Adverse Incentives Research Articles

Adverse Incentives in Crowdfunding

This paper analyzes the substantially growing markets for crowdfunding, in which retail investors lend to borrowers without financial intermediaries. Critics suggest that these markets allow sophisticated investors to take advantage of unsophisticated investors. The growth and viability of these markets critically depend on the underlying incentives. We provide evidence of perverse incentives in crowdfunding that are not fully recognized by the market. In particular, we look at group leader bids in the presence of origination fees and find that these bids are (wrongly) perceived as a signal of good loan quality, resulting in lower interest rates. Yet these loans actually have higher default rates. These adverse incentives are overcome only with sufficient skin in the game and when there are no origination fees. The results from the analysis in this paper provide more general implications for crowdfunding, its structure, and its regulation. This paper was accepted by Wei Jiang, finance.

A Question of Fairness: Time to Reconsider Income-Averaging Provisions

A system of progressive marginal income tax rates, as in Canada, tends to impose a greater tax burden on individuals whose incomes are irregular or fluctuate year-by-year, compared to individuals with steadier incomes of the same average value over several years. Take, for example, a person without dependents living in Ontario. Suppose she earns $50,000 in 2016 and $100,000 the following year. Thus, her average income is $75,000 per year. However, her total income tax for the two years is about $1,900 more than if she had earned, instead, $75,000 in both years. On an annual basis, her extra tax liability is almost $1,000, or 1.3 percent of her average annual income. A similar tax penalty on fluctuating income would occur in a case where her income had fallen from $100,000 in 2016 to $50,000 in 2017. Call it the “fluctuation penalty,” for short. The fluctuation penalty is a policy concern for reasons of fairness and the adverse incentives it may create for risk-taking activities, such as entrepreneurship. In terms of fairness, the fluctuation penalty violates the principle of horizontal equity, which is that equals should be taxed equally. Vertical equity is also weakened, if the fluctuation penalty is most acute for lower-income persons. But how severe is the fluctuation penalty in Canada? The answer will depend, not only on the marginal tax rates and tax credits, but also on the actual patterns and sources of incomes received by individuals over several consecutive years. This study uses longitudinal data spanning the six-year period, 2005-2010. After restricting the data to focus on individuals who can be expected to pay taxes, the sample contains about 7,000 persons. We compare the tax burdens that these individuals paid on their observed incomes with a counterfactual situation, in which the same individuals earned a constant income with the same six-year average value as their observed incomes, adjusted for inflation. The difference in tax burdens is expressed as a percentage of an individual’s income and, hence, represents the increase in the average tax rate paid by an individual taxpayer. The main findings are that the fluctuation penalty is relatively largest for lower-income taxpayers, the unincorporated self-employed, and recipients of capital gains. The fluctuation penalty in Canada appears especially harmful for the poor and for potential entrepreneurs. Prior to 1989, provisions in the tax code allowed taxpayers to smooth their taxable incomes by using an average of more than one year’s income as the basis for calculating the tax liability. Reintroducing one or more of these provisions would help address the fluctuation penalty today.

The Option Value of Membership in a Defense Alliance

Membership in a defense alliance is viewed as an insurance option for a country subject to military threat. The focus is on the trade-off between domestically and internationally provided security as tax-financed public goods under heterogeneous risk classes of the members. A sufficient condition for a low-risk potential member to abstain from participation and a necessary condition for the participation of a high-risk potential member are stated. Disincentives for membership can include the cost of commitment in terms of the required production of the collective good, preemptive maneuvers, and ex post punishments of the enemy. The optimal tax is shown to be declining in the safety classification of a member subject to an adverse incentive effect of free riding. Solutions for the alliance size and the cost of membership are derived in the alliance equilibrium resorting to the fixed-point solution. With costly termination of membership, multiple equilibria can arise.

