Download Public interest theory

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
Need
roof/umbrella
8
39
6
76
Some empirical evidence
Warsaw
Moscow
Time to register
0.72
business (months)
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, timeconsuming, 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