Impact of the Cost of Compliance on Business Performance

Tatya­na Kuz­net­so­va PhD in Eco­no­mic Sci­en­ces, As­so­ci­a­te Pro­fes­sor, Ins­ti­tu­te for the Per­son­nel Train­ing of the State Emp­loy­ment Ser­vi­ces of Uk­raine.

Sum­ma­ry

The ar­tic­le fo­cus­es on the the­o­re­ti­cal basis of tran­sac­ti­on costs, the main com­po­nent in the cost of comp­li­ance with the law. It de­li­vers two mo­dels: the analy­sis of the com­po­nents of the cost of comp­li­ance and the inf­lu­en­ce of the comp­li­ance cost on a busi­ness’s ear­ning power of the en­ter­pri­se.


The prob­lem. Alt­ho­ugh the le­gi­ti­macy of tran­sac­ti­on costs is re­cog­ni­zed by all aca­de­mic eco­no­mists, there is no ge­ne­rally ac­cep­ted ans­wers to the fun­da­men­tal quest­ions of this eco­no­mic ca­te­gory, na­mely:

  • What are tran­sac­ti­on costs?
  • Why are they inc­ur­red and in what form?
  • How to me­a­sure them?
  • What im­pact do they have on com­pany ef­fi­ci­ency?

The rep­re­s­en­ta­ti­ves of the two app­ro­a­ches, i.e. the Neo-clas­si­cal and the property rights app­ro­ach, make at­tempts at ans­we­ring the first quest­ion. There are dif­fe­rent in­terp­re­ta­tions of the na­tu­re of tran­sac­ti­on costs, but none of them gives a clear de­fi­ni­ti­on. I sug­gest the fol­lo­wing de­fi­ni­ti­on: tran­sac­ti­on costs are costs as­so­ci­a­ted with the est­ab­lish­ment, pro­tec­ti­on and exc­han­ge of property rights.

The ab­sen­ce of a ge­ne­rally ac­cep­ted in­terp­re­ta­ti­on for the na­tu­re of tran­sac­ti­on costs has led to the emer­gen­ce of va­ri­o­us the­ori­es that expla­in the ca­us­es and the forms of their exis­ten­ce. The most wi­des­pre­ad are the tran­sac­ti­on cost the­ory, the pub­lic cho­i­ce the­ory, the the­ory of ag­ree­ments, the cont­ract the­ory of the com­pany and the two-fac­tor model of tran­sac­ti­on costs. The aut­hors of these the­ori­es focus on ex­ten­sive forms of tran­sac­ti­on costs and at­tempt at explain­ing their exis­ten­ce th­ro­ugh these forms.

Analy­sis of stu­di­es and pub­li­ca­tions. Most fre­qu­ently, the fol­lo­wing forms of tran­sac­ti­on costs are exa­mi­ned in the eco­no­mic the­ory: the costs of in­for­ma­ti­on se­arch, the costs of neg­o­ti­a­tions and ag­ree­ments, the costs of de­ter­mi­ning the qu­a­lity of goods and ser­vi­ces, the costs of spe­ci­fi­ca­ti­on and pro­tec­ti­on of property rights and the costs of op­por­tu­nis­tic be­ha­vi­o­ur.

The most clear and rea­son­ab­le clas­si­fi­ca­ti­on of tran­sac­ti­on costs is based on these forms and was set up by O. Wil­li­am­son, who di­vi­des tran­sac­ti­on costs to those that pre­ce­de and those that fol­low the tran­sac­ti­on. S. Ar­k­hi­i­e­ri­e­i­ev, on the other hand, de­ve­lops and comp­le­ments Wil­li­am­son’s clas­si­fi­ca­ti­on with due cons­ide­ra­ti­on to the eco­nomy of Uk­raine and the clas­si­fi­ca­ti­on by H. de Soto. In his app­ro­ach, tran­sac­ti­on costs are di­vi­ded into comp­li­ance costs and costs of the il­le­gal eco­nomy.

