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Resistance to outside investment: A rational model of surplus destruction

Resistance to outside investment: A rational model of surplus destruction

Sourav Bhattacharya, University of Pittsburg Tapas Kundu, University of Oslo

Prepared for the Nordic Conference on Development Economics 2009

June 17, 2009

Resistance to outside investment: A rational model of surplus destruction Introduction Background

Recent trend in policy making in developing economies Encouraging private investment Con‡ict with redistribution?

Resistance to outside investment: A rational model of surplus destruction Introduction Background

Private investments are encouraged on the ground of e¢ciency, and creation of higher economic surplus, but most often associated with public resistance Resistance - delaying project …nalization, interruption of production process, blocking production at a public cost Investor-freindliness ! Resistance But is there a reverse causality?

Resistance to outside investment: A rational model of surplus destruction Introduction Questions

Questions

What explains the apparent puzzle of destructive resistance to productive investment? How does surplus destruction by social groups a¤ect the government’s investor-friendliness? How does resistance a¤ect social welfare through competition between governments ?

Resistance to outside investment: A rational model of surplus destruction Introduction Approach

Basic Argument

Resistance has informational value, which is important to the government if it is concerned for inequality However, resistance results in a loss of economic surplus The government can be weak in dealing with the outside investor because -

loss of economic surplus may lead to suboptimal investment by the investor, and the government’s relative bargaining position changes as it expects a di¤erent utility through informative redistribution when resistance reveals information

Resistance to outside investment: A rational model of surplus destruction Introduction Related Literature

Related Literature

Resistance to outside investment in India 1) Bardhan 2005, 2006 2) Suri 2004 Signaling through costly public action 1) Theory survey: Ausubel et al. 2002 2) Application: Delaying - Harstad 2007, Heish 2000

Resistance to outside investment: A rational model of surplus destruction The model Framework

Framework

Players: 2 groups of citizens, A & B The regional government G An outside investor I

Resistance to outside investment: A rational model of surplus destruction The model Framework

Nature of investment

The investor decides the size of a project x 0 Investor’s return (prior to any transfer) x x2 2k k denotes the economic strength (of the region) to attract investment. Bene…t to group J 2 fA, Bg from investment x : vJx vB = v v with probability (1 p) with probability p Assumptions: (1)v > v, (2)vA + v > 0.

Resistance to outside investment: A rational model of surplus destruction The model Framework

Sequence of events

Stage 1: Policy G decides a tax/subsidy τ on the total size of the project x Stage 2: Investment decision I decides the size of x

Resistance to outside investment: A rational model of surplus destruction The model Framework

Stage 3: Signaling B can take a costly action to signal its valuation Public cost: If B takes an action with public cost a > 0, the e¤ective size of the project is x (1 a) Stage 4: Redistribution G distributes/collects tax/subsidy from A and B at some pre-speci…ed rate sτx and (1 s) τx , s 2 [0, 1] G decides a transfer of wealth t from group A to group B

Resistance to outside investment: A rational model of surplus destruction The model Framework

Timing

time Policy Making Investment Signaling Redistribution G offers tax τ to I I decides scale x Valuations vB realized B chooses action a G decides transfer t

Timing of the game

Resistance to outside investment: A rational model of surplus destruction The model Payo¤s

Payo¤s

Investor x(1 a) x2 2k τx

Resistance to outside investment: A rational model of surplus destruction The model Payo¤s

Payo¤s

Investor x(1 a) x2 2k τx Citizens wA = vAx (1 a) + sτx wB = vBx (1 a) + (1 s) τx

Resistance to outside investment: A rational model of surplus destruction The model Payo¤s

Government

Averse to inequality L (t) = [(wA t) (wB + t)]2

Resistance to outside investment: A rational model of surplus destruction The model Payo¤s

Government

Averse to inequality L (t) = [(wA t) (wB + t)]2 A generalized measure of inequality Lλ(t) = [λ(wA t) (1 λ)(wB + t)]2

Resistance to outside investment: A rational model of surplus destruction The model Payo¤s

Government

Averse to inequality L (t) = [(wA t) (wB + t)]2 A generalized measure of inequality Lλ(t) = [λ(wA t) (1 λ)(wB + t)]2 G cares about total wealth, but not at the cost of unequal distribution W2(wA, wB, t) = [(wA t) + (wB + t)] η[λ(wA t) (1 λ)(wB + t)]2

Resistance to outside investment: A rational model of surplus destruction The model Equilibrium selection

Equilibrium selection

Sequential equilibria (separating) with beliefs satisfying Cho-Kreps Intuitive Criterion

Resistance to outside investment: A rational model of surplus destruction Underlying assumptions

Assumptions

Zero cost of redistribution (relaxed later) Positioning of the redistributive stage Informational bene…t

Resistance to outside investment: A rational model of surplus destruction Analysis

Benchmarking

When information can be obtained at zero cost (e¤ect of uncertainty) If signaling can be banned (e¤ect of costly action)

Resistance to outside investment: A rational model of surplus destruction Analysis

First best: Suppose information will be revealed at zero cost

Resistance to outside investment: A rational model of surplus destruction Analysis Costless information (…rst best)

Analysis

When G can costlessly elicit valuations

Proposition Optimal redistribution to = λwA (1 λ)wB Optimal investment xo = k (1 τo) Optimal taxation τo = 1 (vA + EvB) 2

Resistance to outside investment: A rational model of surplus destruction Analysis Costless information (…rst best)

Proposition G will subsidize investment if and only if its comparative expected valuation (with respect to the investor) is positive i.e., vA + EvB 1 > 0.

