Joshua Bates
Dr. Vakulenko
Econ 3370
7 Decenber 2009
The Question of Regulation
The debate through the last century or two has been whether to regulate, or leave industry to its own devices. One political party would cry to break up the monopolies and punish those who are making excessive profits off the backs of the poor, tired workers, overcharged consumers and even more destitute migrants, with no property or home to call their own; preferable those excessive profits would be redistributed to those poor, since they can never improve their station without government help. Inevitably the other party will take up the mantle of business, saying that any regulation at all will lead to prices skyrocketing and job destruction, bringing about higher crime rates, the ruin of the economy, and quite possibly the end of success and capitalism. Both sides appear to be wrong; Hernando De Soto, President of the Institute for Liberty and Democracy, writes on the subject that, “Government programs to give property to the poor have failed over the past 150 years whether they followed the bias of the right (private property rights through mandatory law) or of the left (protecting poor people’s land in government run collectives).” (2000, 169) It is not so much whether a state chooses to regulate or not that generates the effects, but exactly what regulations and in what way they are enacted.
One of the main issues with regulation is that over-regulation leads to shadow economies. The shadow economy, according to the International Monetary Fund, “includes not only illegal activities but also unreported income from the production of legal goods and services, either from monetary or barter transactions. Hence, the shadow economy comprises all economic activities that would generally be taxable were they reported to the tax authorities.” (Schneider and Enste) This can hamper government statistical analysis, cut into tax revenues and undermine the very regulations that may have caused it. It is the conclusion of Dominik Enste that, “regulations are…main causes for the size of the shadow economy.” In fact heavy regulation may even undermine its own cause; Enste concludes that, “Contrary to political intention, the analysis of survey data suggests that tight regulation does not correspond with a high degree of perceived job security.” It would seem that workers feel more secure in a lesser regulated economy knowing that if they are fired, they always have the ability to find a new job. This study seems to correlate heavy regulation with the shadow economy; a case study is required to see why.
Luckily Hernando De Soto has performed several case studies and knows exactly why. Heavy regulation, it appears, makes it quite difficult to do anything legally. De Soto explains his difficulties when attempting to open a legal store in Peru, “[We] spent six hours a day at it and finally registered the business – 289 days later. Although the garment workshop was geared to operating with only one worker, the cost of legal registration was $1,231 - thirty-one times the monthly minimum wage.” (2000, 18) Businesses are not the only legal entities that are costly and difficult to start; legal housing is quite a hurdle as well. De Soto writes, “To obtain legal authorization to build a house on state-owned land took six years and eleven months, requiring 207 administrative steps in fifty-two government offices. To obtain a legal title for that piece of land took 728 steps. We also found that a private bus, jitney, or taxi driver who wanted to obtain official recognition of his route faced twenty-six months of red tape.”(2000, 20) These difficulties are not even localized in Peru; they are all over Latin America, the Middle East, and elsewhere.
It would seem that a number of lesser developed countries have high levels of regulation that can be preventative for people attempting to claim their rightful property. In fact a potential landowner’s quest in the Philippines seems worse than in Peru:
“In the Philippines, if a person has built a dwelling in a settlement on either state-owned or privately owned urban land, to purchase it legally he would have to form an association with his neighbors in order to qualify for a state housing finance program. The entire process could necessitate 168 steps, involving fifty-three public and private agencies and taking thirteen to twenty-five years.”
Similar results were attained when attempting to set up businesses and housing in Egypt and Haiti as well. If this were not enough, it can be just as difficult to stay legal as it was to become legal in the first place. The only conclusion to be drawn is that, “Inevitably, migrants do not so much break the law as the law breaks them – and they opt out of the system.”(De Soto 2000, 21) This is where the shadow economy is born.
This does not mean that all regulation should be abolished for fear of the shadow economy; on the contrary, regulations can help prevent the shadow economy if the correct regulations are properly implemented. Daron Acemoglu is writing a book on this very subject; his bottom line is that, “People need incentives to invest and prosper; they need to know that if they work hard, they can make money and actually keep that money. And the key to ensuring those incentives is sound institutions — the rule of law and security and a governing system that offers opportunities to achieve and innovate.” Regulation must ensure an even playing field from the beginning; contract enforcement and property rights that are relatively simple to obtain and enforce are paramount to economic success. Schneider and Enste summarize that, “Countries with relatively low tax rates, fewer laws and regulations, and a well-established rule of law tend to have smaller shadow economies.” It is not the number of laws, rules and regulations that is important, it is the efficiency with which institutions uphold the rule of law that determines economic success. Corruption, which can be legislated against if the proper authorities will enforce it, is also a driver of the shadow economy.
