Lecture 9. Reform of Government

Lecture outline

• Initial evidence of the importance of reform of government for economic performance

• Empirical evidence of different performance of government

• Different types of government (invisible hand, helping hand, and grabbing hand)

• Regulation• Corruption• Potential causes of different performance of government• How to improve government performance?• The role of tax reform

Importance of government quality for economic performance in transition

• Most E. European economies and Russia had similar economic legacies:

- were industrial economies at the beginning of reforms (unlike China);

- faced disruption due to break-up of COMECON;

- had macroeconomic crisis prior to reforms.

Importance of government quality for economic performance in transition

• There were also important political and policy similarities as most of these countries:- experienced “near-collapse of the state” prior to transition;- established rather “fragmented” party systems and “semi-presidential” regimes;- undertook largely similar rapid liberalization policies (esp. Poland)

Importance of government quality for economic performance in transition

• Why then was Poland’s economy growing 2 years after the start of transition while Russia didn’t begin to grow until 7 years after its reforms?

• One answer (see Shleifer’s paper) is that the reform of government and the quality of government made the difference

Some empirical evidence

• A survey of shops in Moscow and Warsaw (1995) revealed that

- private protection is used more extensively in Moscow

- regulations in Russia are more oppressive than in Poland;

- competition is stronger in Warsaw than in Moscow

Some empirical evidence (% affirmative answers to questions)

Warsaw Moscow

Needed to use courts but didn’t

10 45

Can use courts against business partner

45 65

Contacted by racket in the last 6 months

8 39

Need roof/umbrella

6 76

Some empirical evidenceWarsaw Moscow

Time to register business (months)

0.72 2.71

Inspections last year

9 18.56

% shops fined by inspectors

46 83

# of inspecting agencies

2.65 3.58

How legally vulnerable do you feel (1 – 10)

3.6 5.1

How often do you need to bribe (1-5)

2.21 2.9

Conclusions from empirical evidence

• Private protection is used more extensively in Moscow

• Regulations in Russia are more oppressive than in Poland;

• Competition is stronger in Warsaw than in Moscow

Different types of government

• We can distinguish 3 types of government:– invisible hand– helping hand (variation: iron hand)– grabbing hand

Invisible hand government (USA)

• Government is not above the law and uses power to supply public goods. Courts enforce contracts.

• Government follows rules. Regulation is minimal. Little corruption

Helping hand government (China)

• Government is above law but uses power to help promote business. State officials enforce contracts.

• Legal framework plays a limited role in this model, because bureaucrats adjudicate most disputes.

• Government aggressively regulates to promote some businesses. Organized corruption.

• Iron hand – extreme version of this model (South Korea, Singapore)

Grabbing hand government (Russia, 1990’s)

• Government is above law and uses power to extract rents. Government consists of a large number of substantially independent bureaucrats pursuing their own agendas, including taking bribes

• In the extreme cases, government becomes sufficiently disorganized that it loses its ability to ensure law and order and to provide basic legal protections. Mafia replaces state as enforcer.

• Predatory regulations. Disorganized corruption.

Regulation• more regulation bigger share of

underground economy (UE)

• bigger tax burden (defined including tax administration) bigger UE

• larger UE less tax revenues weaker publicly provided services.

• What else is wrong with large UE?

• But regulation can enhance welfare because many regulations are very much justified from a social efficiency point of view

Theories of regulation

• Three theories of regulation: – public interest theory (benevolent government that

regulates to protect consumers) – regulatory capture (industry acquires regulation for

its own benefit such as keeping out competitors or protecting itself against consumers)

– toll-booth (politicians create regulations to facilitate rent collections, i.e., regulations serve no social purpose).

Implications of the three theories of regulation

• Public interest theory stricter regulation of entry; regulation should be associated with socially superior outcomes

• Regulatory capture Because stricter regulation raises barriers to entry, it should lead to greater market power and profits rather than benefits to consumers;

• Tollbooth theory More extensive regulation should be associated with socially inferior outcomes, particularly corruption

Evidence on regulation• Djankov et al. (2002): Used data on costs of entry for a small

business in 85 countries to test three theories of regulation; • The number of procedures required to start up a firm varies from 2

in Canada to 21 in the Dominican Republic, with the world average of around 10

• The minimum official time for a startup varies from 2 business days in Australia and Canada to the high of 152 in Madagascar, assuming that there are no delays by either the applicant or the regulators, with the world average of 47 business days;

• The official cost of following these procedures ranges from under 0.5 percent of per capita GDP in the US to over 4.6 times per capita GDP in the Dominican Republic, with the world-wide average of 47 percent of annual per capita income.