Resistance to outside investment: A rational model of surplus destruction Analysis Costless information (…rst best)

Two e¤ects if we allow signaling though costly action

• 1. Better redistribution

makes G softer

• 2. Loss of surplus

low surplus for the society: makes G harder low surplus for the investor and so low investment: makes G softer.

Resistance to outside investment: A rational model of surplus destruction Analysis Equilibrium analysis

Equilibrium analysis

4) Redistribution stage te = λwA (1 λ)wB wA t = (1 λ) (vA + vB) x (1 ae) wB + t = λ (vA + vB) x (1 ae)

Resistance to outside investment: A rational model of surplus destruction Analysis Equilibrium analysis

3) Signaling stage Observation:

• High type will take no action
• Condition to ensure that no type misrepresenting its own type

λ (v v) ((vA + v) λ(vA + v)) a λ (v v) (1 λ) (vA + v) Lemma For the signaling subgame, in the unique separating equilibrium with beliefs satisfying intuitive criterion, the optimal action by B, is given by a (v) = a (v) = λ (v v) ((vA + v) λ(vA + v)) = ae 2 (0, 1)

Resistance to outside investment: A rational model of surplus destruction Analysis Equilibrium analysis

2) Investment stage xe = arg max

x

(1 p) x + px (1 ae) x2 2k τx = k (1 τ pae) 1) Policy stage τe = arg max

τ

• (1 p) (vA + v) xe

+p (vA + v) xe (1 ae) + τxe

• =

pae (vA + v 1) +

• 1
• vA + EvB

2

Resistance to outside investment: A rational model of surplus destruction Analysis Equilibrium analysis

Equilibrium Outcome

Proposition Optimal redistribution te = λwA (1 λ)wB Optimal investment xe = k (1 τ pae) Optimal taxation τe = pae (vA + v 1) +

• 1
• vA + EvB

2

Resistance to outside investment: A rational model of surplus destruction Analysis Results

E¤ect of costly mode of information revealing Proposition Compared to no-informational constraint case, subsidies will be provided over a broader range of parameter values. G will subsidize if and only if its comparative expected valuation (with respect to the investor) under no-informational constraint case is above its expected comparative loss at the low state i.e., (vA + EvB 1) > pae vA + v 1

• .

Proposition G will be relatively soft (compared to the no-informational constraint case), i.e., τe < τo if and only if vA + v < 1.

Resistance to outside investment: A rational model of surplus destruction Analysis Results

Proposition The amount of surplus destroyed, i.e. ae is decreasing in λ, vA and v.

Resistance to outside investment: A rational model of surplus destruction Analysis Results

Two e¤ects if signaling (through costly action) is prohibited

• 1. Worse redistribution

makes G harder

• 2. Gain in surplus in absence of costly action

high surplus for the society: makes G softer high surplus for the investor and so high investment: makes G harder.

Resistance to outside investment: A rational model of surplus destruction Analysis Results

Will G prefer avoiding public action? Consider a situation when G makes a redistributive transfer before vB is realized and commits not to renegotiate. Proposition Optimal redistribution tns = λwA (1 λ)EwB Optimal investment xns = k (1 τns) Optimal taxation τns = [1 (vA + EvB)] + 2kF 2 + 2kF where F = ηp (1 p) (1 λ)2 (v v)2.

Resistance to outside investment: A rational model of surplus destruction Analysis Results

Proposition G will prefer signaling through costly action if and only if p 1 + kF h (1 + vA + EvB) pae vA + v + 1 i > (1 + vA + EvB) . Such a possibility will be more likely when λ is low, or k is large, or p is not very large. For large enough p or λ, the government always prefers to pre-commit to a redistributive scheme

Resistance to outside investment: A rational model of surplus destruction Extensions

Extensions

1) Competition between regions 2) Cost of redistribution

Resistance to outside investment: A rational model of surplus destruction Model of competition Framework

The model under competition

2 regions, 1 and 2, competing for investment 1) Policy stage: Both states simultaneously announces tax rates τ1 and τ2 2) Investment stage: I decides where to invest and how much to invest (can invest in one jurisdiction alone) 3) Signaling stage and Redistribution stage as before

Resistance to outside investment: A rational model of surplus destruction Model of competition Analysis

Competitive policy range of a region

Consider the range of tax policy that gives G payo¤ that is at least as high its reservation payo¤ τi = (vAi + EvBi ) + piae

i (vAi + vi)

• τi 1 piae

i = τi

Investor’s expected return is decreasing in τi πi (τi) = ki 2 (1 τi piae

i )

Resistance to outside investment: A rational model of surplus destruction Model of competition Analysis

When does competition matter? πi (τe

i ) < πj

• τj
• for i, j

Without loss of generality, assume 1 wins the investment. Then k1 2 (1 p1ae

1 τ 1)2 = k2

2 [(vA2 + EvB2 + 1) p2ae

2 (vA2 + v2 + 1)]2

Proposition Consider a situation when competition a¤ects the winner’s payo¤. The winner’s payo¤ decreases (increases) as the looser becomes more action-prone if and only if

• vA

2 + v2 + 1

< 0 (vA2 + v2 + 1) < 0 ) I cares about the informational problem in 2 ) I is not so averse to action in 2 ) Region 2 gains bargaining power ) Region 1 looses bargaining power.

Resistance to outside investment: A rational model of surplus destruction Model of competition E¤ects of Competition

E¤ects of Competition

Two parameters of competitiveness: ki (economic e¢ciency) and λi (political structure) Ine¢cient allocation: Investment may not go to the jurisdiction with higher ki if ae

i is also very high there.

Increased action in one region weakly increases the welfare of the other region.

Resistance to outside investment: A rational model of surplus destruction Direction of research

Direction of research

Does signaling bene…t G only? Alternate ways of signaling?

Resistance to outside investment: A rational model of surplus destruction Direction of research

Thank you