H. de Soto’s clas­si­fi­ca­ti­on is the most app­rop­ria­te to de­ter­mi­ne the im­pact of tran­sac­ti­on costs on the per­for­mance of the in­di­vi­du­al en­ter­pri­ses and to expla­in the cho­i­ce of the ins­ti­tu­ti­o­nal en­vi­ron­ment (legal or il­le­gal). Re­se­ar­chers (with the ex­cept­ion of Ar­k­hi­i­e­ri­e­i­ev) only cons­ider ne­ga­tive tran­sac­ti­on costs, and dis­re­gard the value of these costs in­he­rent in a par­ti­cu­lar com­pany and their im­pact on the ef­fi­ci­ency of com­pany ope­ra­ti­on.

Ac­cord­ing to de Soto, tran­sac­ti­on costs comp­ri­se two com­po­nents: the comp­li­ance cost and cost of il­le­gal eco­nomy. It is pos­sib­le to eva­lu­a­te the im­pact of “tran­sac­ti­o­nal burd­en” on the ef­fi­ci­ency of en­ter­pri­ses by using the comp­li­ance cost, which con­sists of the cost of ac­cess to the law and the con­ti­nu­a­ti­on of ac­ting in comp­li­ance with the law. The for­mer inc­lu­de the cost of com­pany (legal en­tity) re­g­istra­ti­on, ob­tain­ing a li­cen­se, ope­ning a bank ac­count, ac­qu­i­ring a legal add­ress and other for­ma­li­ti­es. The lat­ter costs are as­so­ci­a­ted with tax pay­ment lia­bi­li­ti­es, ob­ser­va­ti­on of the law in the field of emp­loy­ment (wor­king hours, mi­ni­mum wages and so­ci­al se­cu­rity), pay­ment of the court costs of conf­lict re­so­lu­ti­on wit­hin the legal court sys­tem. It is well-known that many en­ter­pri­ses and com­pa­ni­es, not­withstand­ing the fre­qu­ently chang­ing tax and legal re­gu­la­tions, are shift­ing to the il­le­gal eco­nomy. This is expla­ined by the high tran­sac­ti­on costs re­la­ted to ac­ting wit­hin the bo­unds of the law.

Howe­ver, the imp­le­men­ta­ti­on of the cont­ract in il­le­gal sec­tor is also as­so­ci­a­ted with ex­pen­ses, “il­le­gal cost”.

De Soto iden­ti­fi­es the fol­lo­wing ele­ments in the comp­li­ance cost:

1. Costs as­so­ci­a­ted with the avo­ida­nce of legal sanc­tions. They inc­lu­de fees for the ser­vi­ces of tax and fi­nan­cial ad­vi­sors, in­co­me lost as a re­sult of “do­ub­le-ent­ry book­kee­ping”.

2. Costs re­la­ted to the trans­fer of in­co­me. All eco­no­mic ac­tors wit­ho­ut ex­cept­ion are sub­ject to pay in­di­rect taxes and in­fla­ti­on tax (first of all, it con­cerns the use of cash only) ac­com­pa­ny­ing il­le­gal exc­hanges. Tho­ugh the trans­fers are one-si­ded, so that the il­le­gal agents can not apply to the state se­e­king pro­tec­ti­on of the property rights.

3. Costs as­so­ci­a­ted with the avo­ida­nce of taxes and char­ges on sa­la­ri­es. They re­du­ce in­cen­ti­ves for the substi­tu­ti­on of la­bour by ca­p­ital and tech­ni­cal upgrad­ing. Cheap la­bour “dep­ri­ves” the com­pany. In ad­di­ti­on, gains from the non-pay­ment of VAT limit the scope of il­le­gal ac­ti­vity only by ext­re­me links in the pro­duc­ti­on chain – na­mely, re­ta­il sales and the ini­ti­al sta­ges of pro­ces­sing raw ma­te­ri­als.

