Author: Admin
Effects of International Taxation on Firm Valuation: Evidence from Japan’s 2009 Tax Reform
This brief highlights the results of a study of Japan’s 2009 adoption of a territorial tax regime exempting corporations’ foreign earnings from domestic taxation. We examine stock market reactions to events leading to the adoption of a dividend exemption system. We use an event study methodology leveraging firm characteristics and accounting for confounding effects from recent financial market developments. We find that relative to other Japanese multinationals, firms facing lower effective tax rates on their foreign operations benefit disproportionately from the reform. Surprisingly, firms with less foreign exposure and fewer opportunities for tax avoidance experience relatively larger abnormal returns overall. We attribute these gains to a combination of enhanced opportunities for international expansion among smaller domestic firms, direct tax savings on undistributed foreign earnings, and general cultural biases against tax planning.
As firms’ operations have expanded their global reach, corporate taxation has become inextricably tied to the taxation of multinational firms’ (MNCs’) foreign earnings. Correspondingly, international tax issues including tax avoidance, tax competition, and multinational competitiveness have dominated discussions on corporate tax reform. Much of the debate focuses on the choice over worldwide (residence-based) versus territorial (source-based) taxation. This brief summarizes a study by Bradley, Dauchy, and Hasegawa (2014) in which we aim to capture the full range of possible effects of Japan’s 2009 adoption of a 95 percent foreign dividend exemption system on firm after-tax profitability by examining stock market reactions around key events leading to the reform. More specifically, our study looks into abnormal stock returns (ARs) defined as extra-normal firms’ returns below or beyond what the market would have predicted, absent the event. ARs surrounding key event dates leading to the reform are used to quantify current and future tax savings on repatriated earnings as well as benefits flowing from firms’ enhanced ability to compete in foreign markets.
Japan’s 2009 Tax Reform
From 2003 to 2009, 10 OECD countries switched from worldwide to territorial tax regimes; the latest and most consequential among these being Japan and the United Kingdom. Motivated by a desire to encourage domestic reinvestment of accumulated foreign earnings, and to enhance Japanese firm competitiveness in foreign markets through reduced tax and compliance costs, the Japanese dividend exemption system arose from a short succession of tax policy discussions. Given the tightly structured nature of Japan’s annual tax reform process, the most informative and authoritative events in the sequence that we consider, are thus the initial May 9, 2008 announcement. The Ministry of Economy, Trade, and Industry (METI) was then instructed to analyze the consequences of adopting a territorial tax regime. This announcement was followed by two subsequent Cabinet meetings, in which details of the proposed reform were refined and ultimately endorsed on June 27, 2008 and January 23, 2009, respectively.
Our data and identification strategy
For our analysis, we use data from Datastream, which consist of daily stock market returns for the largest quartile (by market capitalization) of publicly listed Japanese, U.S., and German firms. These data are combined with annual financial statement information from Orbis on each publicly listed Parent Corporation and all of their foreign subsidiaries. Adapting the standard market model event study methodology, returns on U.S. and German market portfolios are incorporated in our determination of abnormal Japanese stock returns. This is to control for potential confounding events associated with the global financial crisis. Conversely, we also study possible spillover effects of the reform in the U.S. and German markets. The idea is to identify whether the Japanese reform may have affected the prospects for adoption of a territorial tax regime in the U.S.—which now accounts for around 80 percent of GDP among the remaining OECD worldwide regimes – or how this may have affected U.S. and German firm competitiveness, the latter being subject to a dividend exemption system very similar to Japan’s under Germany’s long-standing territorial tax system. Significant differences in investor reactions across the Japanese, U.S., and German markets around our event dates are hence informative about the different channels by which the Japanese reform was perceived to impact firm after-tax profitability.
Figure 1. Cumulative Abnormal Returns on May 9, 2008, by Firm Nationality and Multinational Status.
Notes: This figure plots cumulative abnormal returns (CARs) within a 5 trading-day window centered around the May 9, 2008 event, defined as the sum of daily ARs. ARs are the mean cross-sectional prediction errors derived from estimation of the standard market model including market portfolio returns drawn from the Japanese, U.S., and German exchanges over the last 250 trading days ending 20 days before the first event. Tests of statistical significance (in red) follow Kolari and Pynnönen’s (2010) “adjusted BMP” methodology.
Moreover, we leverage the location of foreign subsidiaries and financial statement characteristics of both parents and subsidiaries to estimate in a single step the contribution to ARs from particular firm attributes. Among these, we emphasize simple distinctions between domestic and multinational firms, or the ownership of at least a single subsidiary in a tax haven, as a proxy for tax planning sophistication. A direct measure of tax savings on the repatriation of accumulated foreign earnings is calculated as the difference between the average effective tax rate on domestic and foreign operations. Further interactions of this potential tax savings rate with measures of intangible intensity are intended to distinguish prospects for future tax savings on intangibles-facilitated income reallocation.
Unexpected Winners
A striking point that emerge from Figure 1 is that Japanese market reactions generally appear larger in magnitude among domestic firms than MNCs. Statistically-significant 1-2 percent cumulated abnormal returns (CARs) observed among the former group appear to validate one of the Japanese reform’s objectives of facilitating expansion of smaller firms into overseas markets (Toder, 2014).
It is also noteworthy that the positive effect on Japanese firms is unmet by comparable reactions in either German or U.S. markets, such that the observed effect in Japan is more credibly attributable to the METI announcement — itself evidently either ignored or perceived as unimportant for U.S. and German firm profitability.
Table 1. Cumulated Event Date AAR Effects by Nationality and MNC Status
Notes: Significance levels are designated as *** (1 percent), ** (5 percent), and * (10 percent). Cumulated marginal effects measure ARs averaged over each three-day event window (AARs) and summed across Cabinet meeting dates.
These results appear to be reinforced after accounting for key firm characteristics, albeit in a nuanced way. Over the course of the full sequence of three Cabinet meeting dates, Japanese MNCs experienced significantly worse cumulated average abnormal returns (AARs) than their domestic counterparts, equal to a difference of 3.8 percent of market capitalization through the end of the January 23, 2009 event window (see Table 1).
As Predicted, Firms with Larger Tax Savings Potential Are Net Winners
Underlying these differences by multinational status, the rate of anticipated tax savings resulting from the reform is nevertheless associated with substantial positive effects on Japanese MNC valuations, with the largest such contributions arising around the last Cabinet meeting date. Over the course of all three events, a 10-percentage point increase in the tax savings rate was associated with AARs of 0.31 percent (top panel of Table 2). Applied to the set of Japanese firms in our sample with an observed average tax savings rate of 21.5 percent, this implies aggregate savings just slightly in excess of predicted tax savings on the repatriation of ¥17 trillion in undistributed earnings held by foreign subsidiaries of Japanese firms in fiscal 2006 according to the best available estimates prior to reform (METI, 2008).
Table 2. Cumulated Event Date AAR Effects among MNCs, by Nationality
Notes: See notes for Table 1.
More sophisticated or tax aggressive firms with subsidiaries located in tax havens performed relatively worse than other Japanese MNCs, while firms in industries characterized by heavier reliance on intangibles likewise saw no additional gains in relation to potential tax savings on future shifted earnings.
Conclusion
Our study reveals that the Japanese adoption of a territorial regime was, at least initially, perceived as being disproportionately valuable for firms that might previously have been deterred from expanding overseas due to international tax compliance issues and lack of competitiveness under the previous worldwide regime, consistent with one of the motives for the reform. More tax savvy Japanese MNCs may have benefited disproportionately less, in part, because the previous regime was not limiting their ability to borrow from their affiliates, or simply because of a lack of interest in tax planning, as is widely reported among tax practitioners.
Our study confirms the importance of the most direct source of gains from adoption of a territorial tax regime – namely, the tax savings on immediate repatriations. At the same time, it highlights the perceived benefits among aspiring entrants into foreign markets of reductions in tax compliance costs and enhanced competitiveness in foreign markets.
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References
- Bradley, Dauchy, and Hasegawa. CEFIR/NES WP Series, No. 201, September 2014. http://www.cefir.ru/index.php?l=eng&id=35
- Kolari, J. and S. Pynnönen (2010), “Event Study Testing with Cross-sectional Correlation of Abnormal Returns,” Review of Financial Studies, Vol. 23, No. 11, pp. 3996–4025.
- Ministry of Economy, Trade and Industry of Japan (2008), “Repatriations of Foreign Profits by Japanese Enterprises: Toward the introduction of a dividend exemption regime (In Japanese: Wagakuni Kigyo no Kaigairieki no Kanryu nitsuite).” http://www.rieti.go.jp/en/columns/a01_0387.html#note2.
- Toder, Eric (2014), “Review of the Conference on What the United States Can Learn from the Experience of Countries with Territorial Tax Systems,” Urban Institute, Washington D.C., June 18. http://www.urban.org/publications/413159.html
Meeting Qualification Mismatch with Vocational Training
While in an ideal world the qualification preferences of job seekers and employers would coincide, in reality this is often not the case. Besides informational asymmetries (job seekers not knowing which qualifications are demanded by employers) the reason is that employers may be in need of qualifications that are not considered attractive by the job seekers. In the country of Georgia, we want to address this problem through a “recommendation system” which will suggest vocational training to job seekers. There are two main problems to be tackled in this project: (1) How can we decide what would be the most useful qualification for a given job seeker, and (2) how can we incentivize the job seekers to follow our recommendations? This policy brief discusses our approach to this problem.
