Pitfalls to Avoid when Measuring the Institutional Environment: Is Doing Business Damaging Business? Benito ARRUÑADA Pompeu Fabra University 2 nd 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), ▪ 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

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 Cost Output

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

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 ▪ Arruñada, B., and N. Garoupa (2005), “The Choice of Titling System in Land,” J. of Law & Econ., 48(2), ▪ Demsetz, H. (1967), “Towards a Theory of Property Rights”, American Econ. Review, 57(2),

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 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