A wide variety of human relationships and institutions, from the most friendly to the most antagonistic, must tackle the thorny problem of value: how can we securely distinguish, using the inputs of our fallible senses, that which we value from that which we do not? How can we figure out what another person values? Money, wage labor, markets, and many other economic institutions take the forms they do primarily because they solve problems of measuring value. Such questions also lie at the heart of the current crisis in accounting.
Questions of value are inherently subjective and personal. Value is very different from the objective phenomena of physics, chemistry, and the like. Societies have evolved institutions such as firms and competitive markets to set prices, legal precedents and judicial proceedings to make judgments, and so forth. These institutions in turn often rely on answering the second question, the topic of our essay -- how can we securely determine value from what we observe? We will examine tax collection as an antagonistic instance of the measurement problem. The last section of this essay will focus on a particular institution developed to measure value -- accounting -- and suggest how it might rise to challenge the radical changes underway in our services and information economies.
In the competitive market, one commodity is traded for another. (Money is just a particularly interesting kind of commodity). In order for this market to work -- in order for prices to accurately communicate value -- first the participants must be able to measure the value of the two commodities traded. Indeed, that's the main property that distinguishes a commodity from a less economically tractable good or service -- the ability of parties to measure its value -- the ability of parties to observe properties of a good or service, matching what they observe against their private preferences, and making sure this process isn't spoofed by wily traders.
The competitive market model was so successful that modern economists are now approaching other economic institutions that we take for granted -- such as the firm -- and asking why they exist at all! They are working backwards from a very clear theory of competitive markets to explain the wide variety of other kinds of economic relationships, usually formalized by property rights and contracts, that we enter into. This school is most widely known as the "transaction cost" school of economics. Often it is referred to as "new institutional", or "property rights school." The idea of transaction costs was developed by Nobel prize winning economist Ronald Coase. His brilliant heirs include Oliver Hart and Oliver Williamson, along with Steve Cheung, Yoram Barzel, Armen Alchian, Harold Demsetz, Janet Landa, Robert Ellickson, and many others.
By comparing a wide variety of contractual forms to the ideal commodity market, and by re-using many of the same assumptions used by neoclassical economists -- individuals with rational self-interest, unique preferences, and unique skills -- we are better understanding these other economic institutions. Modern economies contain a wide variety of commercial institutions, from hierarchically commanded firms on the one hand to freely competitive commodity markets on the other. In between are a wide variety of institutions and the contracts that formalize them.
When somebody starts a new company rather than hiring on as an employee at a current one, we can think of this decision as a "vote" that the economy needs more market relationships and less employee-employer relationships. Contrariwise, when one firm buys out another, they are implicitly betting that the economy needs less market and more firm. Socialists, seeing the trends of integration and economies of scale in industrial capitalism, thought the world would end up as one big firm, and decided this firm should be run by the government. That worked out horribly. Others have idealized a world in which there are no firms -- everybody is a private contractor, selling their services to other individuals. In many industries that's a non-starter as well. Oliver Williamson and other economists have studied many of these forms and come up with some criteria that make competitive commodity markets less than perfect, causing other contractual forms to be used. (Here "contractual form" is shorthand for a certain kind business relationship -- employment, franchising, commodity exchange, etc. The contract used by the parties is usually the most formal and complete description of their relationship, as well as the "security protocol" that defines the basic rules of the relationship).
These economists have identified a number of limitations of ideal commodity exchange that often cause other contractual forms to be used instead. These include
(1) security costs. Other kinds of transaction costs are incurred from parties that are opportunistic -- they are self-interested, but they follow the letter if not necessarily the spirit of the rules of a relationship (whether these rules are legal, contractual, or informal). Security costs are incurred from, or to protect a relationship against, parties that are outright malicious -- they might break any of the rules, use threats of force, or actually carry out acts of trespass, theft, or violence, in order to satisfy their (alas, not so rare) coercive kinds of preferences.
(2) rule incompleteness -- the difficulty for parties to anticipate all contingencies that might occur in a relationship, and thus the inability to plan for them with rules (for example, by terms in a contract). Most disputes that go to court, and most interesting new legal precedents, occur over situations that the parties entering into a relationship didn't foresee well enough to deal with up front.