Introduction
Qualification mismatches are common in many labor markets around the world (see for example, Ghignoni and Verashchagina (2014) for Europe, McGuinness and Sloane (2011) for the UK, and Béduwé and Giret (2011) for France). It is well known that qualification mismatch is a relevant problem also in the country of Georgia, as was shown in various studies (see ISET (2012) and The World Bank (2013)).
The ISET Policy Institute (ISET-PI) was commissioned by the World Bank to assist the Social Service Agency (SSA) of Georgia, an agency of the Ministry of Labor, Health, and Social Affairs, in developing a system which will recommend vocational training to job seekers with the aim to reduce the qualification mismatch in Georgia.
Job Seekers’ Preferences Matter
Vocational training addresses the needs of two different groups. It is demanded by job seekers, who want to improve their human capital in a way that matches their preferences and, in the optimal case, maximizes their chances to get back into employment. At the same time, vocational training also addresses the needs of employers, whose businesses may face shortages in qualified personnel.
It is not enough to only include employers in the analysis if one wants to effectively fight the qualification mismatch. If one does not consider job seeker’s preferences, it may happen that people prefer to not participate in the vocational training system at all. Even if one can effectively incentivize job seekers to attend training programs, as is the case in Germany for example, where the refusal to participate in training is sanctioned by a reduction of unemployment benefits (cf. Neubäumer (2012)), it is likely that involuntary training will be less effective. Therefore, it is problematic that most studies which analyze the demand for qualifications in the job market, for example for the European Union (Lettmayr and Nehls (2012)), New Zealand (Earle (2008)), and Australia (Shah (2010)), exclusively focus on employers and neglect the preferences of the people who are to be trained. In Georgia, we will do it differently.
Why Would Job Seekers Follow Our Recommendations?
The objective of the recommendation system we develop is to maximize the impact the training has on the employment chances of the job seeker. Arguably, this is also the primary goal for most job seekers, as they often state that they want to receive training in an “employable” profession. Therefore, if the purpose of the recommendation system is communicated properly, and if it is transparent and trustworthy, the job seekers may want to voluntarily follow its advice.
Recommendation System vs. Matching Algorithm
One can think of two different ways of advising job seekers in their training choices: recommendation systems and matching algorithms.
Recommendation systems make suggestions to job seekers separately. These kinds of systems are ubiquitous on the Internet. For example, Amazon.com proposes books to its customers based on their purchasing history. In a similar way, a recommendation system for vocational training would suggest vocational training programs to job seekers based on relevant data about their characteristics and the job market situation. Yet its major shortcoming is that a recommendation system will not take into account what other job seekers do and what recommendations were given to them.
For that reason, in a recommendation system, it can happen that the number of people recommended to choose a certain program is larger than that program’s capacity (because the advice comes as a ranking, this does not cause the system to be useless, as the job seeker may then choose the program which is highest in the ranking and which has free places).
Likewise, if many job seekers follow the advice of the recommendation system, oversupply and undersupply of certain qualifications in the job market is not ruled out. This is again due to the fact that recommendations are made separately. If there is a huge demand for, say, plumbers, and many people receive the advice to receive training in plumbing, this may subsequently cause an oversupply of plumbers.
In contrast, a matching algorithm aims at an overall optimum for the whole group of job seekers. Genuine matching algorithms do not make separate recommendations, but propose a globally optimal assignment. In Western countries they are used, for example, to match interns to hospitals, students to universities, and kidneys to dialysis patients. Matching theory is one of the most successfully applied subfields of game theory, acknowledged through the award of the Economics Nobel Prize of 2012 to matching theorist Alvin E. Roth. The standard survey of matching theory is Roth and Sotomayor (1990).
In a matching algorithm, the abovementioned problems of a recommendation system would not occur (up to statistical uncertainty), because the matching algorithm would take into account how the suggestions made by the system affect the demand for a program. It would aim to keep the number of people, likely to choose a program, to remain below its capacity.
While a matching algorithm is more ambitious, it also has disadvantages compared to a simple recommendation system. First of all, the data requirements are higher, as the capacities of programs have to be taken into account. More importantly, in a matching algorithm the recommendations will be generated in a way that is not transparent to the job seeker (though it is possible to give some general explanations). This may reduce acceptance and willingness to participate. The recommendation system, on the other hand, can work in a relatively transparent way. Finally, a recommendation system can be adjusted and changed on an ongoing basis by Social Service Agency personnel without the help of external experts. Given its complexity, this is hardly possible with a matching algorithm.
Therefore, it was decided that the simpler option of a recommendation system is to be pursued. Later, the system may be upgraded to a full-blown matching algorithm.
The Technical Aspects of How Recommendations are made
Consider the situation of a job seeker looking for vocational training. Through the envisioned system, they will receive a recommendation of which qualification to pick in the vocational training system of the SSA.
The pieces of information used for making this recommendation are personal characteristics of the job seeker (like age, gender, preferences, skills, and other information obtained through the website worknet.ge which is operated by the SSA) and the current and future economic situation in different sectors. To this end, we will use value added tax data that can be decomposed into 45 sectors and updated on a monthly basis. For forecasts, we will draw on the Business Confidence Index of ISET, which allows decomposition into 5 sectors.
Given the information about the job seeker and the economic environment in different sectors, we will answer the question: “How many months do we expect the job seeker to be unemployed in the year after the training if the training was in qualification X?” Here, X can be whatever is offered in the vocational training system at the location of the job seeker, for example welder, mechanic, accountant, or IT expert. Alternatively, we could answer the question: “What is the salary we expect the job seeker to have in the year after the training if the training was in qualification X?”
The recommendation made to the job seeker will be: “Choose the training in field X if somebody with your personal characteristics, given the economic situation and outlook, has the lowest expected number of unemployed months (or the highest salary) in X in the year after training in X was received.” This recommendation is likely to be accepted by the job seeker if also the job seeker wants to maximize their employment chances (or maximize salary).
The forecast can be made using econometric regression analysis. Let i be a job seeker and xi be the number of months unemployed in the year after training was received. Then we have for each qualification one estimation equation
where alpha is the intercept and the betas are the coefficients for different personal and economic characteristics. When the alpha and beta coefficients are known, then one can enter the specific data for a job seeker and forecast how long it would take him to find a job if training would be received in a particular field.
For estimating the coefficients, no recommendations will be made for some time (like 3 months) after the system is launched and only information will be collected. The SSA or a specialized survey agency will call the job seekers every month after they received training and ask whether they found employment. Job seekers who received training through the SSA will be obliged to answer this question truthfully. Information about the characteristics of the job seeker is known through their participation in the worknet.ge system, which is a requirement for anybody who wants to receive vocational training through the SSA.
When the recommendation phase starts, further data will be collected. Errors in the estimation of the coefficients will be corrected “automatically” through the feedback (in terms of job market performance of the trainees) that the system gets on an ongoing basis. To increase this effect, the database used for the estimation of the coefficients will be “rolling”, i.e. people who recently received training will be added while those who received training a longer time ago (e.g. one year or more) will be removed from the database.
Conclusion
In Georgia, ISET will design and implement a recommendation system for vocational training, addressing the qualification mismatch in the labor market. As in many other areas, Georgia is willing to go for innovative policy solutions making use of advanced economic methods, very much in line with the country’s reputation as one of the top reformers in the world.
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References
- Béduwé, Catherine and Giret, Jean-Francois (2011): “Mismatch of vocational graduates: What penalty on French labour market?”, Journal of Vocational Behavior 78, pp. 68-79
- Earle, David (2008): “Advanced trade, technical and professional qualifications: Matching supply to demand”, New Zealand Government Ministry of Education, Auckland.
- Ghignoni, Emanuela and Verashchagina, Alina (2014): “Educational qualifications mismatch in Europe. Is it demand or supply driven?”, Journal of Comparative Economics, in press
- ISET (2012): “National Competitiveness Report for Georgia”, Tbilisi.
- Lettmayr, Christian F. and Nehls, Hermann (2012): “Skills supply and demand in Europe: Methodological framework”, CEDEFOP Working Paper No. 25
- McGuinnes, Seamus and Sloane, Peter J. (2011): “Labour market mismatch among UK graduates: An analysis using REFLEX data”, Economics of Education Review 30, pp. 139-145
- Neubäumer, Renate (2012): “Bringing the unemployed back to work in Germany: training programs or wage subsidies?”, International Journal of Manpower 33, pp. 159 – 177
- Roth, Alvin E. and Sotomayor, Marilda (1990): “Two-Sided Matching: A Study in Game-Theoretic Modeling and Analysis”, Econometric Society
- Shah, Chandra (2010): “Demand for qualifications and the future labour market in Australia 2010 to 2025”, Center for the Economics of Education and Training Working Paper, Monash University
- The World Bank (2013): “Georgia: Skills Mismatch and Unemployment Labor Market Challenges”, World Bank Report No. 72824-GE
How Transport Links Help Market Integration: the Case of Moscow Office Rental Market
This brief is based on a research project on the Moscow office real estate (Ignatenko & Mikhailova, 2014). We study the market for office space rentals in Moscow. Our main interest regards spatial competition: when an object is rented, does the rental rate respond to the behavior of competing objects in a geographical vicinity? What is the geographical extent of the market, and how do urban transportation links help integrate local markets and extend the geographical scope of competition? We find that urban transportation “shortens” the effective distances and intensifies competition between geographically differentiated objects. The effects are modest but statistically significant.
