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A Better Way to Regulate

Monday, October 1, 2001

At least since ronald reagan’s election in 1980, voters have expressed dissatisfaction with the traditional, 60 year-old model of government involvement in both the economy and society. Yet this dissatisfaction has resulted in relatively little in the way of comprehensive government reform.

There is a reason for the relative unresponsiveness: the fact that regulation is allowed, and sometimes mandated, by federal statutes that poorly reflect market conditions. To significantly improve government performance, statutory reform must precede regulatory reform and must be carefully tailored to the specific market imperfections that government involvement is designed to correct. Instead, the outdated structure of government statutes often impedes the economy from adapting to new conditions.

Regulation has always been important to economic and social prosperity. But it often imposes unnecessary social costs, reducing competitiveness and economic growth. Over the past few years, the broader public has begun to demand improved government efficiency. In the early 1990s, a book by David Osborne and Ted Gaebler, Reinventing Government: How the Entrepreneurial Spirit Is Transforming the Public Sector, From Schoolhouse to State House (Addison Wesley, 1992), remained on the national bestseller list for over a year. The Clinton administration engaged in a well-publicized attempt to reinvent government led by Vice President Gore’s National Performance Review. Within Congress efforts have focused primarily on regulatory reform, one of the 10 items in the House Republicans’ 1994 “Contract with America.” Although opposition has frustrated reform, congressional Republicans continue to push for key changes in regulatory procedures. These include increased use of cost/benefit analysis, compensation to property owners for the loss in value of private property due to regulation, risk analysis, peer review of agency scientific findings, and broader legal powers to challenge agency determinations in court.

Although almost everyone now acknowledges the need to improve the way government operates, the two parties have taken very different approaches. Democrats have generally preferred a piecemeal approach to reform, taking each regulation or issue separately. This approach, which assumes that government is already doing the right things but needs to do them better, has produced some gains. The Clinton administration ordered each agency to develop plans to reduce unnecessary regulations, become more user-friendly, and adopt a policy of cooperation rather than confrontation with the private sector. The Internal Revenue Service was reorganized. Major regulatory agencies such as the Occupational Safety and Health Administration and the Environmental Protection Agency announced that they were reducing the size of their regulations. Although helpful, these marginal reforms do little to improve the basic structure of the relationship between the government and the private sector.

Republicans so far have focused on broader regulatory reform and efforts to constrain the growth of federal power. Their efforts attempted to shift the balance between regulatory agencies and the private sector by increasing the procedural requirements agencies must meet before promulgating regulations that impose substantial costs on the private sector. Efforts to restrain government spending would force agencies to set priorities among numerous objectives, abandoning those that offer little public benefit.1 The Republican leadership has succeeded in reforming the law in some fields such as welfare, agricultural commodity programs, banking, and worker training. It has also made major progress in other areas such as bankruptcy and telecommunications. In each case, Congress rewrote the underlying statutes governing federal policy. However, relatively little has been accomplished in other regulatory areas such as the environment, worker safety, food and drug inspection, education, and housing — largely because efforts have been limited to improving the regulatory process while preserving the existing statutory framework.

A primarily agency-based regulatory approach is unlikely to produce lasting improvements in the way government works, however. Although incremental reform can produce gains, it does not address the more serious structural problems facing government. Democrats still seem unwilling to challenge the basic philosophy that has guided government’s growth since the 1930s. Republicans, although more convinced of the need for structural reform, have been reluctant to rewrite the major statutes that define the relationship between business and government. And without a clear theory of government, both parties have been unable to distinguish among competing private interests and form a consensus around an alternative approach.

Government’s proper role

Any attempt to change existing laws will set off a clash of competing interests. Efforts to reinvent government must therefore be guided by a theory of the proper role of government, capable of helping legislators distinguish among these interests. Theory, in turn, requires an appreciation of the strengths and weaknesses of private markets.

Over the past six decades, two views of the proper relationship between the private and public sectors have contended for support. The left argued that the public sector represents the repository of popular consent without which all private activity is suspect. As the repository of consent, government is better able to consider all the interests of society and, through proper planning, can command the private sector to produce optimal results.

This view is motivated by a philosophy of government that puts great faith in the ability of government agencies to discover and implement the best public policies. Regulatory agencies were given broad powers to interpret and enforce legislation. The existence of specialized agencies often gave Congress an excuse to pass vague and often contradictory statutes, leaving important public issues to regulators rather than elected representatives to decide.

Unfortunately, this approach often failed to achieve important social goals at a reasonable cost and produced rules that were unable to adapt to changes in the economy. For instance, until recently banking and securities laws seriously impeded the ability of financial markets to take advantage of changes in international finance and technology. Efforts at statutory reform often lag as much as a decade behind market developments as regulators and legislators struggle to understand changing conditions. Several additional years can separate the beginning of reform efforts from the appearance of a final bill and accompanying regulations, by which time the markets have evolved further.