(3) exit costs and/or investments that are specific to a particular relationship. For example, when you take a class to learn how to use Windows or Word, you are investing in a relationship with Microsoft. Another example is when a railroad is built to a coal mine -- the railroad now depends on the mine for business, and the mine operator depends on the railroad to ship his coal. A third example is the layout on a factory floor, where the results of one machine's operation feed into another specific machine. The most common examples are employees developing relationships and learning skills that are specific to a particular job. In these kinds relationships with high investments or exit costs, without good contractual safeguards you can end up stuck in a bad relationship -- even if it goes sour, the other guy cheats on you, it may be too expensive to exit the relationship, or you may lose your investment.
When there is both lack of ability to specify rules and relationship specific investments, the result is often vertical integration into a single firm. The coal mine might buy the railroad, the machine operations occur on a factory floor owned by a single company, and so on. On the other hand, a firm has diseconomies of scale due to the increasing inability to match preferences to skills in larger firms. As Friedrich Hayek pointed out, diseconomies of scale in the distribution of knowledge about skills and preferences are a big reason why socialism works so much more poorly than market economies. More generally, these diseconomies limit firm size. Certain innovations (such as in accounting at the beginning of the industrial revolution, or in supply chain management in the last two decades) have improved the reliable distribution of knowledge within a firm and thereby allowed firms to grow larger.
Innovations that better cover contingencies or reduce the need for relationship specific investments and exit costs can disadvantage larger firms and advantage a larger number of smaller firms. Rather than an commodity market often a contractual form intermediate between a market and a firm, such as a franchise, is used. A franchise is a long term contract that, roughly speaking, specifies many basic rules for operating a business but leaves temporary or unique problems to the discretion of the local operator.
(4) We will shortly turn to perhaps the most important kind of transaction cost, the measurement of value, the main subject of our essay.
Before we do that, however, let us note that these kinds of transaction costs, while first studied in the context of markets, are not confined to markets or even market-embedded institutions. They occur any time a good is transferred or a service rendered according to a set of rules or customs, however simple or complicated. Not only do these transaction costs provide a basis for comparing non-market or extra-market institutions such as the firm to the market; they also apply to a wide variety of other institutions, including many we may not typically think of as economic institutions. So, for example, the ancient institutions of inheritance, marriage, tribute, tax collection, and tort law all involved an important component of wealth transfer. All are subject to the main kinds of transaction costs outlined here -- including that of our main topic.
Even this simple case of trading blood for blood, is, however, far more complicated then it seems. Just how do the bats estimate the value of blood they have received? Do they estimate the value of a favor by weight, by bulk, by taste, by its ability to satiate hunger, or other variables? Just the same, measurement complications arise even in the simple monkey exchange of "you scratch my back and I'll scratch yours".
For the vast majority of potential exchanges, the measurement problem is intractable for animals. Even more than the easier problem of remembering faces and matching them to favors, the ability of both parties to agree with sufficient accuracy on an estimate of the value of a favor in the first place is probably the main barrier to reciprocal altruism among animals.
It is also likely the most important barrier to exchange among humans. Many kinds of exchange, probably many more than most economists perceive, are rendered infeasible by the inability of one or both parties to the exchange to estimate its value. For most of human history, most kinds of markets that are possible today were not then feasible, in large part due to the inability of potential market participants to measure value: to estimate the value of the transaction to themselves and then use these estimates to discover and agree on a common objective measurement. Measurement of value was and is also important to the development of many economic institutions related to markets. Accounting, which we will examine below, was crucial to the development of large companies and modern systems of taxation.
The process of determining the value of a product from observations is necessarily incomplete and costly. For example, a shopper can see that an apple is shiny red. This has some correlation to its tastiness (the quality a typical shopper actually wants from an apple), but it's hardly perfect. The apple's appearance is not a complete indicator -- an apple sometimes has a rotten spot down inside even if the surface is perfectly shiny and red. We call an indirect measure of value -- for example the shininess, redness, or weight of the apple -- a proxy measure. In fact, all measures of value, besides prices in an ideal market, are proxy measures -- real value is subjective and largely tacit.