We analyze a unique dataset on office space rental deals in Moscow in 2001-2010. The dataset was collected by an analyst team at Cushman & Wakefield Russia and includes all the deals on office spaces that were publicly advertised, with detailed and verified information on the object characteristics, rental prices, and the contract dates. We also have information on the object’s location – precise geographical coordinates – and thus we are able to study this market at a very detailed level of geographical aggregation.
Moscow Office Rental Market in 2001-2010, an Overview
The market for office space in Moscow went through a stage of rapid growth through 1990s and 2000s. Economic development drove the demand for all types of offices at all price ranges. The demand was met by a conversion of residential and industrial spaces into offices, as well as by new construction. In our sample, the top year in terms of the number of transactions was 2005, with a slight decline in the years after, and a somewhat sharper drop in 2009 after the global financial crisis. The composition of different types of offices and their characteristics have changed toward slightly higher quality through that decade: the share of transactions with class A and B+ offices was steadily rising (see Figure 1).
Figure 1. Number of Office Rental Transactions by Year and Class of Office
Source: Authors’ own calculations.
Up until the third quarter of 2008, the rental rates were constantly increasing. Average office rental prices in Moscow grew more than two-fold during 2001-2008, but fell almost to the initial level after the global financial crisis and the subsequent crush of the market. Figure 2 illustrates the quarterly index of simple average office rental rates and the corresponding hedonic price index. A hedonic index is constructed using a regression of the objects’ prices onto the observed characteristics of the objects and a set of time period indicators. Thus, the regression decomposes the overall price into the contributions of object quality and time period. The estimated time effects give the hedonic index, cleaning the time series of prices from all of the effects of changes in quality. Interestingly enough, the value of the hedonic index at the beginning of 2010 was exactly at the same level as in 2001. Thus, although the average price level was higher in 2010, all the price gains can be attributed to an increase of the average object’s quality.
Figure 2. Average Price and Hedonic Price Index of Moscow Office Rentals, 2001-2010
Source: Authors’ own calculations.
In Moscow we observe a typical behavior of the real estate market during booms and busts. While prices rise, tenants switch to lower quality objects to fit the budget, and the hedonic index rises faster than the average price. When prices fall, tenants support the higher end of market, looking for high-quality bargains, and the hedonic index falls faster than the average price. Overall, Moscow real estate market fits the basic stylized facts.
A hedonic analysis reveals the value of the object’s characteristics in the eyes of the consumer. The presence of transport infrastructure creates direct benefits. Consumers value an accessible transport infrastructure: offices lose 9% of rental price for each 10 minutes of walking distance to the nearest subway station. It is easy to calculate the surplus from a new subway line: it would increase the value of the land and real estate objects in the area of service. Because land and real estate are supplied inelastically, the bulk of this benefit goes to the owner. Consumers (in our case, tenants) receive the benefit of shorter commuting time, but in exchange for higher rental prices.
In addition to these direct benefits, transport links also tend to promote market integration by making objects that are near and objects that are far away, more substitutable in the eyes of the consumer. Transport links lower the degree of product differentiation in the geographical dimension. And, as with any kind of product differentiation, this should limit seller’s market power and reduce prices. The benefits of increased competition (if any) go directly to consumers. We analyze competition between the offices for rent in the context of geographical distance to determine whether transport links indeed make competition stronger.
Spatial Competition and Transport Infrastructure
We use the dataset to study price competition between real estate objects. Real estate objects are best thought of as differentiated goods. Each object possesses a set of characteristics and a fixed location, i.e. objects are differentiated by consumer characteristics and by geography. Each object is essentially unique, but the owners’ market power is limited by competition. Competition between objects is stronger if objects are closer in consumer characteristics and in location, so that potential tenants view them as closer substitutes. An owner of an object reacts to the behavior of their competitors, i.e. sets the price reacting to the prices set by similar objects in the neighborhood. We study how the strength of price reaction depends on geographical distance between objects by estimating the slope of the reaction function of the owners in a price competition game.
Our estimates show that price reactions of competition from the neighboring objects are very modest. Hypothetically, if two offices of similar size in the same location are for rent, and one of them cuts a price by 10%, the other responds on average by cutting price by only 1.7%. Even at a zero geographical distance between competing objects, there is substantial market power, presumably because of strong differentiation in the other product characteristics. The response is weaker if competing objects are located further away from each other, and at 1.8 kilometers is statistically indistinguishable from zero, i.e. such objects practically do not compete.
When we consider competition inside a more narrowly defined class of offices (grouping A and B+ offices vs B- and C offices), the results change slightly. We find that offices compete mainly within their own class. The reaction to the prices of another class is not different from zero, even in the immediate geographical vicinity. For the offices within the same class the geographical range of competition extends from 1.8 km to 2.1 km, and the reaction to neighbor’s prices is slightly stronger, with an elasticity of 0.2.
As a next step, we include transport links into our measure of distance. Consider offices that are located on the same subway line, i.e. where a passenger can travel between locations without changing the line. Price response to such competing objects is not much stronger: about 22% of the shock, but it stays above zero at longer distances. Price responses become indistinguishable from zero only at a distance of about 4.7 km. Figure 3 compares the two estimated price response functions: for all offices and for offices of the same class and on the same subway line.
Figure 3. Price Response as a Function of Geographical Distance when Objects are Connected by a Direct Subway Line
Source: Authors’ own calculations.
To summarize, our findings confirm the old stylized fact: the real estate market is very “local”. It is local not only in a geographical sense, but also in a product space sense: objects compete only with similar objects and mainly in the immediate geographical neighborhood. Direct transportation links (subway) promote market integration: it “shortens” the effective distance and makes the geographical boundaries of a market much wider. In the case of office real estate, the effect on the price level is very modest. The price reaction is weak even in the immediate vicinity, and it decays quickly with the distance. Yet our research underscores that the effects of transportation links on market integration and competition are real and measureable, and should be considered in cost-benefit analysis of transportation projects.
References
Ignatenko, Anna and Tatiana Mikhailova “Spatial Competition and Transport Infrastructure: The Case of Moscow Office Rental Market”, mimeo, 2014
Decentralization Reform in Ukraine
The current Ukrainian political system, which is a highly centralized “winner-take-all” system, is one of the main causes of the recent mass street protests. A decentralization reform is needed to make the system more stable by providing people with more impact on policy making, and increasing accountability of the government. A decentralization reform would reduce paternalistic expectations and provide people with more opportunities to take responsibility for public policy design in their region. In addition, it would improve the quality of national politics by introducing more competition and allowing successful regional politics to spread to the national level. However, as all reforms, decentralization bears some risks. This policy brief discusses the benefits and risks of such reform, suggests some ways of mitigation of the risks, and the procedure for reform development.
“In decentralized systems, problems can be solved early and when they are small. And when there are terrible failures in economic management—a bankrupt county, a state ill-prepared for its pension obligations—these do not necessarily bring the national economy to its knees.” / Nassim Taleb
In their path-breaking article Roger Myerson and Tymofiy Mylovanov argue that the underlying reason for the Ukrainian street protests in 2004 and 2014 is a fundamental flaw in the country’s Constitution, namely, the design of its government system. Currently, it is basically a “winner-take-all” system, where a winner of the national elections gains almost a dictator’s power, and then tries to prolong his stay in office with all means.
Such a system – where almost all the power is concentrated in the hands of the central government, and where local authorities, even the elected ones, have very little room for their own decisions – resembles an inverted pyramid and is therefore unstable. A natural way to stabilize the system is to put the pyramid on its foundation – i.e. to provide people with more impact on (and responsibility for!) both local and central government policy.
However, the Ukrainian government has announced a decentralization reform, and has already adopted a Decentralization Concept, which defines the main goals and milestones of the reform. According to the Concept, the legislative base for the decentralization should be developed by the end of 2014. However, it is clear that these plans are unrealistic. This, since on top of Constitutional changes, the reform implies changes to the administrative structure of the country, a redistribution of responsibilities between different levels of local government, and changes to the Tax Code, the Budget Code, and to several other documents. Such a scope of reforms is hardly attainable within the planned timeframe.
So far, the President’s office has developed changes to the Constitution, and the Cabinet of Ministers has drafted changes to the Budget Code. However, both documents miss the main point of the reform – empowering of people (rather than simply delegating some responsibilities from central to local governments). Instead, the drafted law on changes to the Constitution empowers the President, and the drafted changes to the Budget Code are an attempt of the central government to get rid of its “headaches” (e.g. ecological or social housing programs) while at the same time consolidating “electorally valuable” spheres, such as education and healthcare. This Draft Law proposes transferring some revenue sources from central to local levels, and at the same time to extract a part of the revenues that currently belong to local budgets to the central budget. A more detailed analysis of the proposed changes is provided in this article.
To my mind, the main impediment to the decentralization reform is a lack of a systemic approach. The Decentralization Concept does not provide a clear reform path, and changes to the legislation proposed so far look like pieces of a puzzle that do not fit together.
I suggest that the decentralization reform should be developed together with the administrative reform and proceed according to the following algorithm:
- Define functions of the state and distribute them between different levels of government according to a subsidiarity principle; i.e. a function should be transferred to the lowest government level capable of implementing it.
