity and job growth in Ethiopia” (6).

Ethiopia’s economy resembles that of an early-stage transition country.  The state dominates non-agricultural output, private job creation has lagged, the informal sector remains large at approximately 30 percent of GDP, and unemployment remains high.  The state was responsible for 80 percent of industrial output in the mid 1990s and 50 percent in the 2000s.  Overall, the country is one of the poorest in the world.  Currently, “very small firms predominate and the highly productive formal SME sector is thus underdeveloped” (7).  Due to this stagnation, productivity growth has been much slower in Ethiopia than in other emerging economies such as China, India, Mozambique, and Uganda.  Job growth has not kept pace with urban population growth, leading to rising unemployment.  Employment has not shifted from the informal to formal sector.  In a World Bank survey, 70 percent of Ethiopian entrepreneurs named high taxes as a complaint, followed by an inefficient tax administration and unclear property rights and land access.  The authors conclude that “In sum, even in 2010, the Ethiopian private sector consists mostly of small-scale, informal, low-productivity firms” (9).

The authors develop a model to illustrate the problems in the Ethiopian economy and potential policy solutions.  The model consists of entrepreneurial startups in an economy facing labour and product market frictions with a large informal sector and imperfect information in the market for skilled workers.  It predicts that labour market failures produce suboptimal outcomes.  Specifically, the authors find that “The large informal sector and the lack of institutions blur entrepreneurs’ information about available workers and discourage them from search, and vice versa. Together with the rigid business climate, they impede the highly-productive private sector employing skilled labor” (6).

The model predicts that “Because of frictions in the business environment, entrepreneurs under-invest in searching for business opportunities relative to the effort they would exhort in a more conducive climate. As the impact of the lack of skilled vacancies is amplified by the imperfect information in the labor market, workers are uncertain that they will find skilled jobs and thus under-invest in training.  …The harsh business climate, high tax rates, weak monitoring of tax evasion and strong bargaining power of skilled workers drive high productivity firms into the informal sector. By lowering productivity and skilled wages, these factors discourage workers from acquiring skills” (15).

The authors propose several policy interventions to address these problems.  Ethiopia has offered income tax and duty exemptions to small and medium sized enterprises in targeted industries and areas since the 1990s, but this scheme’s impact has been generally limited to enterprises in the Addis Ababa region.  The authors suggest that rural agro-processing is a promising sector for targeted policies.  They comment that “subsidies may help, but the government’s choice of the type of subsidy must address the main constraints that the private sector faces. In countries such as Ethiopia, where entrepreneurship is limited and productivity low, the key objective should be to help entrepreneurs open high-productivity firms, regardless whether in the formal or informal sector. In such a situation, the search (or start-up) subsidy is useful, as it encourages entrepreneurs to search for highly-productive business opportunities.  In contrast, wage subsidies (tax cuts) would be less effective for start-ups as they mostly do not affect firms in the informal sector, where most SMEs in Ethiopia operate.”

In addition, improved property rights are crucial as a basis for reform.  Employment exchange offices would help to improve information in the labor market.