Part of the growth of the shadow economy also tends to result from the law not recognizing the needs of the people. This is not an issue with regulation, but an issue with the wrong regulations being enacted. De Soto comments that, “If the legal system does not facilitate the people’s needs and ambitions, they will move out of the system in droves.”(2000, 169) The issue is that there are already customs and informal agreements in place in many regions without property rights; any regulation that does anything other than legitimizing these agreements is doomed to fail. These failures are not only a problem for the people who live in the agreements, but also an issue for governments going forward, corrupt or not. The issue is that, “formal law is increasingly losing its legitimacy as people continue to create property beyond its reach.” (De Soto 2000, 169) As the extralegal sector erodes the authority of the government, there will come a time when governments cannot fix the problem.
An innovative proposed method for solving the problem comes from Paul Romer. He suggests that if people from the developed world were to be allowed to found cities in the developing world with just the right amount and type of regulation, the developing world would see how beneficial a working city can be to their economies and their balance sheets. Paul Romer describes his proposed plan to Dwyer Gunn of the New York Times’ Freakonomics blog:
There are many signs of the value created by all the exchange that takes place in a city. We see it in productivity and wage data. We also see it in the increase in the value of the land. Millions of people are willing to pay high rents just to live and work around millions of other people who are also paying high rents. Why? To get the benefits that come from exchange and interaction with so many others.
In the developing world, most people don’t yet live in big well-run cities. Given the chance to move to one, hundreds of millions of people would go there to get a job, get an education for their children, and live in a place that is clean, safe, and healthy. Other people will make a profit by hiring them or supplying them with infrastructure and other services. If the rules let this happen, everyone can be better off. It doesn’t take any charity to build well-run cities. (September 29, 2009)
By placing one of these well functioning cities in a strategic area in a lesser developed country, not only will the city flourish, as well as the people in the cities, but it will show the country how to build an economy.
If necessary, a contract could be signed by a third party nation to guarantee that developing country would not interfere with the workings of the city, as a hedge against corruption; many countries would not need this. In fact, this idea is not even new, but this is merely a creative implementation:
If a national government has sufficient credibility, it could start a charter city within its own territory and administer it from the national capital. This is, in effect, what some countries have done when they have created special economic zones with rules that are different from the ones that prevail in the rest of the country. You could imagine that a country like India might try something like this to speed up urbanization by cutting through many local rules that get in the way of urban development. (Dwyer Gunn Freakonomics blog, September 29, 2009)
Successful implementation does not only benefit the developing world, however. The developed world, “could try many new types of innovative structures.” (Dwyer Gunn Freakonomics blog, September 29, 2009) These charter cities could be a test bed for new types of regulation and legislation that would be impossible to implement in the first world without some kind of proof that it works; perhaps municipal Wi-Fi could have used a test run somewhere before billions were wasted on a service nobody wanted or needed. Like much of Romer’s previous work, these charter cities could not only help the developing nations, but the entire world.
The key to regulation lies less in the amount and more in the quality. The issue of regulation seems to lie more in shadow economies than anywhere else; Schneider and Enste find that, “shadow economies tend to be smaller in countries where government institutions are strong and efficient. Indeed, some studies have found that it is not higher taxes per se that increase the size of the shadow economy, but ineffectual and discretionary application of the tax system and regulations by governments.” The solution lies in providing incentives to bring about the proper regulation and enforcement. One way is with charter cities that showcase how good regulation can impact the economy of any country, no matter how harsh the customs or geography. If this research is correct and workable solutions present themselves, poverty may be on the verge of being wiped off of the face of the earth. However, the last man to say that poverty was nearly a thing of the past presided over the Great Depression. Let history not repeat itself.
References
Acemoglu, Daron. “What Makes a Nation Rich? One Economist’s Big Answer.” http://www.esquire.com/features/best-and-brightest-2009/world-poverty-map-1209
De Soto, Hernando. 2000. The Mystery of Capitalism. Basic Books.
Enste, Dominik H. “Regulation and shadow economy: empirical evidence for 25 OECD-countries.” Constitutional Political Economy, http://www.springerlink.com.libproxy.utdallas.edu/content/b48k160w26473361/fulltext.html
Freakonomics. http://freakonomics.blogs.nytimes.com/
Johnson, Simon, Daniel Kaufmann, and Pablo Zoido-Lobaton. 1998. "Regulatory discretion and the unofficial economy." American Economic Review 88, no. 2: 387-392. Social Sciences Abstracts, EBSCOhost (accessed December 6, 2009).
Schneider, Friedrich and Enste, Dominik. Hiding in the Shadows: The Growth of the Underground Economy. http://www.imf.org/external/pubs/ft/issues/issues30/index.htm#f1
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