4. Costs as­so­ci­a­ted with the lack of leg­ally fixed property rights. It is pos­sib­le to trans­fer the el­i­gi­bi­lity of property rights only to a li­mi­ted num­ber of people who may not ne­ces­sa­rily inc­lu­de a buyer wil­ling to pay the hig­hest price. Mo­re­o­ver, this ca­p­ital can­not be used as a bail, in­ves­ted, fre­ely sold or som­etimes even just pas­sed on as in­her­i­tance.

5. Costs as­so­ci­a­ted with the ina­bi­lity to use the cont­ract sys­tem. Il­le­gal cont­rac­ting pro­ce­du­res im­pe­de the re­a­li­za­ti­on of long-term ag­ree­ments, in which a large num­ber of eco­no­mic ac­tors is in­vol­ved. Since the be­li­ef that in any event the rights of in­ves­tors are pro­tec­ted stands for a real in­cen­tive for in­vestment in a long-term pro­ject.

6. Costs as­so­ci­a­ted with the two-si­ded na­tu­re of the il­le­gal cont­racts.

7. Cost as­so­ci­a­ted with ac­cess to the il­le­gal pro­ce­du­res in dis­pu­te re­so­lu­ti­on.

Legal ju­di­ci­al sys­tem has a num­ber of substi­tu­tes like fa­mily and mafia conf­lict re­so­lu­ti­on me­chan­isms. The use of these al­ter­na­ti­ves is att­ri­bu­ted to the cost of ma­in­tain­ing fri­endly re­la­tions with nu­me­rous re­la­ti­ves, count­ry­men and other ‘fel­low’ people tak­ing time and money to pro­vi­de signs of att­rac­ti­on and the exc­han­ge of ser­vi­ces. Re­quest for the ser­vi­ces of mafia per­form­ing the func­tions of ju­di­ci­al and law en­for­ce­ment or­ga­ni­za­tions is expla­ined by the need to pay a par­ti­cu­lar tax. The eco­no­mic par­ti­ci­pants’ se­lec­ti­on of the ins­ti­tu­ti­o­nal en­vi­ron­ment for their busi­nes­ses, whet­her legal or il­le­gal, is de­fi­ned by the cor­re­la­ti­on of the comp­li­ance cost and the cost of the il­le­gal eco­nomy.

The pur­po­se of the study is to iden­ti­fy the most im­por­tant com­po­nents of the comp­li­ance cost and as­ses­sing its im­pact on the pro­fi­ta­bi­lity of en­ter­pri­ses.

Pre­s­en­ta­ti­on of the basic ma­te­ri­al. With the help of ex­pe­ri­men­tal eva­lu­a­tions and sta­tis­ti­cal cal­cu­la­tions, the cost of ac­cess to law inc­ur­red by Uk­ra­i­ni­an en­ter­pri­ses has been de­fi­ned. Ni­nety en­ter­pri­ses were sur­veyed in Kyiv, Dni­pro­p­et­rovsk and Za­po­rizhzhia. Stu­di­es show that the ex­pen­ses as­so­ci­a­ted with reg­is­te­ring a li­mi­ted lia­bi­lity com­pany amount to USD 240 (and take 7 to 30 days, the cost of re­g­istra­ti­on via in­ter­me­di­ary com­pa­ni­es is bet­ween USD 350 and 600, and take 4–15 days. The re­g­istra­ti­on of pri­vate joint stock com­pa­ni­es cost USD 1500 to 1900 (and take bet­ween 35 days and 3 months), and USD 3,000 to 5,000 th­ro­ugh in­ter­me­di­ary com­pa­ni­es (re­qu­i­ring 18 to 30 days).