- Estimate the volume of funds needed to implement these functions.
- Assign sufficient revenue sources to local governments.
- If a community is too small to generate a sufficient revenue flow, merge several communities and repeat steps 3-4, keeping the distance between the center of such a united community and its most remote settlement below a defined limit.
- Establish feedback mechanisms through which people in a community could control the authorities and impact their decision-making. These mechanisms are not only elections, but also, more importantly, permanent between-elections activities, such as public hearings/discussions of drafts of local government decisions.
- Use a few communities as pilots and thus find out potential strengths and weaknesses of the proposed reform and make necessary corrections.
The outcome of this algorithm should be a logically connected package of legislative changes rather than a bunch of separate documents.
The development of this reform should be as transparent as possible, and accompanied by wide information and education campaigns about the opportunities that decentralization will provide, and the ways to use these opportunities. These information campaigns are necessary because many Ukrainians now think that decentralization (or federalization) is pushed by the Russian president in order to split Ukraine into parts.
As with all reforms, the decentralization has its potential benefits and risks, which should be accounted for. Fortunately, there exists both a wide academic literature and international experience on this issue.
The economic literature, both theoretical and empirical, does not unambiguously show that “decentralization is good”. Rather, a success of decentralization depends on a number of other factors, such as the presence of democracy (Inman, 2008) and a sufficient accountability of the government (both local and central).
In itself, decentralization does not lead to higher economic growth (e.g. the review of Feld et al, 2013). However, when accompanied by other growth-enhancing reforms, decentralization can positively impact a country’s economic development (Bardhan 2002).
Both the literature and experience of other countries suggest the following major risks of decentralization:
- Decentralization may increase corruption at the local level. If a local official is not accountable to a higher-level government, she may try to extract some rent from her position. This risk can be reduced by a high transparency of the government and working mechanisms of control of citizens over officials.
Indeed, Lessmann and Markwardt (2009) show that decentralization lowers corruption in countries with high levels of freedom of the press, and is harmful for countries where monitoring of the government is not efficient. Besides, Fan, Lin and Treisman (2009) find that “giving local governments a larger stake in locally generated income can reduce their bribe extraction”, i.e. for decentralization to lower corruption, the institutional setup should encourage local officials to create a favorable business environment in their regions.
- Decentralization may intensify secessionist movements. To lower this risk, the largest volume of responsibilities should be transferred to the lowest (community) level. It is rather easy for separatists to buy support of oblast-level officials and get control over an entire oblast. It would be much harder for them to buy every community head in an oblast. Moreover, getting control over an oblast, even rayon by rayon, let alone by community, is practically infeasible.
- Decentralization enhances initial inequality between regions – so the central government has to step in by providing subsidies/subventions to less developed regions (Cai and Treisman, 2005).
At the same time, the “bonuses” of decentralization are worth taking the risks:
- Reduction of tensions between the regions. In the Ukrainian situation, this implies removing grounds for mutual accusations that “one region feeds other regions” or “one region rules the entire country”. If a party that wins a majority in the national elections does not have extensive power over the daily life of people, they can more easily accept the fact this is not the party they voted for.
- Improvement of the national politics by increasing competition between local officials, and between local and central officials. As we know, competition typically increases the quality of a product. Political competition is no exception. As Myerson (2006) notes, “by creating more opportunities for politicians to build reputation as responsible democratic leaders, a federal [decentralized] system can effectively offer an insurance policy against general failure of democracy”. Thus, democracy and decentralization strengthen each other.
- More efficient government. On average, policy decisions will be made closer to their final beneficiaries and hence, will be more fitted to the needs of a certain community. At the same time, all levels of government will work more efficiently.
Decentralization does not imply a weakening of the central government. Rather, it frees its institutions from an unnecessary workload allowing them to concentrate on more strategic tasks, such as:
- protecting people’s rights by establishing a working judicial and security (police and army) systems;
- forming a strategic vision and general directions of the country’s development;
- protecting the country’s interests on the international level.
To make sure that decentralization does not result in feudalization, local officials should be controlled not only by local citizens but also by the central government (law enforcement); strong country-wide political parties would also help to hold the country together.
Conclusions
A decentralization of the Ukrainian political system is currently in the very focus of political, public and research debate.
However, this reform is not likely to be an easy one. The prerequisites for successful decentralization include functioning democratic mechanisms – fair elections, a free press and a strong civil society – resulting in government accountability. Also, for the decentralization reform to succeed, it needs to be coherently bundled with a range of political and administrative reforms (such as the development of a functioning judicial system, deregulation, reduction of rent-seeking opportunities etc.), and development and implementation of such a package is challenging and time-consuming.
At the same time, a wisely designed decentralization process will be highly beneficial for Ukraine, both politically and economically. It will strengthen democracy (by increasing people’s participation) and improve the quality of national politics by introducing more competition into the political system. It is also likely to significantly contribute to economic growth and prosperity, and these benefits make the decentralization reform in Ukraine a challenge worth undertaking despite of all the costs and risks.
References
- Bardhan, Pranab (2002). “Decentralization of Governance and Development,” Journal of Economic Perspectives, American Economic Association, vol. 16(4), pp. 185-205
- Brancati, Dawn (2006). Decentralization: Fueling the Fire or Dampening the Flames of Ethnic Conflict and Secessionism? International Organization. Vol.60, issue 03, pp. 651-685
- Cai, Hongbin and Daniel Treisman (2005). Does competition for capital discipline governments? Decentralization, globalization and public policy. The American Economic Review, Vol. 95, No. 3, Jun.2005
- Cai, Hongbin and Daniel Treisman (2009). Political decentralization and policy experimentation. Quarterly Journal of Political Science. Vol 4. Issue 1.
- Deiwiks, Christa, Cederman, Lars-Erik und Kristian S. Gleditsch (2012). Inequality and Conflict in Federations. Journal of Peace Research. March 2012 vol. 49 no. 2, pp. 289-304
- Enikolopov, Ruben and Ekaterina Zhuravskaya (2007). Decentralization and political institutions. Journal of Public Economics, No. 91, pp. 2261–2290
- Fan, C. Simon, Lin, Chen and Daniel Treisman (2009). Political decentralization and corruption: Evidence from around the world. Journal of Public Economics. Vol.: 93 (2009)
Issue: 1-2, pp: 14-34 - Inman, Robert P. (2008). Federalism’s Values and the Value of Federalism. NBER Working Paper 13735. http://www.nber.org/papers/w13735
- Lars P. Feld, Baskaran, Thushyanthan and Jan Schnellenbach (2013). Fiscal Federalism, Decentralization and Economic Growth: A Meta-Analysis. Public Finance Review 41 (4), 421-445
- Lessmann, Christian and Gunther Markwardt (2009). One Size Fits All? Decentralization, Corruption, and the Monitoring of Bureaucrats, CESIFO Working Paper No. 2662, Cat. 2: Public Choice.
- Myerson, Roger B. (2006). Federalism and Incentives for Success of Democracy. Quarterly Journal of Political Science, 2006, 1: 3–23
- Treisman, Daniel (2006). Fiscal decentralization, governance, and economic performance: a reconsideration. Economics and Politics, July 2006, 18, 2, pp. 219-35.
Gender and Development: the Role of Female Leadership
This policy brief reports on a discussion of the role of female leadership in development held during a full day conference at the Stockholm School of Economics on June 16, 2014. The event was organized jointly by the Stockholm Institute of Transition Economics (SITE) and the Swedish Ministry for Foreign Affairs, and was the fourth installment of Development Day – a yearly development policy conference. It is well known that women fall behind men on many markers of welfare and life opportunities, both in developed and developing countries. For most indicators, though, such as education and labor force participation, both the absolute and relative position of women tend to improve with economic development. However, in some areas the beneficiary effect of raising incomes is less clear. Access to leadership positions and decision-making roles are examples of such areas. To discuss this question, the conference brought together a distinguished and experienced group of policy oriented scholars and practitioners from government agencies, international organizations, civil society and the business community.
Governance Quality as a Determinant of FDI: the Case of Russian Regions
This brief highlights the results of a study of the effect of poor governance quality on foreign direct investment in Russia. Using a survey of businesses across forty administrative districts, we find that a higher frequency of using illegal payments and a higher pressure from regulatory agencies, enforcement authorities, and criminals, negatively affect foreign direct investment (FDI). We find that moving from average to top governance quality across Russian regions more than doubles the FDI stock.
What are the reasons for the large heterogeneity in investment across cities, regions, and countries? Why do some of them prosper while others struggle in attracting investors and developing in the long term? This brief summarizes a study (Kuzmina et al, 2014) where we explore how quality of governance affects a specific type of investment – foreign direct investment (FDI). FDI is a very important source of economic growth, especially for developing countries. It allows them to overcome the local deficiencies in capital, technologies, and expertise, and has strong and long-lasting effects on growth – through both direct and spillover channels. Analysis of the determinants of FDI is popular among academic researchers, however, the existing empirical research, especially the one based on cross-country variation in governance quality, is not entirely convincing.