Analyzing the Effects of Insuring Health Risks

This paper quantitatively evaluates the trade-off between the provision of social insurance and the incentives to maintain good health through costly investments of labor market and health insurance policies. Our study is motivated by recent US legislation that has tightened regulations on wage discrimination against workers with poorer health status (such as the 2008 amendment of the Americans with Disability Act from 1990, the ADAAA) and that prohibits health insurance companies from charging different premiums for workers of different health (a provision in the Patient Protection and Affordable Care Act, PPACA, that went in effect in 2014). To do so we construct and estimate (using PSID and MEPS data) a dynamic model of health investments and health insurance in which the cross-sectional health distribution evolves endogenously and is shaped by labor market and health insurance policies.The static gains from better insurance against poor health induced by these policies are traded off against their adverse dynamic incentive effects on household efforts to lead a healthy life. In our quantitative analysis we find that although the competitive equilibrium features too little consumption insurance and a combination of both policies is effective in providing such insurance period by period, it is suboptimal (from an ex-ante welfare perspective) to introduce both policies jointly since such a policy innovation severely undermines the incentives to lead healthier lives and thus induces a more rapid deterioration of the cohort health distribution over time. This effect more than offsets the static gains from better consumption insurance so that expected discounted lifetime utility is lower under both policies, relative to implementing one policy in isolation.

The new Norwegian incentive system for publication: from bad to worse

The new Norwegian system for calculation of publication credits is examined. The new system was launched due to criticism for penalizing collaborative research. It turns out that adverse incentive problems emerge as a result of this system change. We show by a simple case, that institutions will benefit (credit-wise) by adding more authors to a scientific publication. Even worse, the beneficial effect increases the more authors the paper has initially. Alternative cases indicate even stronger incentives for co-author maximization.

Risk Adjustment for Medicare Total Knee Arthroplasty Bundled Payments.

The use of bundled payments is growing because of their potential to align providers and hospitals on the goal of cost reduction. However, such gain sharing could incentivize providers to "cherry-pick" more profitable patients. Risk adjustment can prevent this unintended consequence, yet most bundling programs include minimal adjustment techniques. This study was conducted to determine how bundled payments for total knee arthroplasty (TKA) should be adjusted for risk. The authors collected financial data for all Medicare patients (age≥65 years) undergoing primary unilateral TKA at an academic center over a period of 2 years (n=941). Multivariate regression was performed to assess the effect of patient factors on the costs of acute inpatient care, including unplanned 30-day readmissions. This analysis mirrors a bundling model used in the Medicare Bundled Payments for Care Improvement initiative. Increased age, American Society of Anesthesiologists (ASA) class, and the presence of a Medicare Major Complications/Comorbid Conditions (MCC) modifier (typically representing major complications) were associated with increased costs (regression coefficients, $57 per year; $729 per ASA class beyond I; and $3122 for patients meeting MCC criteria; P=.003, P=.001, and P<.001, respectively). Differences in costs were not associated with body mass index, sex, or race. If the results are generalizable, Medicare bundled payments for TKA encompassing acute inpatient care should be adjusted upward by the stated amounts for older patients, those with elevated ASA class, and patients meeting MCC criteria. This is likely an underestimate for many bundling models, including the Comprehensive Care for Joint Replacement program, incorporating varying degrees of postacute care. Failure to adjust for factors that affect costs may create adverse incentives, creating barriers to care for certain patient populations. [Orthopedics. 2016; 39(5):e911-e916.].

Executive Compensation and Misconduct: Environmental Harm

We explore the relationship between managerial incentives and environmental harm. We find that high-powered executive compensation packages can increase the odds of environmental law-breaking by 40-60% and the magnitude of environmental harm by over 100%. We document similar results for the setting of executive compensation and financial accounting misconduct. Finally, we outline some managerial and policy implications to blunt these adverse incentive effects.

Working Time Reductions at the End of the Career: Do They Prolong the Time Spent in Employment?

In this paper we study the effects on the survival rate in employment of a scheme that facilitates gradual retirement through working time reductions. We use information on the entire labour market career and other observables to control for selection and take dynamic treatment assignment into account. We also estimate a competing risks model considering different (possibly selective) pathways to early retirement. We find that participation in the scheme initially prolongs employment, as participants keep accumulating full pension rights. However, as participants become eligible for early retirement subsequently, these larger financial incentives induce them to leave the labour force prematurely. These adverse incentives are stronger for individuals who reduce their working time most. After two (four) years for men (women), the positive effects reverse. The more favourable effect for women is likely a consequence of their lower opportunities to enter early retirement. The gradual retirement scheme fails the cost-benefit test.

Working Time Reductions at the End of the Career. Do They Prolong the Time Spent in Employment?

