International charity under asymmetric information

Economics Letters 74 (2001) 107–111 www.elsevier.com / locate / econbase

International charity under asymmetric information Marie-Franc¸oise Calmette a , Maureen Kilkenny b , * a

ARQADE, Universite des Sciences Sociales, 21 Allee de Brienne, Bat. F 31000 Toulouse, France b Department of Economics, Iowa State University, 181 Heady Hall, Ames, IA 50011, USA Received 16 October 2000; accepted 24 June 2001

Abstract International charity is often subject to moral hazard and adverse selection problems. We show that the burden of informational asymmetries are borne by the most needy countries, even when charities design incentive contracts which limit the rents that some countries can extract.  2001 Elsevier Science B.V. All rights reserved. Keywords: International charity; Incentive contracts JEL classification: D82; F35; I38; O19

1. Introduction Charities spend billions of dollars annually to help people in other countries survive famines and hardships due to natural or man-made disasters. Information asymmetries mean that charitable activities are subject to moral hazard and adverse selection problems. Thus, empirical evidence shows that too little charity goes to the truly needy, and too much to countries that exaggerate their needs and / or shirk (Alesina and Weder, 1999). This paper models how and why international charity encourages recipient governments to shirk, and why the payment of informational rents cannot be avoided. We adapt the analytical framework from the optimal tax / income maintenance program design field that is used to explain how transfers encourage socially inefficient and self-enriching personal choices (Besley and Coate, 1992; Kanbur et al., 1994). The impacts of information asymmetries on domestic transfer program outlays and individual incentives are well-known (cf., Besley and Coate, 1995). Participants may reduce work effort or migrate in order to qualify for more benefits. In this paper we show the impacts of asymmetric information on foreign charity transfers and government incentives. * Corresponding author. Tel.: 11-515-294-6259; fax: 11-515-294-3838. E-mail address: [email protected] (M. Kilkenny). 0165-1765 / 01 / $ – see front matter PII: S0165-1765( 01 )00526-2

 2001 Elsevier Science B.V. All rights reserved.

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We develop the model sequentially from a base case of self-sufficiency. A disaster undermines the country’s self-sufficiency. We compare unconditional charity to conditional charity with asymmetric information. Finally, we characterize the optimal incentive contract for the principal-agent problem where the recipient country is also required to internalize the cost of international transfers under incomplete information.

2. Self-Sufficiency Consider a country with rich and poor citizens. They are ‘rich’ if their income is high, denoted YH , with probability P $ 0. With probability (1 2 P ) they are ‘poor’ with the income YL that is lower than the subsistence minimum, Z; YH . Z . YL . The government’s objective is to maximize household income while guaranteeing that all citizens survive. It has two tools: it can transfer income, Z 2 YL , to each of the poor, and devote public resources, g, to increase the probability that citizens are rich. Both are financed by taxes, t, on the rich. Public works affect the probability that YH is realized. With public works, the probability of being rich is P( g), with P(0) 5 P, P9( g) . 0, P0( g) , 0, and lim P( g → `) , 1. The share of the population that is poor is 1 2 P( g). The government chooses g to maximize its objective function which is, with the survival condition internalized, N 5 (1 2 t)P( g)YH 1 (1 2 P( g))Z

(1)

subject to the balanced-budget constraint: tP( g)YH 5 g 1 (1 2 P( g))(Z 2 YL )

(2)

The optimal level of spending on public works, g*, equates the expected marginal benefit of public works to the marginal cost: P9( g*)(YH 2 YL ) 5 1

(3)

The marginal benefit from public works is the expected increase in net national income. The higher is the marginal efficiency of public works, the less need be spent on income transfers. To those who remain poor, the transfer guarantees subsistence: (1 2 P( g*))(Z 2 YL ). As long as public works productivity and rich incomes are high enough, the budget constraint (2) can be satisfied and the country is self-sufficient. A disaster, like a flood or a war, that reduces the productivity of public works, the incomes of the rich, and / or incomes of the poor may force a country into dependency on foreign transfers.

3. Information asymmetries In this section we show the moral hazard and adverse selection aspects of foreign charity. Consider a disaster that reduces the productivity of public works from P( g) to ] P( g), such that the government must spend more, gD . g, for P( g) 5P( ] gD ), but has no effect on marginal productivity. If it does not spend more on public works, the disaster will increase the portion of the population below

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subsistence. A charity that shares the country’s concern for the survival of all citizens offers to assume the burden of providing income transfers of the amount U 5 (1 2P( ] g))(Z 2 YL ). This relaxes the country’s budget constraint to: tP( ] gM )YH 5 gM

(2 M )

where subscript ‘M’ denotes the moral hazard situation. The government’s problem is still to choose g to maximize net household income. Given the disaster and the charity’s affect on the budget constraint, this is: NM 5P( ] gM )YH 1 (1 2 (Pg ] M )) Z 2 gM

(1 M )

which implies that the country would choose the level of public works to satisfy: P9( ] gM )(YH 2 Z) 5 1

(3 M )