FDI Inflows in Russian Regions
During the first decade of transition in 1990s, the inflow of FDI to Russia was low compared to the Eastern European countries and other emerging economies. However, this changed dramatically around 2003. As oil prices surged FDI flows into Russia increased ten-fold within just a few years. As Figure 1 shows, a maximum of $74.8 billion was achieved in 2008 (corresponding to 4.5% of the country’s GDP), and Russia became one of the top countries in the world for inward FDI. By 2006, FDI inflows to Russia in per capita terms had surpassed FDI into China.
Figure 1. Foreign Direct Investment in Russia 1992-2012
Notes: This figure plots the evolution of FDI in Russia in 1992-2012. The blue line measures net inflows in current US$ billions (the scale corresponds to the left axis), and the red line measures net inflows as the percentage of GDP (the scale corresponds to the right axis). The data come from the World Bank(http://databank.worldbank.org/).
Nevertheless, the stock of FDI in Russia has remained substantially lower than in some comparable middle-income countries. The accumulated stock of FDI as a share of GDP (PPP) in Russia was 21% in 2013. This is only slightly more than in Ukraine (18%), and significantly less than the 28% in Brazil and the 30% in Poland. The stock of FDI in 2012 was distributed mainly between manufacturing (32%), real estate (15%), mining and quarrying (15%), and financial services (13%). Given the diversity of Russian regions in terms of natural, economic and institutional conditions, we also observe a substantial heterogeneity of FDI across Russian regions. The accumulated stock of FDI per capita is only $0.32 in the Republic of Karachaevo-Cherkessia, while it reaches a substantial $30,371 in the Sakhalin region. The average regional accumulated stock is just above $1,000 per capita. In terms of total stock, Moscow City is the leader with more than $39 billion of accumulated FDI.
An important feature of FDI in Russia is a significant share of so-called round-tripping investments. In 2012, $7.5 billion out of $18.5 billion of inward FDI in Russia came from offshore financial centers, with the most important OFC being Cyprus that delivered around 80% of total offshore investments. On overall, about half of total inward FDI stock in Russia comes from offshore countries.
There are several reasons behind the significant role of offshores in external Russian transactions. The traditional cause for using offshore financial centers (OFC) in developed countries is tax avoidance. While profit concerns are relevant for Russian law-abiding entrepreneurs, there are also other important reasons that force them to use offshore shells for their Russian-based enterprises. The possibility to get cheaper international financing and some other financial services for large Russian companies is important for large companies. On the other hand, underdeveloped institutions and poor property right protection are often referred to as the main driving forces for small and medium sized companies to go offshore (Ledyaeva et al., 2013; Kheyfets, 2013).
Given the importance of round-tripping investments in the Russian economy and the differences in incentives behind regular FDI and the one from offshores, we need to distinguish between these two types of investments when studying their determinants. On the one hand, poor regulatory governance might be a reason for the higher volumes of round tripping investments, but on the other hand, they might be a reason for the low attractiveness for true foreign investments.
Diversity of Quality of Governance across Russian Regions
The stable macroeconomic environment in Russia over the last decade has benefited Russian regions in attracting FDI. The diversity of Russian regions in various institutional aspects is, however, recognized in many studies. Yakovlev and Zhuravskaya (2007) report substantial differences in the speed of regulatory reform in twenty Russian regions over 2002-2005. A recent subnational survey of firms in 37 Russian regions by the World Bank indicates significant differences in the list of the most severe obstacles for firms’ performance across regions (World Bank, 2013).
The governance quality data in our study come from the Index of Support (“Index Opory”) survey conducted in 2011. This is a survey of directors of small and medium Russian firms that was collected by the Eurasia Competitiveness Institute (a not-for-profit think tank) and Opora Rossii (a non-for-profit organization that supports small business). It includes about 6000 firms and is designed to be a random sample of small businesses, stratified by size, location (urban or rural), and industry (with about two thirds from agriculture and manufacturing industries, and the rest from infrastructure and services).
Our data cover 40 regions. The surveyed regions are the most developed ones and their economic weight corresponds to 84% of total FDI stock and 83% of GDP in 2011.
All respondents of the survey were asked to answer a set of questions related to regional infrastructure, availability of labor, capital, and intermediate goods, and the absence of administrative pressures. Their answers were then aggregated within regions and all regions were ranked according to each criterion. We use the data coming from the administrative pressure section of the survey. The surveyed regions are ranked according to the average answers on questions reagrding the frequency of firms in the region using illegal payments to officials (Bribes to Officials), the frequency of firms facing abuse on the side of inspection authorities (Inspection Agencies Pressure), the side of enforcement authorities (Police Pressure), and the criminal community (Criminal Pressure).
To give a few examples, the top regions in terms of governance quality are Belgorod and Astrakhan Regions, as well as Stavropol and Krasnodar Territories. For example, the Belgorod region is ranked first in terms of police pressure, second in terms of bribes to officials and criminal pressure, and sixth in terms of inspection agencies pressure. This makes it the top region overall. The Kaluga region, which is commonly viewed as one of the best regions to invest in, in Russia, is ranked fifth overall, achieving some of the best positions in all indicators except for bribes to officials where it is somewhere in the middle (ranked 16th). To give a comparison, Moscow City ranks 27th overall. Leningrad, Irkutsk, Voronezh, Ryazan, and Rostov Regions take the bottom five places.
Worker Strikes in 1895-1914 and Why They Matter for Today
The common problem in this type of research is the reverse causality between the main variable of interest – quality of governance – and FDI. The effect of foreign investors might go through the better practices they bring to the host country or through the legal restrictions imposed on their business by the domestic jurisdiction in any country in which they decide to invest. To deal with the reversed causality problem in our study, we rely on an instrumental variable approach. As an instrument for governance quality in Russian regions, we choose the intensity of worker strikes in Russian provinces 1895-1914. We assume that the intensity of strikes in this period can be used as a proxy for the trust between the local businesses and the political elites, on the one hand, and ordinary people, on the other.
The choice of this period is not accidental. First, this was a period of unprecedentedly high growth of Russian industries. In 1887-1900, the production of many industrial goods and fuels in Russia increased by factor 3 to 5 in real terms; around five thousand kilometers of railroads were put in operations annually. Not surprisingly, the conflicts between workers, on the one hand, and management and owners, on the other, intensified in the 1890s. The police was an important instrument that managers and owners relied upon to keep control over the workers. The important link between local authorities and industrialists was formed to ensure the alignment between the interests of police and business owners. The formation of enforcement agencies was strongly influenced by this alignment, and this alignment in turn defines the level of trust between the elites and enforcement agencies, and the population.
Second, before 1897 no law regulated the duration of working hours in Russia. It was in discretion of the factory owners to establish the norms. On June 2, 1897 the first law governing working hours at a level well below the pre-existing level in Russian factories was signed into force. This law was an important first step towards improving the living conditions of Russian workers. With this law, workers could now claim their rights against the factory management. The factory inspections that were launched earlier, around 1882, were supposed to control the enforcement of labor regulation in general and the new labor law in particular. However, as conflicts between workers and capital owners and management dramatically intensified, these regulatory agencies were used to control workers and their organizations (Kupriyanova, 2000).
We interpret the intensity of strikes at the regional level as a measure of the revealed conflict between the state and the owners of existing businesses, or the local elite, on one hand, and the population on the other. In these conflicts, the enforcement and first regulatory agencies were used to secure the interests of small groups of local elites against interests of the broad population. In this way, we may rely on the intensity of strikes as an inverse proxy for the trust between population and local elites.
Modern research recognizes the importance of history for economic development. Nunn (2009) indicates several mechanisms that justify the projection of history onto modern life. For our study, two of these mechanisms are especially relevant. One is the historical root of modern formal institutions. The second is the effect of history on social and cultural norms. Aghion et al. (2010) suggest a mechanism of possible coevolution of trust and regulation: people in low-trust environments want more government interventions even though they are aware of the low quality of governance. For our study, the prediction of the study by Ahgion et al. (2010) – about the link between the trust and the quality of governance and their coevolution – is especially relevant.
One important issue about using our instrument is whether we can reasonably assume the preservation of some institutions or social norms through the two later dramatic changes in the Russian political regime. While there is evidence of institutional persistency, some aspects of institutions do change often. Acemoglu and Robinson (2006) address this question of whether changes in certain dimensions of institutions are consistent with overall institutional persistence. One of the results of their study is the possible persistence of the institutions that are essential for the allocation of resources in the economy despite the changes in the political regime. The essential condition for institutional persistence is the persistence of the incentives of those in power to distort the economic system for their own benefit. Therefore, as long as the incentives are preserved, the institutions may survive changes in the regime.
A number of empirical studies support this conclusion. To cite just one relevant study in the Russian context, Dower and Markevich (2014) show that the measure of conflict brought by the Stolypin land reform in Russian farmer’s communities about a hundred years ago explains current attitudes toward the privatization outcomes of the 1990s.
Results: Good Governance Matters for Non-Offshore FDI
Putting together data on the FDI stock in Russian regions, the level of governance quality in regions as of 2011, and some other controls, our results indicate that a higher administrative burden, a higher pressure of enforcement and regulatory agencies, a poor criminal situation and a higher level of corruption reported by the businesses in Russian regions contribute to a lower level of investments of foreign residents. Using the instrumental variable, which proxies the conflict between elites and people at the time when the regulatory agencies were formed a century ago, we can find the causal effect of governance quality on foreign investment. As an additional test, we study the effect of governance on offshore-related direct investments. We show that the sensitivity of offshore investments on governance quality is positive and non-significant. These results confirm our assumption that poor quality of governance decreases the reward of investments and is an important determinant of economic activity.
