Benito ARRUÑADA econ.upf.es/~arrunada Pompeu Fabra University

1. Pitfalls to Avoid when Measuring the Institutional Environment: Is Doing Business Damaging Business? Benito ARRUÑADAhttp://www.econ.upf.es/~arrunada Pompeu Fabra University 2nd Workshop on “Measuring Law and Institutions”Paris, December 15, 2007

2. 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

3. 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

4. Outline • Theoretical weakness leads to unsound reform priorities • Biased methodology impedes considering tradeoffs in institutional design • Emphasis on averages precludes local adaptation • Coda on measurement errors

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. b) Presence of ex post benefits: Substitution b/w ex ante & ex post costs in mortgage foreclosure Months from default notice to execution sale (registration in blue, recording in yellow; data from EMF’02, Butler’03)

13. 3. Emphasis on averages impedes adaptation • Emphasizing average costs leads to • Forgetting demand and value • Capital intensive reforms that disregard demand, value and efficiency

14. Avg Cost Output Example 1: Economies to scale in Spanish registers

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

16. 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

17. 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), 709-27. • Demsetz, H. (1967), “Towards a Theory of Property Rights”, American Econ. Review, 57(2), 347-59.

18. 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 

19. How Doing Business tells it: “one day” “within 20 days”

20. 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: 

24. 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

25. 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

26. Thanks