This shows that ex post, a country reduces spending on public works even though the charity has assumed the entire cost of transferring income to the destitute. Since ] P9( g) 5 P9( g) and Z . YL , (3 M ) shows the moral hazard result: the amount spent on public works is lower, since the marginal product at that level, ] P9( gM ), is higher. This shirking further increases the proportion of poor, in addition to the increased poverty due to the disaster. If the charity can observe both the actual effort and the outcome of the effort, it can commit to withhold aid until the recipient country exerts a satisfactory effort. This is related to the Samaritan’ s dilemma (Buchanan, 1975; Lindbeck and Weibull, 1988; Coate, 1995). In the ideal perfect information case, if the recipient exerts sufficient self-help effort which internalizes all costs, the charity can offer the ex ante anticipated amount of transfers to raise the incomes of the poor to the target minimum. This is a principal-agent problem. Given a marginal cost, l, of charity transferred internationally, the recipient country government must provide a higher level of public works, such that:

* * P9(g ] ] A )(YH 2 YL ) 1 lP9(g ] ] A )(Z 2 YL ) 5 1

(4)

When there are ex ante information asymmetries, there is also an adverse selection problem. Assume ] the disaster reduces public works efficiency either a little, ] P( g), or a lot, P( g). It is possible for a recipient of charity to obtain an informational rent by pretending that the disaster reduced their efficiency a lot. If the charity does not realize that the recipient country is misrepresenting itself, it applies the rules determined above. The contract offered to the dishonest country would be a higher ] level of transfers (1 2P(g] *A ))(Z 2 YL ), and a lower level of public investment g] *A , such that ] ] ] P9(g *A )(YH 2 YL ) 1 lP9(g] *A )(Z 2 YL ) 5 1. There are four consequences. First, the public works requirement is lower than it should be. Second, the lower public works means more poor. The income distribution will be more skewed. Third, since public spending is lower, the rich will pay lower taxes. The rich in the recipient country free ride on the donor agency. Fourth, the country receives more than it deserves in transfers. This is the rent captured by a government that exploits its hidden information. This adverse selection problem cannot be solved merely by making a conditional contract as if information were complete.

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4. Mechanism design To overcome a recipient’s incentive to pool with countries where public works are less productive, or which were worse hurt by the disaster, a charity must offer compensation. This compensation should be sufficient to induce country governments to represent themselves honestly. Assume the donor knows only that a country is less hurt P( g) 5P( ] g), with probability a, or worse ¯ hurt P( g) 5 P( g), with probability (1 2 a ). The charity should offer a contract that maximizes expected social welfare under participation and incentive compatibility constraints. The incentive compatibility constraint for a less hurt country is that its net national income, under the contract designed for it, is as least as great as under the other contract (where subscript ‘i’ denotes the incentive contract scenario): ¯ ¯ ¯ ¯ U 1P( ] ] gi )YH 1 (1 2P( ] gi ))YL 2 gi $ U 1P(g ] i )YH 1 (1 2P(g ] i ))YL 2 gi

(5)

The difference between the LHS and RHS is the informational rent that a corrupt, less hurt country can capture even if mechanism design is used. Taking these constraints into account, the donor chooses transfers and conditions to maximize expected global welfare: ]] ]] ] ] S 5 a [P(g ] ]i )YH 1 (1 2P(g ] ]i )YL 2g]i 2 lU ] ] 1 (1 2 a )[P(gi )YH 1 (1 2P(gi ))YL 2gi 2 lU ] The solution is a set of incentive contracts (I and II), which are:

(6)

] * ] ] i* )](YH 2 YL ); (Ia) a gross transfer of ] U 5U 1 (g *i 2g] *i ) 2 [P(g ] ] i ) 2P(g ] (Ib) a public investment requirement g *i , such that ] P9(g *i )(YH 2 YL ) 5 1; and ] ] ] ] * (IIa) a transfer of U 5 (1 2 P(g i ))(Z 2 YL ); (IIb) a public investment requirement, ]g *i , such that: ] ] ] ] * * * al[P9( g *i )(Z 2 YL ) 1 1 2P9( ] g i )(YH 2 YL )] 1 (1 2 a )[P9(g i )(YH 2 YL ) 2 1 1 lP9( g i )(Z 2 YL )] 5 0. If a country is less hurt, Contract I will be preferred and will be chosen by it. The worst hurt countries are better off with, and will choose, Contract II. Only the former types capture rents. Three effects of information asymmetries are clear, while a fourth effect is ambiguous. First, as predicted, a charity must provide rents to less hurt countries, to solve the adverse selection problem and induce that type to accept Contract I. Second, the level of public works in Contract I, while lower than the perfect information case (4) by the administrative cost of international charity is, however, equal to the level of public investment that would be optimal in the absence of charity. Thus, the mechanism solves the moral hazard problem. Third, the transfer in Contract II for the worst hurt is what it would be under complete information. They cannot extract rents. The relative level of effort required of worst hurt countries (IIb), however, may be higher or lower, depending on the productivity differences between recipient countries and initial income disparities between classes (details from the authors on request). Furthermore, Contract II requires the most needy to internalize the costs of funds, while Contract I does not. The magnitude of the burden on the more needy depends on the magnitude of the uncertainty (a ) as well as on the costs of transferring funds internationally ( l).

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5. Conclusions The empirical evidence indicates that there is a positive relationship between the level of corruption and the level of aid a country receives from other countries (Alesina and Weder, 1999), and a negative relationship between aid and own effort (Cashel-Cordo and Craig, 1997). Focusing on the simple problem of international transfers of income, which is charity as opposed to aid, we presented a model showing the basis of these adverse selection and moral hazard problems. We show that the less needy can earn informational rents and the more needy bear the costs of informational asymmetries, even when charities use incentive contracts.

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