There is a straightforward policy application of our result. The improvement of governance quality alone, better compliance of regulatory agencies with existing legislation, is an important source of increases in the attractiveness of the regions for foreign investors. In particular, moving from average governance quality to the top increases FDI by 158%. This suggests that there are large returns to improving the quality of governance at the regional level, and this policy does not require a lot of budget spending which is especially important in modern Russia.
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References
- Acemoglu, D., and Robinson, J. (2006) “De Facto Political Power and Institutional Persistence”. American Economic Association Papers and Proceedings 96(2), pp. 325-330.
- Aghion, P., Y. Algan, P. Cahuc and A. Shleifer (2010) “Regulation and Distrust,” The Quarterly Journal of Economics, vol. 125(3), pp. 1015-1049
- Becker, S., Boeckh, K., Hainz, Ch. And L. Woessmann, (2011) “The Empire Is Dead, Long Live the Empire! Long-Run Persistence of Trust and Corruption in the Bureaucracy”, IZA Discussion Paper No. 5584
- Dower, P., and A. Markevich, (2014) “On the Historical Origins of Resistance to Privatization in the Former Soviet Union”, Journal of Comparative Economics, forthcoming
- Kheyfets, B. (2013) “De-offshorization of Economy: International Experience and Russian Specifics”, Voprosy Economiki, Issue 7 (in Russian)
- Kupriyanova, L., (2000) The “labor problem” in Russia in the second half of XIX – early XX century. History of entrepreneurship in Russia. Book 2. Moscow (in Russian)
- Ledyaeva, S., Karhunen, P., And J. Whalley. (2013) “Offshore Jurisdictions, (Including Cyprus), Corruption Money Laundering and Russian Round-Trip Investment”, NBER WP 19019
- Nunn, N., (2009) “The Importance of History for Economic Development.” Annual Review of Economics, 1(1), pp. 65-92
- Yakovlev, E., and E. Zhuravskaya, (2013). “The Unequal Enforcement of Liberalization: Evidence from Russia’s Reform of Business Regulation,” Journal of European Economic Association, 11(4), pp. 808–838.
The Relationship between Education and Migration. The Direct Impact of a Person’s Education on Migration
This brief is based on a section from a large policy report, which investigates to what extent education directly influences major migration decisions. The results indicate that education does not have a clear and persistent effect on most of the migration decisions of Ukrainians — while in 2005-2008 education did not have any effect on the probability of migration at all, in 2010-2012 an inverse relation between qualification and probability of migration appeared. It has been observed that education is positively related to the probability of finding high profile positions, such as professionals, technicians or clerks. Still, the analysis of 2005–2008 data tends to support the “brain-waste”, or better to say, “skills-waste” hypothesis for white-collar Ukrainian migrants but not for blue-collar workers. In 2010-2012 the hypothesis doesn’t hold. *
Hedge Funds Non-Transparency: Skill of Risk-Taking?
This policy brief raises the issue of whether the secretive nature of hedge funds allows funds to misbehave and take excess risks that may in turn be contagious for the whole economy. We use a novel dataset and a new methodology to argue that at least part of the excess performance of more secretive funds during the pre-crisis period was indeed due to higher risks taken.
Hedge Funds – the Secretive Investment Vehicles
In the modern era of delegated portfolio management, hedge funds constitute some of the most interesting and complicated investment vehicles, with a global industry size of over US$2.5 trillion and an overall number of funds of about 10,000 (according to Hedge Fund Research, Inc). The industry grew dramatically during the early 2000s, often providing investors with returns superior to those available in other financial sectors.
The natural question arising is then what exactly made hedge funds enjoy these superior returns. Historically, hedge funds have operated in a relatively secretive way that did not require them to disclose the details about their operations to regulators. Some have argued that it is this secretive nature of hedge funds that has allowed fund managers to employ superior trading strategies and effectively preserve the managerial know-how (in terms of stock-picking skill, market timing or faster trading technology) from being potentially replicated by others.
At the same time the secretive nature of hedge funds might simply allow the fund managers to hide the excessive risks their strategies are exposed too, thereby earning superior returns during relatively good periods (when risky strategies earn the risk premium), but having drastic collapses during relatively bad periods (when these risks realize).
Distinguishing between these two major explanations of superior performance is critically important for potential policy implications regarding hedge funds transparency and disclosure. If the secretive nature of hedge funds attracts more skillful managers that employ proprietary know-how strategies and invests into acquiring more information about the instruments they trade (i.e. generate so called “alpha”), more disclosure would not be necessarily good. This, since it would allow other funds or investors to free-ride on these more skillful managers, reducing their competitive advantage and incentives for providing superior performance. If on the other hand, secrecy allows hedge funds to misbehave and take more systematic risk than they claim they take (i.e. they have a higher “beta”), then there may be a rationale for increasing disclosure requirements, so that investors understand what they are being compensated for in the form of superior returns.
Is There More Risk in Secretive Hedge Funds?
The traditional approach to distinguishing between high-alpha and high-beta funds involves adopting a certain model of risk, i.e. selecting a set of observable risk factors that hedge funds may load on, and then adjusting their raw performance using the estimated exposures to these different factors. This would yield alpha – the risk-adjusted return – that can in turn be used as a measure of managerial skill.
In Gorovyy et al. (2014), we argue that the above methodological approach may sometimes be misleading in evaluating managerial performance. Indeed, in the absence of the true model (e.g. not knowing all factors or not being able to observe them) such alpha would be overestimated as long as these omitted or unobserved factors are earning positive returns during the estimation period (and underestimated, respectively, if the returns are negative). For practical purposes this means that if hedge funds load on unobservable factors, which during the estimation period happen to crash rarely, but deliver a positive return most of the time, we would erroneously attribute funds’ superior returns to managerial skill and not risk.
To tackle this issue, we offer a different approach and suggest that during relatively good times high-alpha and high-beta explanations may be observationally equivalent, but during relatively bad times, they are not. In particular, if during bad times the risks that funds have been loading on realize, we would observe relatively worse performance of funds that loaded more on such factors, ceteris paribus. Thus, in order to distinguish between high-alpha and high-beta funds, we need to look precisely at periods when we would be comfortable assuming that such unobserved factors are likely to crash.
In order to implement this idea, we use a novel proprietary dataset obtained from a fund-of-funds – that is, a hedge fund that invests in other hedge funds, and, hence, has a lot of information about these other hedge funds – and spans April 2006 to March 2009, to directly measure the secrecy level of a fund that is missing in public hedge-fund databases. This qualitative measure describes the willingness of the hedge-fund manager to disclose information about its positions, trades and immediate returns to fund investors. It is based on formal and informal interactions of the fund-of-funds with hedge funds it invests in, such as internal reports, meetings with managers and phone calls.
Figure 1. Performance of Secretive vs. Transparent Funds
Source: Author’s own calculations.
First of all, we document that secretive funds significantly outperform transparent funds during the relatively good times, as suggested, for example, by the period between April 2006 and March 2007 – a growth period according to NBER, and a period of rapid rise of the U.S. stock market indices. In particular, we find that the most secretive funds earned on average about 5% in annualized terms more than the most transparent funds during this period, even when we control for differential risk exposure of different strategies over time and various hedge-fund control variables.
In order to understand whether this superior performance of more secretive funds is due to managerial skill, or some other factors that may not be observable or not known in the model, we need to see what happened to these funds during the relatively bad period of time, i.e. during the period when we would feel comfortable assuming that risk factors on which hedge funds may have loaded did indeed realize. Although we may have in mind some of the omitted factors being potentially related to rare events and tail risk (as also supported by loadings on strategies associated with option-based returns as in Agarwal and Naik, 2004), they may well represent other risks that were likely to realize during the crisis period. We therefore label April 2008 to March 2009 as the “bad” period – a recession period according to NBER, highlighted by the bankruptcy filing by Lehman Brothers in September 2008 and some of the largest drops of stock market indices in history.
As we see from the graph in figure 1, the performance comparison between secretive and transparent funds largely reversed during this bad period. In particular, also supported by our more saturated regression results, transparent funds outperformed the secretive ones during the crisis by the magnitude of about 10-15% in annualized terms, depending on the exact specification. This explicit consideration of the bad period allows us to conclude that at least a part of the performance differential between secretive and transparent funds during good times can be attributed to a higher risk-taking by secretive funds, which earned a premium during good times but faced these realized risks during bad times.
Potential Policy Implications
As a response to the recent financial crisis, many developed economies have passed regulatory reforms considerably increasing the required disclosure levels, suggesting that the secretive nature of alternative investment vehicles has been considered to be something undesirable (e.g. for contagious effects on the economy, or the ex-post bailouts of the “too-big-to-fail” financial institutions). The examples of such policies include the U.S. Dodd-Frank Wall Street Reform Act passed in July 2010, the European Union Alternative Investment Fund Managers Directive 2011/61/EU that entered into force in July 2013, and the Regulation Guide 240 issued by the Australian Securities and Investments Commission in September 2012.
However, given that hedge funds receive money from relatively sophisticated and wealthy investors (i.e. generally having at least $1 million in net worth), whether more risk in hedge funds strategies is good or bad for them in particular, and the society in general becomes a somewhat debatable question. More importantly, the essence of many of the hedge-fund strategies lies in the so-called dynamic trading – with asset positions and risk exposures being adjusted daily or even more frequently. In such an environment, reporting these positions to the regulatory authorities even on a monthly basis may not adequately describe the exact risks taken by the hedge funds.