• For an entrepreneur, legal entry is extremely cumbersome, time-consuming, and expensive in most countries in the world.

Evidence on regulation (cont.)

• In a cross-section of countries, stricter regulation of entry is not associated with higher quality products, better pollution records or health outcomes, or keener competition. (Table IV)

• But stricter regulation of entry is associated with sharply higher levels of corruption, and a greater relative size of the unofficial economy. (Table V)

evidence favors public choice (regulatory capture and toll-booth) over the public interest theories of regulation

Evidence on regulation (cont.)

• Potential endogeneity? • Heavy regulation in some countries might reflect

some existing problems (both significant market failures and the lack of alternative mechanisms of addressing them, such as good courts or free press).

• In addition, corruption and a large unofficial economy may be unavoidable consequences of benevolent regulation, and hence cannot be used as evidence against the public interest view.

Evidence on regulation (cont.)

• To get around the potential endogeneity problem, let’s ask which governments regulate entry?

• The public interest theory predicts that governments whose interests are more closely aligned with those of the consumers, (i.e., the more representative and more limited governments), should regulate entry more strictly.

• In contrast, the public choice approach (capture and tollbooth theories) predicts that the governments least subject to popular oversight would pursue the strictest regulations, to benefit themselves and possibly the incumbent firms.

• Knowing who regulates thus helps to discriminate among the theories.

Evidence on regulation (cont.)

• Countries with more open access to political power, greater constraints on the executive, and greater political rights have less burdensome regulation of entry – even controlling for per capita income -- than do the countries with less representative, less limited, and less free governments. (Table VII)

Evidence on regulation (cont.)

• The fact that better governments regulate entry less, along with the straightforward interpretation of the evidence on corruption and the unofficial economy, point to the tollbooth theory: entry is regulated excessively because doing so benefits the regulators.

Corruption

• Definition: The use of public office for private gain in a way that contravenes the existing law

• Measures (mostly perception-based)– Mostly based on surveys (to both foreign and

domestic business men, others)– Also based on observation of real data (more

difficult to come by)

Benefits of corruption

• Helps against regulations and red tape (this is a benefit if regulations are excessive)

• Can help direct government services to those economic agents who value them most

• Supplements incomes of officials, reducing the need for tax revenue

Benefits of corruption (cont.)

• More generally, assuming zero transaction costs (TC) of negotiations and the involvement of all affected parties, corruption would result in socially efficient outcomes (Coase Theorem)

Counterarguments to benefits of corruption

Assuming non-trivial TC:

• Excessive regulations might be developed to increase bribe revenue

• Processing might be slowed down for everybody to facilitate “speed money”

• While bribes reduce the need for tax revenue, bribes are more distortive than taxes

Examples of distortions due to corruption

• Red cars are valued at 15, green cars are valued at 10; either car costs 5 to produce; demand for cars is fixed at 10 surplus of 100 (=10 x 10) can be appropriated by government via a tariff

• Green cars can be smuggled in; red cars are too visible and cannot be smuggled in

• Corrupt custom officials charge a bribe of 5 per green car for a total of 50 < 100

• Other distortions are due to uncertainty and possibly because of monopoly position of corrupt officials (see example later)

Costs of corruption (cont.)

Even if TC are low for the directly involved parties, other affected parties (e.g., general population) are not included corruption benefits well-organized interests. Examples: poor quality of school construction in China, poor quality construction of modern apartments in Italy.Generally, bribes facilitate evasion of socially efficient regulations

Summary of the main costs of corruption

• Evasion of efficient regulations, larger government, and more regulation to compensate for corruption

• Promulgation of excessive regulations to facilitate extortion

• Benefits to well-organized groups at large cost to general public

• Distortions in economic structure (reduced competition, lower private investment but higher public investment into corruption prone sectors, etc.)

• Costs due to secrecy

Costs of corruption (cont.)

Corruption is particularly costly when it is disorganized, i.e., corrupt officials do not coordinate their bribe demands and paying off one official may not prevent other officials from demanding bribes for complementary services (Shleifer&Vishny, QJE 1993)Example: http://mypage.iu.edu/~malexeev/e386_corruption_example.html

Empirical evidence on corruption

• Corruption appears to lower economic growth in some countries, but this evidence is weak

• Corruption lowers private investment and foreign direct investment (both level and predictability of corruption are important).

• Corruption increases military spending, and particularly, procurement

• Corruption is related to higher child & infant mortality, percent of low birth-weight babies, higher dropout rates in primary schools

Potential causes of differences in government performance

• Why was government performance in Russia so different from that in Poland and some other E. European STE’s?