Such observations also come at a cost. It may take some time to sort through apples to find the shiniest and reddest ones, and meanwhile the shopper bruises the other apples. It costs the vendor to put on a fake shiny gloss of wax, and it costs the shopper because he may be fooled by the wax, and because he has to eat wax with his apple. Sometimes these measurement costs comes about just from the imperfection of honest communication. In other cases, such as waxing the apple, the cost occurs because rationally self-interested parties play games with the observable.
Measures are critical components of institutions-- such as auctions, contracts, accounting systems, legal damage rules, tax rules, etc. -- that align incentives between parties who, prior to participating in the institution, have incompatible incentives. We can divide the measurement problem into two components -- the first, choosing the phenomena and units that will be measured, and second, measuring those attributes in a way that minimizes spoofing of the measure between parties whose incentives with respect to the value are misaligned.
Cost can usually be measured far more objectively than value. As a result, the most common proxy measures are various kinds of costs. Examples include:
(a) paying for employment in terms of time worked, rather than by quantity produced (piece rates) or other possible measures. Time measures sacrifice, i.e. the cost of opportunities foregone by the employee.
(b) most numbers recorded and reported by accountants for assets are costs rather than market prices expected to be recovered by the sale of assets.
(c) non-fiat money and collectibles obtain their value primarily from their scarcity, i.e. their cost of replacement.
We now look at a particularly challenging set of measurement problems -- those faced by a tax collector. Taxation being the least cooperative kind of economic relationship -- the incentives between the parties being the most misaligned -- the measurement game played between the parties takes its most serious form.
From the point of view of many taxpayers this is an incredible claim, given that tax collectors take money we ourselves know how to spend quite well, thank you, and often spend it on amazingly wasteful activities. And the rules by which they take it often seem quite arbitrary. Tax rules are usually complex but nevertheless fail to let us account for many events important to the earning of our incomes that differentiate us from other taxpayers.
How the money gets spent is outside the scope of the claim that tax collectors are uncommonly efficient. It is the collection process itself that is the subject of that claim, and the tax collection rules. This essay will demonstrate the efficiency of tax collector's rules by two arguments:
(1)First, we will show why tax collectors have an incentive to be efficient (and what "efficiency" means in this context)
(2)Second, we will explore the problem of creating tax rules, and see how the difficulty of measuring value rears its ugly head. Tax rules solve the value measurement problem through brilliant, often very non-obvious solutions similar to solutions developed in the private and legal sectors. Often (as, for example, with accounting) tax collectors share solutions used to measure value in private relationships (such as the absentee investor-management relationship in joint stock corporations). It is in making these very difficult and nonintuitive trade-offs, and then executing them in a series of queries, audits, and collection actions, that tax collectors efficiently optimize their revenue, even if the results seem quite wasteful to the taxpayer.
The tax collector's incentives are aligned with the other branches of their government in a task that benefits all associated with the government, namely the collection of their revenue. No organization of any type collects more revenue with fewer expenditures than tax collection agencies. Of course, they have the advantage of coercion, but they must overcome measurement problems that are often the same as other users of accounting systems, such as owners of large companies. It is not surprising, then, that tax collectors have sometimes pioneered value measurement techniques, and often have been the first to bring them into large scale use.
Like other kinds of auditors, the tax collector's measurement problem is tougher than it looks. Investment manager Terry Coxon has described it well. Bad measures or inaccurate measurements allow some industries to understate their income, while forcing others to pay taxes on income they haven't really earned. Coxon describes the result: the industries that are hurt tend to shrink. The industries that benefit pay fewer taxes than could be extracted. In both cases, less revenue is generated for the tax man than he might be able to get with better rules.
This is an application of the Laffer curve to the fortunes of specific industries. On this curve, developed by the brilliant economist Arthur Laffer, as the tax rate increases, the amount of revenue increases, but at an increasingly slower rate than the tax rate, due to increased avoidance, evasion, and most of all disincentive to engage in the taxed activity. At a certain rate due to these reasons tax revenues are optimized. Hiking the tax rate beyond the Laffer optimum results in lower rather than higher revenues for the government. Ironically, the Laffer curve was used by advocates for lower taxes, even though it is a theory of tax collection optimum to government revenue, not a theory of tax collection optimal to social welfare or individual preference satisfaction.