In this paper we study the effects on the survival rate in employment of a scheme that facilitates gradual retirement through working time reductions. We use information on the entire labour market career and other observables to control for selection and take dynamic treatment assignment into account. We also estimate a competing risks model considering different (possibly selective) pathways to early retirement. We find that participation in the scheme initially prolongs employment, as participants keep accumulating full pension rights. However, as participants become eligible for early retirement subsequently, these larger financial incentives induce them to leave the labour force prematurely. These adverse incentives are stronger for individuals who reduce their working time most. After two (four) years for men (women), the positive effects reverse. The more favourable effect for women is likely a consequence of their lower opportunities to enter early retirement. The gradual retirement scheme fails the cost-benefit test.

Brown coal exit: A market mechanism for regulated closure of highly emissions intensive power stations

In this paper we propose a market mechanism for regulated exit of highly emissions intensive power stations from the electricity grid. The starting point is that there is surplus capacity in coal fired power generation in Australia. In the absence of a carbon price signal, black coal generation capacity may leave the market instead of high emitting brown coal power stations. We lay out options for a mechanism of regulated power station closure using a market mechanism. Plants bid competitively over the payment they require for closure, the regulator chooses the most cost effective bid, and payment for closure is made by the remaining power stations in proportion to their carbon dioxide emissions. This could overcome adverse incentive effects for plants to stay in operation in anticipation of payment for closure and solve the political difficulties and problems of information asymmetry that plague government payments for closure and direct regulation for exit. We explore the issues theoretically and provide empirical illustrations. These suggest that closure of a brown coal fired power station in Australia could yield emissions savings at costs that are lower than the social benefits. The analysis in this paper is applicable to other countries.

More Manipulation, Less Risk Taking?

Executive stock options are a dominant component of managers pay in the United States. This common compensation feature entails two perverse side effects: driving managers to engage in manipulative practices, and generating excessive risk-taking. Tellingly, some scholars blame the first side effect for the wave of Enron-style fraud in 2001-2002 and the second for the 2007-2010 financial crisis. To date, however, no one has investigated the interaction between these two types of adverse incentives, for manipulation and risk-taking. In this paper, we study the effects of manipulation practices on risk-taking decisions of managers holding large amounts of stock options. We first show that sufficient manipulation restrains excessive risk-taking but it does not impede managers from taking beneficially risky projects. We then show that mild levels of manipulation have complex effects on managers’ preference for risk taking, but they too tend to decrease risk taking. Our analysis suggests that when regulation improves disclosure and impedes manipulative practices, excessive risk taking may erupt. Policy-wise, we recommend that anti-manipulative regulatory policies be accompanied by measures designed to prevent excessive risk taking.

Target Ratcheting and Achievability of Earnings Targets

A fundamental problem of incentive contracting, often referred to as the ratchet effect, is that good performance in one period may be penalized by next-period targets that are more difficult to achieve. Several studies provide evidence that favorable performance relative to target is associated with target increases in the next period. The maintained assumption in much of this literature is that target revisions upward render targets more difficult to achieve. In contrast, our study uses data from a unique survey panel to directly examine whether favorable performance relative to target leads to next-period targets that are more difficult to achieve. First, we replicate prior results that favorable performance relative to target is associated with next-period target increases. Second, and contrary to the maintained assumption in prior work, we show that favorable performance relative to target is also associated with increases in the likelihood that next-period targets will be achieved. Thus, our results suggest that firms revise performance targets in a way that allows well-performing managers to repeatedly meet their targets. This is consistent with the theory that commitment facilitates multi-period contracting and allows firms to overcome the adverse incentive consequences of the ratchet effect.

Does the Implementation of Official User Charges Help to Eradicate Informal Payments - Lessons to be Learnt from the Hungarian Experience.

User fees for health care services are a frequently applied policy tool to improve efficiency by controlling demand and contain costs. It is also applied to increase resources for health care, especially when public resources are limited or the increase of income-related contributions is not feasible or not desirable. In addition, in Central and Eastern European (CEE) countries, where informal payments are widespread, the introduction of user fees is often promoted by politicians and policy makers as a potential policy tool to eradicate or “formalize” informal payments (1). Informal payments are unofficial cash payments or gifts in kinds directly given to the health care personnel before or after using health care services. The literature on informal payments suggests that these payments violate the idea of transparency in health care financing and the accountability of providers, which results in an inefficient use of health care resources and inequalities in access to health care Furthermore, informal payments create adverse incentives for their beneficiaries, which can be in conflict with the government’s policy objectives. (2). Thus, in the last decades in the CEE countries, several policies have been implemented to eradicate these payments, including the introduction of official user fees for health care services. However, there is no evidence that supports this expectation. On the contrary, there is evidence to suggest that patients continue to pay informally after the introduction of user fees (3–5). In this case, user fees induce a double financial burden on patients, aggravating the existing problems caused by the informal payments. This makes user fees even more unpopular among the public. According to the OECD Health Statistics in Hungary, the total health expenditure accounts for 8% of the GDP in 2012, with a per capita expenditure of 1,358 USD, which is lower than the OECD average. The share of out-of-pocket payments in total health expenditure has increased considerably during the last decades, and has reached 28.3% in 2012, and accounts for about 5% of the total household expenditure. This level is one of the highest among European OECD countries. Above 80% of these payments are co-payments for pharmaceuticals (80%). There are no official co-payments for health care services, however informal payments are widespread. Hungarian health care consumers have been paying informally for medical services on a routine basis, especially in in-patient care. According to a study carried out in 2010 around one-fifth of the respondents who used physician services during the last 12 months, made informal payments, on average 60 €, and almost half of the respondents who were hospitalized during the last 12 months, paid informally on average 130 € (6). Studies suggest that the scale of these payments has not changed considerably during the last two decades. (7). In 2007 in Hungary, official user fees were introduced for the use of health care services covered by the social health insurance. The introduction of these fees was one element of the reform package to contain health care cost. According to the documented policy objectives, it was expected that official fees will contribute to the eradication of informal payments (8). Although the amount of user fees was relatively low (about 1 € per physician visit and per day spent in hospital), the implementation met with strong political opposition and unpopularity among the public. One year later, in April 2008, the payments were abolished as a result of a population referendum initiated by the opposition party in the parliament, where more than 80% of the voters supported the abolishment of the fees (8). The introduction and abolishment of users fees in Hungary can be considered a natural experiment, and enable us to study the association of formal and informal charges. The aim of this paper is to summarize findings on this issue based on studies carried out to examine the Hungarian case, and draw some policy conclusions.

When Rock Trumps Paper: A Theory of Constitutional Resistance

When emergency provisions in the constitution are abused, they pose a threat to the legal order. Citizen mobilization has been proposed as a mechanism to constrain the executive from such abuses of power. Specifically, if the executive oversteps its authority, the opposition can overthrow the government by mobilizing citizens against the power maximizing behavior. Despite the abundance of contributions on citizen's activism, constitutionally protected resistance has been neglected. This paper covers the gap by proposing a definition of constitutional resistance, which distinguishes it from other forms of disobedience and protest. Moreover, the importance of properly delineating the right is discussed and it is argued that such a right is not simply a parchment barrier. Specifically, the paper theorizes that the inclusion of the right tips the scale in favor of resisting even minor transgressions, leading to a more constrained executive power. However, if the right is not properly delineated it creates adverse incentives, jeopardizing political stability.

Why the Three-Point Rule Failed to Sufficiently Reduce the Number of Draws in Soccer: An Application of Prospect Theory.

Incentives guide human behavior by altering the level of external motivation. We apply the idea of loss aversion from prospect theory (Kahneman & Tversky, 1979) to the point reward systems in soccer and investigate the controversial impact of the three-point rule on reducing the fraction of draws in this sport. Making use of the Poisson nature of goal scoring, we compared empirical results with theoretically deduced draw ratios from 24 countries encompassing 20 seasons each (N = 118.148 matches). The rule change yielded a slight reduction in the ratio of draws, but despite adverse incentives, still 18% more matches ended drawn than expected, t(23) = 11.04, p < .001, d = 2.25, consistent with prospect theory assertions. Alternative point systems that manipulated incentives for losses yielded reductions at or below statistical expectation. This provides support for the deduced concept of how arbitrary aims, such as the reduction of draws in the world's soccer leagues, could be more effectively accomplished than currently attempted.