More relevant questions, on the other hand, may be about whether investors correctly perceive the exact risks faced by the fund, how large the degree of asymmetric information is within the hedge fund industry, and whether any action may be needed to correct it. These remain open questions and we hope that future research will address them.
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References
- Agarwal, V., and Naik N.Y., 2004, “Risks and portfolio decisions involving hedge funds,” Review of Financial Studies, 17(1), 63-98.
- Gorovyy Sergiy, Patrick Kelly, and Olga Kuzmina, “Hedge Funds Non-Transparency: Skill of Risk-Taking?”, CEFIR Working paper.
More Commitment is Needed to Improve Efficiency in EU Fiscal Spending
The member states of the European Union coordinate on many policy areas. The joint implementation of public good type projects, however, has stalled. Centralized fiscal spending in the European Union remains small and there exists an overwhelming perception that the available funds are inefficiently allocated. Too little commitment, frequent rounds of renegotiation and unanimous decision rules can explain this pattern.
Currently, the EU allocates only about 0.4% of its aggregate GDP to centralized public goods spending (European Commission (2014)). This is surprising given the fiscal federalism literature’s classic predictions of efficiency gains from coordinated public goods provision (see for example Oates (1972) and the more recent contributions of Lockwood (2002) and Besley and Coate (2003) for a discussion). Yet, recent proposals to expand centralized fiscal spending in the EU have been met with skepticism if not outright rejection. The most frequently cited argument claims existing funds are already being allocated inefficiently and any expansion of centralized spending would turn the EU into a mere transfer union (Dellmuth and Stoffel (2012) provide a review).
Centralized fiscal spending in the EU is provided through the “Structural and Cohesion Funds”, which are part of the EU’s so called “Regional Policy” and were initially instituted in 1957 by the Treaty of Rome for the union to “develop and pursue its actions leading to the strengthening of its economic, social and territorial cohesion” (TFEU (1957), Article 174). At that point, the six founding members agreed it was important to “strengthen the unity of their economies and to ensure their harmonious development by reducing the difference existing between the various regions and the backwardness of the less favoured regions” (stated in the preamble of the same treaty). A reform in 1988 has further emphasized this goal by explicitly naming cohesion and convergence as the main objectives of regional policy in the EU.
Today, actual fiscal spending in the EU is far from achieving this goal. The initially agreed upon contribution schemes are often reduced by nation specific discounts and special provisions as the most recent budget negotiations for the 2014-2020 spending cycle showed yet again. Moreover, the perception is that available funds are being spent inefficiently (see for example Sala-i-Martin (1996) and Boldrin and Canova (2001)).
Figure 1. 2011 EU Structural and Cohesion Funds
Figure 1 shows the national contributions to the structural funds as well as EU spending from that same budget in each member nation in per capita terms (data published by the European Commission). If fiscal spending was efficiently structured to achieve the above mentioned goal of convergence, one would observe a strong negative correlation between contributions and spending. The data shows, however, that while some redistribution is clearly implemented, rich nations still receive large amounts of the funds meant to alleviate inequality in the union (see Swidlicki et al. (2012) for a detailed analysis of this pattern for the contributions to and spending of structural funds in the UK).
What prevents a group of sovereign nations from effectively conducting the basic fiscal task of raising and allocating a budget to achieve an agreed upon common goal? In a recent paper, we theoretically examine the structure of the bargaining and allocation process employed by the EU (Simon and Valasek (2013)). Our analysis suggests that efficiency both in terms of raising contributions and allocating fiscal spending cannot be expected under the current institutional setting. While poorly performing local governments, low human capital in recipient regions, and corruption might all play a role in creating inefficiency (see for example Pisani-Ferry et al. (2011) for a discussion of the Greek case), improving upon those will only solve part of the problem.
We demonstrate that the inefficiency of EU spending in promoting the goal of convergence can be explained by the underlying institutional structure of the EU, where sovereign nations bargain over outcomes in the shadow of veto. Specifically, we model the outcome of the frequent negotiation rounds employed by the EU as the so-called Nash bargaining solution, explicitly taking into account the possibility for each member nation to veto and to withdraw its contribution (as the UK threatened in the most recent budget negotiations). It turns out that it is precisely the combination of voluntary participation, unanimity decision rule and the lack of a binding commitment to contribute to the joint budget that generally prevents efficient fiscal spending. In such a supranational setting, the distribution of relative bargaining power arises endogenously from countries’ contributions and their preferences over different joint projects. This creates a link between contributions to and allocation of the budget that is absent in federations, where contributions to the federal budget cannot simply be withdrawn and spending vetoed. Since the EU members lack such commitment, this link will necessarily lead to an inefficient outcome.
Why Does the EU Have These Institutions?
If the currently employed bargaining process cannot lead to an efficient outcome, why then did the EU member nations not institute a different allocation process right from the start? Of course, agreeing on a binding contract without the possibility for individual veto is politically difficult. More complicated bargaining processes may also be much more costly in terms of administration than is relying on informal negotiations and mutual agreement. Our analysis suggests another alternative: If the potential members of the union are homogeneous with respect to their income and the social usefulness (or spillovers) of the projects they propose to be implemented in the union, then Nash bargaining will actually lead to the budget being raised and allocated efficiently. The intuition behind this result is simple: If all countries have the same endowment, their opportunity costs of contributing to the joint budget are the same. Moreover, symmetric spillovers do not give one country a higher incentive to participate in the union than the other. Consequently, all countries have the exact same bargaining position. Thus, equilibrium in the bargaining game must produce equal surpluses for all nations. At the same time, with incomes and spillovers perfectly symmetric, the efficient allocation also produces the same surplus for each nation, so that it coincides with the Nash bargaining solution. It is important to notice, though, that symmetric income and spillovers do not imply homogeneous preferences: Each nation can still prefer its “own” project to the others. Instead, symmetry leads to a perfectly uniform distribution of bargaining power in equilibrium. Moreover, our analysis shows that efficiency is achieved if the union budget is small relative to domestic consumption and member countries have similar incomes.
This resonates well with the history of the European Union. In fact, the disparities between the founding members were not large, so that the current bargaining institutions could reasonably have been expected to yield efficiency. Only the inclusion of Greece, Ireland, Portugal and Spain created a more economically diverse community (European Movement (2010)). Our model shows that as the asymmetries between member countries or the importance of the union relative to domestic consumption grow, Nash bargaining leads to increasingly inefficient outcomes. Figure 2 shows this effect for a union of two nations. Keeping aggregate income constant and assuming symmetric spillovers between the two nations’ preferred projects, we vary asymmetry in their domestic incomes. The graphs show the Nash bargaining outcome (marked with superscript NB) compared to the generally efficient solution. As country A’s income increases, so does its outside option (i.e. all else equal, the higher the income, the less a country would lose if the joint projects were not implemented). Thus, country A’s bargaining position relative to country B increases in equilibrium, leading to an inefficient outcome. The allocation of funds to the union projects (upper right panel) depicts this channel very clearly: While the efficient allocation is independent from the distribution of national incomes, the Nash bargaining solution reflects the changing distribution of power. Nation A is able to tilt the allocation more toward its own preferred project the higher its income. Moreover, it is able to negotiate a “discount” for its contribution. While its contribution (labeled xa) does increase with its income (labeled ya), country A still pays less than would be budgetary efficient given its higher income (upper left panel). As a result of the inefficiencies introduced by the bargaining process, aggregate welfare in the union declines as asymmetry grows. Again, it is worth noting, that the loss in aggregate welfare is relatively small when asymmetry is small, but grows more than proportionally as the countries become more and more unequal (lower right panel).
Figure 2. The Effect of a Union of Two Countries
This has troubling implications for the EU, as income asymmetry has increased with every subsequent round of expansion while the bargaining procedure for the fiscal funds has essentially stayed the same. It is not surprising then that a larger and more asymmetric EU has resulted in supranational spending that is increasingly inefficient.
The EU as a “Transfer Union”
We go on to show that the level of redistribution inherent in the Nash bargaining solution depends crucially on the overall size of the budget the union intends to raise. Increasing the EU’s budget for centralized fiscal spending would indeed lead to more “transfers” to low income members (in terms of net contributions), bringing the EU closer to the original goal of convergence. In fact, the EU could pick a budget such that inequality in terms of total welfare between member nations is completely alleviated. Such an outcome necessarily implies that the net gain from being part of the union for high-income nations is lower (albeit still positive) than for low-income members. However, this in turn has consequences for the endogenous distribution of bargaining power: Richer nations would be able to assert even more power and push even further for their own preferred projects, rendering the allocation of funds across projects less efficient. This trade-off between equality and efficiency implies that complete convergence is not necessarily socially desirable.
Arguably, this trade-off might be more important for a transition period than in the long run. If fiscal spending does not only lead to convergence in instantaneous welfare, but also has a positive effect on long-run performance and GDP growth, income asymmetries across countries will decrease even if the allocation of spending across projects is not entirely efficient. Less inequality in turn will lead to a more efficient allocation process in the future and endogenously reduce the level of necessary transfers. However, whether the growth effect of the EU’s structural funds is indeed positive remains a much-debated empirical question (see for example Becker et al. (2012)).