On a larger scale, the Laffer curve may be the most important economic law of political history. Adams uses it to explain the rise and fall of empires. The most successful governments have been implicitly guided by their own incentives – both their short-term desire for revenue and their long-term success against other governments -- to optimize their revenues according to the Laffer Curve. Governments that overburdened their taxpayers, such as the Soviet Union and later Roman Empire, ended up on the dust-heap of history, while governments that collected below the optimum were often conquered by their better-funded neighbors. Democratic governments may maintain high tax revenues over historical time by more peaceful means than conquering underfunded states. They are the first states in history with tax revenues so high relative to external threats that they have the luxury of spending most of the money in non-military areas. Their tax regimes have operated closer to the Laffer optimum than those of most previous kinds of governments. (Alternatively, this luxury may be made possible by the efficiency of nuclear weapons in deterring attack rather than the increased incentives of democracies to optimize to tax collection).
When we apply the Laffer curve to examining the relative impact of tax rules on various industries, we conclude that the desire to optimize tax revenues causes tax collectors to want to accurately measure the income or wealth being taxed. Measuring value is crucial to determining the taxpayer's incentives to avoid or evade the tax or opt out of the taxed activity. For their part, taxpayers can and do spoof these measurements in various ways. Most tax shelter schemes, for example, are based on the taxpayer minimizing reported value while optimizing actual, private value. Tax collection involves a measurement game with unaligned incentives, similar to but even more severe than measurement games between owner and employee, investor and management, store and shopper, and plaintiff-defendant (or judge-guilty party).
As with accounting rules, legal damage rules, or contractual terms, the choice of tax rules involves trading off complexity (or, more generally, the costs of measurement) for more accurate measures of value. And worst of all, as with the other rule-making problems, rule choices ultimately ground out on subjective measures of value. Thus a vast number of cases are left where the tax code is unfair or can be avoided. Since tax collectors are not mind readers, tax rules and judgments must substitute for actual subjective values its judgments of what the “reasonable” or “average” person's preferences would be in the situation. Coxon provides the following example. Imagine that we wanted to optimize the personal income tax rules to measure income as accurately as possible. We might start reasoning along these lines:
... look a little closer and you find that an individual incurs costs and expenses in earning a salary. He has to pay for transportation to and from work. He may spend money on clothes he wouldn't otherwise buy and on lunches that would cost less at home. And he may have spent thousands of dollars acquiring the skills and knowledge he uses in this work.
Ideal, precise rules for measuring his income would, somehow, take all these and other costs into account. The rules would deduct the cost of commuting (unless he enjoys traveling about town early in the morning and later in the afternoon). They would deduct the cost of the clothes he wouldn't otherwise pay (to the extent it exceeds the cost of the clothes he would buy anyway). They would deduct the difference between the cost of eating lunch at work and the cost of lunch at home (unless he would eat lunch out anyway). And each year these ideal rules would deduct a portion of the cost of his education (unless he didn't learn anything useful in school or had enough fun to offset the cost).
Because there are limits to complexity, and
because tax agents can't read minds, the government gives them arbitrary rules to follow: no deductions are allowed for commuting expenses, for clothing that is suitable for wearing outside of work, for lunches that aren't part of the “business entertainment” or for the cost of acquiring the skills a job requires (although you can deduct the cost of improving your skills).
The resulting rules often seem arbitrary, but they are not. They are trade-offs, often non-obvious but brilliant, between the costs of measuring more value with greater accuracy and extra revenue extracted thereby. However, the value measurement problem is hardly unique to tax collection. It is endemic when assessing damages in contract and tort law, and when devising fines punishments in administrative and criminal law. Many private sector rules found in contracts, accounting, and other institutions also have the quality that they use highly non-obvious measures of value that turn out, upon close examination, to be brilliant solutions to seemingly intractable problems of mind-reading and the unacceptable complexity of covering all cases or contingencies. Such measurement problems occur in every kind of economic system or relationship. The best solutions civilization has developed to solve them are in most institutions brilliant but highly imperfect. There is vast room for improvement, but failed large-scale experiments in attempts to improve these measures can be devastating.