Ac­cord­ing to a re­se­arch by the World Bank, the aver­age cost of ac­cess to law for Uk­ra­i­ni­an ent­rep­re­ne­urs in 2015 was USD 97.3 (inc­lu­ding USD 33 pri­vat­ely paid funds), and part of the cost of con­ti­nu­ing ope­ra­ti­on wit­hin the law, cons­idered as fi­nan­cial los­ses th­ro­ugh inspec­ti­on ac­ti­vi­ti­es, re­qu­i­red an aver­age of USD 1,177.8. Cons­ider­ing that pay­ments to the bud­get amount to 40% of the in­co­me (and it also cons­ti­tu­tes costs as­so­ci­a­ted with con­ti­nu­ed ope­ra­ti­on wit­hin the law), it is clear that, firstly, the comp­li­ance cost is rat­her high and, and se­condly, the lion’s share of the “burd­en of tran­sac­ti­on” is due to the tax com­po­nent. My sur­vey shows that the es­sen­ti­al com­po­nent of the comp­li­ance cost in Uk­raine be­longs to tax comp­li­ance. Thus, taxes on in­co­me range bet­ween 21 and 35%. This expla­ins the low level of app­li­ca­ti­on of the law to en­sure the daily func­tion­ing of the com­pa­ni­es. Al­most all the aut­hors exa­mi­ne the im­pact of one or more taxes on the com­pany’s ef­fi­ci­ency or its pro­fi­ta­bi­lity. That is to say, it is rea­son­ab­le to study the total ef­fects of tax pres­su­re on busi­nes­ses, be­ca­u­se in this case it is pos­sib­le to exp­lo­re the sy­ner­gis­tic ef­fect of joint inf­lu­en­ce of taxes.

Met­ho­do­log­i­cal guide­li­nes have been de­vel­oped to as­sess the im­pact of the comp­li­ance cost.

In the first stage the com­pany’s ef­fi­ci­ency is eva­lu­a­ted, and the comp­li­ance cost and its com­po­nents are de­ter­mi­ned. The pur­po­se of this stage is to ob­ta­in the in­for­ma­ti­on re­qu­i­red for buil­ding eco­no­met­ric mo­dels and creat­ing sta­tis­ti­cal da­ta­ba­se for furt­her analy­sis.

The se­cond stage aims at est­imat­ing the sig­ni­fi­cance of the cons­ti­tu­ents of comp­li­ance cost. The pur­po­se of this stage is to build an eco­no­met­ric model for the comp­li­ance cost and to de­ter­mi­ne its es­sen­ti­al com­po­nents.

In the third stage the im­pact of the main com­po­nents of the comp­li­ance cost on busi­ness pro­fi­ta­bi­lity is as­ses­sed. The pur­po­se of this stage is to build an eco­no­met­ric model to de­ter­mi­ne the im­pact of the comp­li­ance cost.

The met­ho­do­log­i­cal guide­li­nes were app­ro­ved for road con­struc­ti­on en­ter­pri­ses. The fi­nan­cial con­di­tions of these busi­nes­ses were analy­sed on the basis of their sta­tus, pro­fi­ta­bi­lity, ef­fi­ci­ency, sol­vency and busi­ness ac­ti­vity.

The ef­fi­ci­ency est­ima­te has shown that du­ring the sur­vey, all com­pa­ni­es were ope­rat­ing in an un­sus­ta­in­ab­le man­ner.

An eco­no­met­ric model (1) has been set up with comp­li­ance cost as a de­pen­dent fac­tor, and value added tax, in­co­me tax, so­ci­al cont­ri­bu­tions and ad­mi­nistra­tive costs as in­de­pen­dent fac­tors.

TYA­GAR= 1,015409277 ADM0,4326557487 * VAT0,4821704674* SOC0,3058248766* PROT0,02457605771,(1)

where TYA­GAR is the comp­li­ance cost, thou­sand UAH; PROT is the in­co­me tax, thou­sand UAH; SOC stands for so­ci­al cont­ri­bu­tions, thou­sand UAH; VAT stands for the value added tax, thou­sand UAH; ADM stands for ad­mi­nistra­tive costs (exc­lu­sive of costs which are not tran­sac­ti­o­nal), thou­sand UAH; C stands for the cons­tant, which de­ter­mi­nes the deg­ree of inf­lu­en­ce of fac­tors not inc­lu­ded into the model.