• Potential reasons:– Shock therapy– Trust, social capital, civil society– Cultural antagonism to capitalism– Human capital of politicians– Incentives of local politicians

Turnover of politicians

• Human capital of politicians is important (as is human capital of managers)

• Poland: 75% of local leaders elected in 1990 had no record of government service and 45% were under the age of 40

• In Russia (still under Soviet times) 33% of local election winners came from opposition movements and 49% were communists

Incentives of politicians

• Local governments generally have relatively weak tax base (because most important taxes are more easily collected at the national level) but most services are provided locally local governments need to receive transfers from upper levels of government (e.g., central governement)

• [if states competed with tax rates to draw in new people, we will have negative externalities due to tax rates too low to provide adequate public goods]

Incentives of politicians (cont.)

• Let local government collect TAX amount in local taxes and receive TRANS amount in transfers

• Suppose local government increases its tax base and tax collections by dTAX. Then, the central government may want to change its transfers by dTRANS.

• Let dTAX = b*dTRANS• If b is close to -1, local government has no incentives to

develop its tax base; instead, it might as well take bribes from local businesses in exchange from not collecting taxes from them (see example here: http://mypage.iu.edu/~malexeev/local_government_incenitves_example.pdf

• If b is close to zero, local government has strong incentives to develop its tax base

Incentives of politicians (cont.)

• It appears that in Russia coefficient “b” was close to -1 while in Poland and China it was closer to zero

• But why would Russian central government behave in this seemingly counterproductive way?

Potential causes of differences in government performance (cont.)

• Elections do not serve as an effective check on the authorities

• Initial conditions of the economy are important– Multiple equilibria problem (crime, corruption,

underground economy, government attitude towards private sector – see next slide)

– Expectations of government officials (if officials expect large investments in the future, they would not want to jeopardize that potential investment by preying on current investors)

Initial conditions & multiple equilibria

• Consider again incentives of local government. It can try to develop its own tax base by helping local small business via light regulations, little red tape, low local taxes

• Alternatively, local government could lobby for transfers from central government and prey on local small business

• The first approach works well (for local government) if local small business is large (b/c tax base can be large)

• The second approach works better (in the short run) if local small business is small

• But under the second approach, legal small business remains small and the economy is stuck in a bad government equilibrium

• Responsibility to voters is likely to promote the first approach• Poland benefited from regular local elections; In Russia local

elections have not been particularly meaningful

Multiple equilibria and crime

Crime: • Many criminals in society law enforcement

resources are spread thin many crimes are not solved probability of being convicted is low many people decide to commit crimes (high crime equilibrium)

• Few criminals law enforcement resources are sufficient to solve most crimes probability of being convicted is high few people commit crimes (low crime equilibrium)

Multiple equilibria and corruption

• Corruption is widespread difficult to fight corruption, because “corruption fighters” are also likely to be corrupt and population views corruption as more or less normal; moreover, victims of corruption might be afraid to complain, because they would be afraid of corrupt law enforcement corruption is not punished and it is safe to extort and take bribes

• Also, if corruption is common, official positions are sold to the highest bidders and only those who plan to take bribes would be willing to pay to get the position

• All this perpetuates corruption

Multiple equilibria and corruption (cont.)

• When corruption is rare, it is easy to find people to monitor officials and population is ready to complain when officials are asking for bribes officials are afraid to ask for bribes even if they would have liked to

• Official positions are not sold and, therefore, there is no selection of corruptible individuals into government service

Multiple equilibria problems explained [repeat maybe?]

• Consider incentives of local government. It can try to develop its own tax base by helping local small business via light regulations, little red tape, low local taxes

• Alternatively, local government could lobby for transfers from central government and prey on local small business

• The first approach works well (for local government) if local small business is large (b/c tax base can be large)

• The second approach works better (in the short run) if local small business is small

• But under the second approach, legal small business remains small and the economy is stuck in a bad government equilibrium

• Responsibility to voters is likely to promote the first approach

Local government reform in China

• The Chinese local government has apparently functioned reasonably well despite no elections.

• Expectation of relatively large future FDI– Amount of foreign investment because of the

fairly rich Chinese diaspora

• Reform of government– Chinese government was managed regionally

instead of nationally

Local government reform in China (cont.)

• Main features of government reform in China:– Mandatory retirement program ( new

human capital)– Fiscal decentralization ( better incentives

for local governments)– Permission for the bureaucrats leaving

government jobs to join businesses (ambiguous incentives)

Legal reforms

• Public laws and enforcement vs. private laws and enforcement

• Disadvantages of private laws • Disadvantages of public enforcement (if

government is corrupt)• Advantages of private enforcement of public

rules in an economy in transition if the rules are:– Clear (bright line);– Private right of action– Rules should try to agree with prevailing customs