The Laffer curve and measurement costs can also be used to analyze the relative benefits of various tax collection schemes to government. Prior to the industrial revolution, for example, the income tax was infeasible. Most taxes were on the prices of commodities sold, or on various ad-hoc measures of wealth such as the frontage of one's house. (This measurement game resulted in the very tall and deep but narrow houses that can still be found in some European cities such as Amsterdam. The stairs are so narrow that even normal furniture has to be hauled up to the upper story and then through a window with a small crane, itself a common feature on these houses).
Prior to the industrial revolution, incomes were often a very private matter. However, starting in England in the early nineteenth century, large firms grew to an increasing proportion of the economy. Broadly speaking, large firms and joint-stock companies were made possible by two phases of accounting advances. The first phase, double-entry bookkeeping, was developed for the trading banks and "super companies" of early fourteenth century Italy. The second phase were accounting and reporting techniques developed for the larger joint stock companies of the Netherlands and England, starting with the India companies in the seventeenth century. Accounting allowed manager-owners to keep track of employees and (in the second phase) for non-management owners to keep track of managers. These accounting techniques, along with the rise of literacy and numeracy among the workers, provided a new way for tax collectors to measure value. Once these larger companies came to handle a sufficient fraction of an jurisdiction's value of transactions, it was rational for governments to take advantage of their measurement techniques, and they did so -- the result being the most lucrative tax scheme ever, the income tax.
While the incentives between investors and managers of public companies are not as badly misaligned as that between tax collector and taxpayer, the incentives to play games with measurements are still quite substantial. Let's now look at the challenges that investors, playing an accounting game with management, face as we move beyond the industrial era.
This usually works because (a) costs are usually based on verifiable events which can be signed off on and audited, whereas predictions of cash flow are mere speculations about the future, (b) under most conditions we expect that managers have acted rationally, expending money only where they expect, on average, an eventual greater return, and (c) skilled readers of financial statements have learned from experience what games can be played by managers (because their incentives differ from other stakeholders), and to detect signs that managers have acted irrationally (e.g. over or under investment in particular assets).
Thus, accounting numbers for tangible assets have never been take too literally or in isolation by skilled readers of financial statements. Indeed, the seeming concreteness of tangibles can be quite misleading. A skilled reader knows that most accounting numbers represent costs not value, and apply their knowledge of the industry to determine for themselves how well value may actually be estimated by these costs. For example, a naive reader will take current assets at face value, whereas a skilled reader will look for conditions such as abnormal growth of inventory or receivables. The actual function of a financial statement is to provide clues for analysts based on well-verified facts, not to provide pat final answers for those seeking to evaluate a company.
Some objections to including intangibles on the balance sheet are invalid. For example, it is argued that internally generated intangibles cannot be valued because they have not been purchased on the market. However, this is also often the case for unique industrial investments and inventories. We have developed methods such as specific identification to value internally generated assets, and these could be applied to internally generated intangibles as well. Allocation of costs common to several intangible assets (e.g. a software library used in two different software products) can be based on long experience allocating costs common to multiple tangible assets.
Another more valid objection is that the actual value, in expected cash flow, of intangibles is far more uncertain than for most physical assets. Thus, the mapping from cost to value is far more uncertain. This mapping can be done with greater certainty only over an aggregate of diverse investments. However, there are certain kinds of physical assets whose value is also highly uncertain, yet are assigned a value based on costs. Rational managers discounted their original investments to take into account such risks. The same is true for intangible assets. Skilled readers of financial statements know when to expect high uncertainty. Often they will demand further details from management about the specific investments. Providing greater detail where intangibles are involved is highly advisable, a point I return to below.
On the other hand, many proposed measures of intangible value are non-starters for the purposes of accounting or financial statements. For example, various measures have been put forth allegedly related to expected cash flows (e.g. measuring web site hits, customer retention rates, etc. to try to estimate the value of a brand). The only time expected value rather than cost is used on a balance sheet for tangibles is when the asset can be currently priced on an efficient, competitive, and public market. (For example, inventories of publically traded commodities can be valued in this manner). Otherwise, it is far better to use cost, the actual event of expenditure, and let the skilled readers of the financial statement interpret these numbers properly.
Here are some specific comments and proposals for specific kinds of intangible assets: