Pitfalls to Avoid when Measuring the Institutional Environment: Is Doing Business Damaging Business?

Benito ARRUÑADAhttp://www.econ.upf.es/~arrunadaPompeu Fabra University

2nd Workshop on “Measuring Law and Institutions”Paris, December 15, 2007

Today’s talk will intersperse:▪ Pitfalls

♦ Arruñada, B. (2007), “Pitfalls to Avoid when Measuring the Institutional Environment: Is ‘Doing Business’ Damaging Business?” J. of Comparative Econ., 35(4), 729-47.

▪ Next step♦ Theory of business formalization♦ Lessons for measurement♦ Lessons for policy: priorities

Motivation▪ Seeing how administrative simplification,

inspired by DB, is being made in the field♦ Dubious “best practice” standards♦ Naïve incentives in international aid—e.g., MCC♦ Mistaken policies—observed: IDB, SNLE

▪ Several factors♦ Rent seeking♦ Magic power of numbers♦ Difficulties and mistakes in measurement♦ Measurement without any theory of the institution

Outline

I. Theoretical weakness leads to unsound reform priorities

II. Biased methodology impedes considering tradeoffs in institutional design

III. Emphasis on averages precludes local adaptation

IV.Coda on measurement errors

I. Lack of theory distorts priorities

▪ De Soto, Dankov et al. say formalization is valuable ♦ But lack a theory as to why♦ In fact, focus on costs and mainly rent seeking (this

explicitly in Djankov et al. “Regul of Entry” 2002 paper)

▪ Problem: the goal is efficiency, not cost♦ Focus on costs sensible if value is unaffected or

secondary, but we are dealing with catalysts here♦ Rent seeking is only the price of specialization

Consequence 1: We should emphasize value—not costs

▪ Formalization is a catalyst: provides services that reduce transaction and enforcement costs, both private and public.

▪ Example: Companies registers ♦ Other firms (legal representative)♦ Courts all contractual parties of registering firm

Consequence 2: A different concept of user is required

▪ Firms are not the only—not even the main—users

▪ Examples: ♦ Courts do not only affect litigants but also produce

precedents and have systemic effects on all firms♦ Company registers, no only registering firms but

their future customers and creditors♦ Land registers equally affect future buyers &

creditors

2. Defective methodology

▪ Double bias: ♦ considering only mandatory & ex ante costs

▪ Two substitutions are relevant ♦ b/w mandatory and voluntary♦ b/w ex ante and ex post

Consequence 3: Should consider standard instead of mandatory procedures

▪ No difference b/w procedures being publicly mandated or privately imposed by professional monopolies (e.g., lawyers in MA vs notaries in F)

▪ Likely to be the minimum cost as driven by free choice

Consequence 4: Consider facilitators

▪ When measuring♦ New indicators: cost of a shell company

▪ When reforming♦ Will avoid creating new public facilitating

bureaucracies (e.g., one-stop shops)♦ No need to vertically integrate the facilitating

function into public bureaucracy

Consequence 5: Should measure all costs, not only those incurred ex ante

▪ It avoids bias against legal systems relying more heavily on ex ante control

▪ Two examples: ♦ Reality of ex ante control♦ Presence of ex post benefits

0

10

20

30

40

50

60

70

80

90

Netherl

ands

Sweden

Austria

Demna

rk

Finlan

dSpa

in

German

yUK

USA

Greec

e

France

Mexico

Irelan

d

Portug

al

Belgium

Croatia Ita

ly

Months from default notice to execution sale (registration in blue, recording in yellow; data from EMF’02, Butler’03)

b) Presence of ex post benefits: Substitution b/w ex ante & ex post costs in mortgage foreclosure

3. Emphasis on averages impedes adaptation

▪ Emphasizing average costs leads to ♦ Forgetting demand and value♦ Capital intensive reforms that disregard demand, value

and efficiency

Example 1: Economies to scale in Spanish registers

Avg

Co

st

asientos508 42943

.005939

.23622

Avg Cost

Output

Example 2: Intl. cross section of DB data (income per head and starting business avg. cost)

Formalization cost

0 10000 20000 30000 40000

Income per head

0

100

200

300

400

Policy consequences of focusing on avg. costs

▪ No attention paid to fixed costs▪ No attention to level of demand▪ Two examples:

♦ Peru titling effort spent a fortune to achieve little when compared to less formal titling

♦ Spain: avg. subsidy of formalization in the one-stop window was about € 5,560 in the first 3 years • a shell co. can be bought in one hour for €800

▪ Waste, new bureaucracies, bad reputation of institutional reforms

Consequence 4: Need of gradual and multiple formalization solutions

Formality without ex ante

control

Maximum value of the firm

Informality Formality

with ex ante control

45º Value of the firm

Value of the firm in the absence of transaction costs

▪ Arruñada, B., and N. Garoupa (2005), “The Choice of Titling System in Land,” J. of Law & Econ., 48(2), 709-27.

▪ Demsetz, H. (1967), “Towards a Theory of Property Rights”, American Econ. Review, 57(2), 347-59.

4. Coda on measurement errors & biases. Just one example:

▪ What NY State says:♦ “If your business is required to be registered as a

vendor, it must obtain a Certificate of Authority .... If your business makes taxable sales before it receives the Certificate of Authority, it may be subject to substantial penalties. To obtain a Certificate of Authority, you must complete Form DTF-17.... and send it ..., at least 20 days before you begin operating your business” (NYSDTF, Publication 20 (10/04), p. 19).

▪ But Doing Business gives 1 day for NYC

How Doing Business tells it:

“within 20 days”

“one day”

Is it exceptional?

▪ DB does seem to suggest that the 20 days term is exceptional:♦ “Businesses selling ‘tangible personal property

(goods) as well as certain other goods and types of services’ are required to be registered … within 20 days before the company starts operating”)

▪ But it is not exceptional:

Consequences for Doing Business ranking

▪ In 2007, USA ranks 3-5 in “Starting Business”, together with Denmark and Iceland

▪ Applying DB methodology correctly, USA would rank 57-60, with El Salvador, Lithuania and Sierra Leone

Summary

▪ Measurement errors not the main issue▪ Function of business formalization calls for a

change in priorities from cost to value▪ Need to consider

♦ Tradeoff b/w ex ante and ex post costs♦ Tradeoff b/w mandatory and voluntary services♦ Demand: local adaptation

Thanks