Institutions Fit for a Diverse Union
As the EU has expanded from the original six nations to the current 27, there has been a concurrent evolution of decision-making rules. A qualified majority rule is now used in many areas of competency. We show that the allocation of fiscal spending could also benefit from the implementation of a majority rule. Efficiency would be improved as long as the low-income member nations endogenously select into the majority coalition while their contributions to the budget remain relatively low. In connection to this, the EU might benefit from enforcing rules specifying contributions as a function of national income (such rules exist, but are easily and often circumvented), forcing wealthier member nations to pay more. An exogenous tax rule without the possibility to negotiate a discount, for example, may indeed improve overall efficiency.
It is important to note, however, that a unanimous approval of such a change is unlikely. The institutional mechanism of Nash bargaining is an “absorbing state” after the constitution stage, in the sense that not all member nations can be made better off by switching to an alternative institution. Therefore, the discussion of alternative institutions and decision making processes is particularly relevant when considering new mechanisms that increase fiscal spending at the union level, such as the proposed EU growth pact. If the same bargaining process remains to be employed even for new initiatives, even though a majority rule is preferable and implementable relative to the status quo, the opportunity for the EU to achieve efficiency in its fiscal spending is lost.
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References
- Becker, S. O., Egger, P and von Ehrlich, M (2012) “Too Much of a Good Thing? On the Growth Effects of the EU’s Regional Policy”, European Economic Review 56: 648 – 668
- Besley, T. and Coate, S. (2003) “Centralized versus Decentralized Provision of Local Public Goods: A Political Economy Approach” Journal of Public Economics 87: 2611 – 2637
- Boldrin, M and Canova, F (2001) ”Europé’s Regions – Income DIsparities and Regional Policies” Economic Policy 32: 207 – 253
- Delmuth, L.M. and Stoffel, M.F. (2012) “Distributive Politics and Intergovernmental Transfers: The Local Allocation of European Structural Funds” European Union Politics 13: 413 – 433
- European Commission (2014) Data available at http://ec.europa.eu/regional_policy/what/future/index_en.cfm
- European Movement (2010) “The EU’s Structural and Cohesion Funds” Expert Briefing, available at http://www.euromove.org.uk/index.php?id=13933
- Lockwood, B. (2002) “Distributive Politics and the Cost of Centralization” The Review of Economic Studies 69: 313 – 337
- Oates, W.E. (1972) “Fiscal Federalism” Harcourt-Brace, New York
- Pisani-Ferry, J., Marzinotto, B. and Wolff, G. B. (2011) “How European Funds can Help Greece Grow” Financial Times, 28 July 2011.
- Sala-i-Martin, X (1996) ”Regional Cohesion: Evidence and Theories of Regional Growth and Convergence”, European Economic Review 40: 1325 – 1352
- Simon, J. and Valasek, J.M. (2013) “Centralized Fiscal Spending by Supranational Unions” CESifo Working Paper No. 4321.
- Swidlicki, P., Ruparel, R., Persson, M. and Howarth, C. (2012) “Off Target: The Case for Bringing Regional Policy Back Home” Open Europe, London.
- TFEU (1957) “Treaty Establishing the European Community (Consolidated Version)”, Rome Treaty, 25 March 1957, available at: http://www.refworld.org/docid/3ae6b39c0.html
Trust and Economic Reforms
This brief discusses the importance of trust in economic development. In the aftermath of the 2008 financial crisis, many countries experienced a decline in the level of both general trust and trust and confidence in the government and market institutions. Trust is important for economic growth as it facilitates economic transactions by reducing uncertainty and risk. A lack of trust in the government hinders implementation of structural reforms needed for economic development. Hence, policies aimed at rebuilding trust in the government and institutions become especially important for countries like Ukraine.
Recent events in Ukraine have highlighted an acute crisis of trust in the Ukrainian society (such as trust in the government, politicians, institutions, etc.). Over the past two decades, in the absence of a fair and transparent legal and court system, Ukrainians have become accustomed to relying on informal and often corrupt ways of living and doing business. According to a poll conducted in December 2013, less than 20 percent of the Ukrainian population said that they trust the government, police and courts.
A low level of trust in society is not, however, limited to Ukraine; this problem is also pronounced in many other parts of the world. According to the 2012 Edelman Trust Barometer survey, the general level of trust in most countries surveyed decreased compared to 2011. The most notable decline was in Brazil (36.3%), Japan (33.3%) and Spain (27.5%). These countries also experienced large drops in the level of confidence in the government: Brazil went down by 62.4%, Japan by 51% and Spain by 53.5%. According to the OECD report, generally, less than half (40%) of the citizens trust their government (OECD, 2013).
General trust is important for economic life as it reduces uncertainty and costs associated with economic transactions. Trust affects the functioning of businesses, financial markets, and government intuitions. The level of general trust varies significantly across countries (see Figure 1). While only 3.8 percent of people in Trinidad and Tobago fully trust most people, the Scandinavian countries’ share of trusting people exceeds 60 percent (Algan and Cahuc, 2013).
Economists have in their studies repeatedly appealed to the problem of trust because there are several channels through which trust may influence economic development. First, trust creates favorable conditions for long-term investment and financial market development (Algan and Cahuc, 2013). Second, a higher level of trust in various regulatory authorities increases the level of compliance with the rules and regulations if citizens believe in the fairness of such rules and regulations (Murthy, 2004). In Tabellini (2010), the level of economic development (measured by GDP per capita) of different regions of the EU member countries is compared to their level of trust (defined as in the Figure 1) and respect (defined as the proportion of people who mentioned the quality “tolerance and respect for other people” as being important). Using data from the World Value Survey rounds conducted in the 1990s, he shows that regions with a high level of trust and respect are also the regions that are the most economically developed.
In his Master thesis, the graduate of the Kyiv School of Economics Oleksii Khodenko (Khodenko 2013) analyzed the relationship between the level of trust in the government and the attitude towards market economy (in particular, the attitude towards competition and private property). For this purpose, he used data from the World Values Survey and the European Values Survey. His results have different implications for developed and less developed countries. While a lack of trust in the government in developed countries is transformed into a desire to see more market mechanisms in the economy, this mistrust of the government in developing countries (including Ukraine) undermines the faith in the entire market economy.
Khodenko’s results highlight important policy implications for transition countries: people who grew up in a centrally planned economy tend to underestimate the benefits of the free market and, therefore, only puts confidence in the government and the state as a whole to achieve the development of market mechanisms. Thus a lack of trust hinders, or even prevents implementation of structural economic reforms, which are often “painful” for some groups or for society as a whole. In countries with a low level of trust, the long-term promise of the implemented reforms to improve the lives of people is not perceived as credible. Instead of being viewed by the general public as a today’s sacrifice in the name of future prosperity, they are rather viewed as a deadweight loss (Györffy, 2013).
Figure 1. The Level of Trust in the World
Source: Yann and Cahuc (2013), Figure 1.
Note: Trust is computed as the country average from responses to the trust question in the five waves of the World Values Survey (1981-2008), the four waves of the European Values Survey (1981-2008) and the third wave of the Afrobarometer (2005). The question regarding trust asks: “Generally speaking, would you say that most people can be trusted or that you need to be very careful in dealing with people?” Trust is equal to 1 if the respondent answers ”Most people can be trusted” and 0 otherwise.
Moreover, low levels of trust affect all types of structural reforms. Elgin and Garcia (2012) show that the effect of the tax reform on the economy can significantly differ depending on the level of trust in the government; under low levels of trust the announced tax cuts do not lead to exit from the informal sector.
The question is then how to revive or rebuild trust? Knack and Zak (2003) argue that the most efficient policies for building general trust are policies that (1) reduce income inequality since people in countries with more equal income distribution tend to have higher levels of interpersonal trust, and (2) strengthen civil society to increase government accountability. Income inequality often resulting from unequal opportunities can be reduced via increases in educational attainment and income redistribution programs. The presence of a strong civil society with free press ensures that the government is accountable and responsive to its citizens. A government needs to be reliable, open and transparent to effectively address citizens’ demands (OECD, 2013). All these policies cannot be implemented without a fair legal system that guarantees equal treatment of all citizens.
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References
- Algan, Y. and P. Cahuc (2013) “Trust, Growth and Well-being: New Evidence and Policy Implications”, IZA Discussion Paper No. 7464
- Elgin, C. and M. Solis-Garcia (2012), “Public Trust, Taxes and the Informal Sector”, Journal Review of Social, Economic and Administrative Studies, 26(1), pp. 27-44
- Györffy, D. (2013), Institutional Trust and Economic Policy: Lessons from the History of the Euro, Central European University Press
- Knack, S. and P.J. Zak (2003), “Building Trust: Public Policy, Interpersonal Trust, and Economic Development”, Supreme Court Economic Review, 10, pp.91-107
- Khodenko, Oleksii (2013). How Does Confidence in the State Authorities Shape Pro-market Attitudes?
- Murthy, K. (2004), “The Role of Trust in Nurturing Compliance: A Study of Accused Tax Avoiders”, Centre for Tax System Integrity, Working paper No49
- OECD (2013), Government at a Glance 2013, OECD Publishing.
- Tabellini, G. (2010), “Culture and Institutions: Economic Development in the Regions of
- Europe”, Journal of the European Economic Association, 8(4), pp. 677–71