Incentive effects of fiscal federalism: Evidence for France

AbstractThis paper provides an empirical analysis on the question whether equalization payments across regions and transfers from the central government stimulate regional growth or impede it. Using a panel of 22 French regions from 2002 to 2008, we find that regional economic growth is positively affected by the fiscal equalization system. We employ two indicators of this system: the transfer volume measure (approximated by either tax revenues in other regions or transfers to regions) and the marginal retention rate. Our main finding is that the transfer volume effect is positive for growth in both donor and recipient regions. Hence, we do not find any evidence that regional governments in France allocate transfers inefficiently. This finding contradicts previous empirical studies for federal countries that tend to find adverse incentive effects of fiscal equalization on regional governments and growth. A major explanation behind this result could be that the volume of the transfers in France may appear ...

Cui Bono, Benefit Corporation? An Experiment Inspired by Social Enterprise Legislation in Germany and the US

Abstract How do barely incentivized norms impact incentive-rich environments? We take social enterprise legislation as a case in point. It establishes rules on behalf of constituencies without institutionalized means of enforcement. By relying primarily on managers’ other-regarding concerns while leaving corporate incentive structures unaltered, how effective can such legislation be? We ran a laboratory experiment with a framing likened to German corporate law which traditionally includes social standards. Our results show that a stakeholder provision, as found in both Germany and more recent US regulation, cannot overcome material incentives. Yet even in the absence of adverse incentives the stakeholder duty does not foster other-regarding behavior. Our experiment illustrates the paramount importance of taking into account both incentives and framing effects when designing institutions. We tentatively discuss potential policy implications for social enterprise legislation and the stakeholder debate.

Primary Education in West Bengal – A Case of Moral Hazard

There has been a gross inefficiency in the delivery of primary education in the developing countries like India and the situation has continued to remain so for a long time. Though there has been political willingness in recent times to correct the imbalance the situation continues to be grim. One possible reason for this can be that stakeholders are not sufficiently empowered so that effective intervention on their part is not forthcoming. Also it may be possible that adverse incentives on part of the agents are creating a moral hazard problem which is perpetuating this inefficiency. In India the problem is more serious as an overwhelming majority of people has to depend on state run education system where education is a social good and normal market principles are quite ineffective here. The paper tries to look at the problem from the stakeholders’ point of view. With the help of some game theoretic tools we build up a model accompanied by some empirical evidences in support of the model where we try to understand the whole matter in a Principal-Agent framework.

The Value of NATO Option for a New Member

The paper introduces a welfarist approach to the national safety of a nation with membership in a defense alliance as an option. The members are risk averse but heterogeneous in their safety classification. There are two public goods as insurance devices, the domestic military budget and the incremental safety provided by the membership in the alliance. The commitment of the alliance in the creation of safety is, however, imperfect. A sufficient condition is stated for the non-membership. Under a positive option value of the membership, several adverse incentive effects shaping the option value are identified, including the incentive to free ride in domestic defense investment and a moral hazard effect in terms of national commitment to the defense effort. The cost of participation is determined in the spirit of the median voter theorem. The alliance equilibrium is shown to be of two potential types, a stable alliance equilibrium with a positive mass and or a degenerate one with one member only. The driving force in the adjustment of the alliance is its size relative to the safety class of the median voter. Expectations of the decision making of the co-members concerning the commitment can result in multiple equilibria.

‚Stairway to Heaven‘ oder ‚Highway to Hell‘? – Eine Einschätzung der Europäischen Bankenunion / ‚Stairway to Heaven‘ or ‚Highway to Hell‘? – An Evaluation of the European Banking Union

Zusammenfassung Der Beitrag beschreibt die wesentlichen Elemente der Europäischen Bankenunion (EBU) und prüft, inwieweit sie mikro- und makro-prudenzielle Stabilität im Bankensektor garantieren können. Es wird gefragt, ob es in Europa eines einheitlichen Regelwerks für Banken bedarf und ob die Bankenaufsicht besser bei der Notenbank oder bei einer bankspezifischen Aufsichtsbehörde liegen sollte. Zudem wird geprüft, ob ein einheitlicher Abwicklungsmechanismus für Banken und eine europaweite Einlagensicherung zweckmäßig sind. Außerdem wird untersucht, ob bei Konstruktion der EBU für die Finanzmarktstabilität relevante Elemente vernachlässigt wurden.