The ade­qu­acy of the model was eva­lu­a­ted by mul­tip­le de­ter­mi­na­ti­on co­ef­fi­ci­ents

R2iR2, F-sta­tis­tics and stan­dard de­vi­a­ti­on. The high value of co­ef­fi­ci­ents R2iR2 (R2 = 0.9994, R2 = 0.992), F-sta­tis­tics (5438,93) and the low value of the stan­dard de­vi­a­ti­on (0,23) con­firm the ade­qu­acy of the model.

The sta­tis­ti­cal sig­ni­fi­cance of the com­po­nents inc­lu­ded in the model was also con­fir­med by the tests (stan­dard de­vi­a­ti­on of the reg­r­es­si­on co­ef­fi­ci­ent, t-sta­tis­tics P). This model (1) en­ab­led the as­sess­ment of the im­pact of the comp­li­ance cost com­po­nent and re­ve­aled that:

  • 1% inc­re­a­se in ad­mi­nistra­tive costs inc­re­as­es the comp­li­ance cost by 0.43%;
  • 1% inc­re­a­se in VAT inc­re­as­es the comp­li­ance cost by 0.48%;
  • 1% inc­re­a­se in so­ci­al cont­ri­bu­tions inc­re­as­es the comp­li­ance cost by 0.31%;
  • 1% inc­re­a­se in the in­co­me tax inc­re­as­es the comp­li­ance cost by 0.025%.

The cu­mu­la­tive im­pact of these fac­tors on the comp­li­ance cost re­ve­aled that 3% and 5% dec­re­a­se in the value added tax and in the in­co­me tax, respec­ti­vely, com­bi­ned with 1% inc­re­a­se in the ad­mi­nistra­tive costs and in so­ci­al cont­ri­bu­tions, inc­re­a­se the comp­li­ance cost by 0.8%. The re­sults of the eco­no­met­ric analy­sis ack­now­ledge that the ad­mi­nistra­tive costs are the most im­por­tant com­po­nent in the comp­li­ance cost, along with the tax com­po­nent, which inc­lu­des value added tax, in­co­me tax and other taxes and fees. The­re­fo­re, an eco­no­met­ric model was built in the third stage for the pur­po­se of as­ses­sing the inf­lu­en­ce of the most im­por­tant comp­li­ance costs cons­ti­tu­ents on the pro­fi­ta­bi­lity of the en­ter­pri­ses.

Model (2) is as fol­lows:

NPROF = 3.64326 * TAXE-1,068571 * ADM-0,754974, (2)

where NPROF stands for the net pro­fit, thou­sand UAH; TAXE stands for the tax com­po­nent of su­bor­di­na­te to law cost, thou­sand UAH; ADM stands for ad­mi­nistra­tive costs,

thou­sand UAH. High co­ef­fi­ci­ents R2 (0.873648), R2(0.82344) and F-sta­tis­tics (13.41714), and the low value of the stan­dard de­vi­a­ti­on (0.31) prove the model ade­qu­acy.

The eva­lu­a­ti­on of the tests of the model pa­ra­me­ters pro­ves their sta­tis­ti­cal sig­ni­fi­cance.

This model (2) sug­gests that 1% tax inc­re­a­se ca­us­es 1.07% dec­line in the net pro­fit, and if the ad­mi­nistra­tive costs inc­re­a­se by 1%, the net pro­fit dec­re­as­es respec­ti­vely by 0.75%. The com­bi­ned ef­fect of the al­te­ra­ti­on in both fac­tors will re­du­ce the pro­fit by 1.82%.

Conc­lu­sions. The de­vel­oped mo­dels can be used by ma­nag­ement ex­perts at va­ri­o­us le­vels to as­sess the im­pact of changes in tax leg­i­sla­ti­on and other re­gu­la­to­ry me­a­sures on the pro­fi­ta­bi­lity of en­ter­pri­ses and busi­nes­ses, and for fo­re­casting their pro­fits by chang­ing the un­derly­ing tax rates and the value of ad­mi­nistra­tive costs.

Re­fe­ren­ces

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