Although statutes are frequently amended, changes usually add a new layer of complexity to existing law. The basic approach to federal involvement is seldom reformed to reflect new circumstances. Over time, regulatory agencies often fall into a bureaucratic mindset that lacks an appreciation and understanding of market forces. At other times, agencies become hostage to special-interest groups and reflect their views rather than the public interest. Most important, the goal of minimizing costs is not stressed nearly as much as that of increasing perceived benefits.

Libertarians believe that private markets, which allow each individual to make his own decisions, increase freedom. The legitimacy of market solutions comes from their voluntary nature rather than from government sanction. Although full of uncertainty and imperfections, markets provide an incentive for continued improvement and increase public welfare by offering greater flexibility and choice. Although both the libertarian and progressive approaches are logically consistent, in practice the market approach has clearly done a better job of increasing living standards for the majority of citizens over the medium and long term. Any successful efforts to improve government performance significantly must make greater use of market forces to increase individual welfare.

Yet, the superiority of market forces does not eliminate the need for government. The efficient operation of any market requires a clear set of rules that guide expectations and encourage people to reach mutually beneficial agreements. Government’s most important role is to define the general rules within which the markets are allowed to operate and to resolve disagreements about how these rules apply to specific cases.

For example, corporate law including limited liability allows individuals to buy and sell stock in individual companies without risking more than the price of the stock they are purchasing and, in most cases, without noticeably affecting the management and operations of the company. This freedom allows companies to raise large sums of capital quickly and efficiently.

Conversely, Hernando De Soto in The Mystery of Capital (Basic Books, 2000) argues that a major obstacle to economic growth in many developing countries is the absence of institutions that allow individuals to sell and mortgage the little wealth they already have. The legal systems in these countries also make it difficult for average citizens to create a new business or develop property.

Most of the burden of defining the rules that apply to specific market transactions has traditionally fallen on the courts, which adjudicate individual disputes by applying an accumulated body of case law. Complex legislation is seldom necessary for this task. Only in the past few decades have the legislative and executive branches asserted their influence through detailed legislation and regulation.

When government limits itself to the role of applying general rules to specific cases, markets usually produce good results. In fact, in most cases there are good reasons for believing that government planning will not produce better economic or social results than efficient markets. Unless one believes that the public sector can out-plan the market, public preemption of private markets is justified only when a clear market failure exists.

However, in some cases the outcomes produced by private markets may be seriously flawed. There are a number of reasons why this may be so.

Some views may not be adequately represented in the initial bargaining. Private markets generally do a good job of balancing competing interests. However, these interests are generally weighed according to the financial resources each party is willing to put behind its position. The interests of those with inadequate income generally are ignored. Aside from war, the appearance of famine anywhere in the world is due solely to the inability of the inhabitants to afford the relatively minimal cost of producing and delivering food to them. Where individuals are unable to afford basic goods at the market price, redistribution of income can give beneficiaries the market power to make their needs felt.

Bargaining among competing interests is never perfect. Transactions and information costs may make it difficult for private parties to reach a favorable agreement. Private parties already have an incentive to develop ways to reduce these costs. In some cases, however, government may be better placed to perform this service. Although government activity is never free, occasionally its involvement can reduce the total costs of producing a given good or service. The pension aspect of Social Security made much more sense when relatively high brokerage fees made it difficult for the average worker to create a diversified investment portfolio. Technological advancements have reduced this rationale, however, by allowing mutual funds to keep track of millions of individual accounts at a cost of less than 1 percent of assets. Perhaps the best way of deciding whether government services truly add value is to make the private beneficiaries pay the full cost of having government provide them while allowing private and nonprofit organizations to compete on equal terms.

In many cases part of the problem is that consumers have a difficult time verifying the quality of a good or service. Government safety, inspection, and licensing regulations have usually been justified by pointing to the need to guarantee that certain products, such as beef and children’s toys, meet minimum standards of public safety. However, it is not clear that in setting these standards, government regulators will reflect popular opinion in making the tradeoff between the costs and benefits of added safety.

The outcome of private markets is likely to be fairer if competition among producers and consumers gives each person a number of choices. Competition in some markets may not produce an adequate number of players to guarantee true competition. Each competitor has a strong incentive to prevent others from competing with him on equal terms. These efforts retard market efficiency and limit choice. The need for antitrust enforcement and government regulation of natural monopolies is well established. It should be noted, however, that technological innovation and the integration of global markets have already introduced greater competition into many markets. In some cases such as long-distance telephone service and electricity, markets that were once assumed to be natural monopolies have been opened to competition, reducing the role of government.

Finally, in some cases the outcome of private markets may still be regarded as inferior even if all sides are adequately represented. Private markets generally do not pursue any goal broader than the private interests of their participants. Although these private interests may include social goals such as charity and collective action, public officials may feel that the market still ignores broader social goals that cannot be achieved merely by rebalancing the power of competing interests. This rationale for government intervention is the most problematic, because it assumes that government policymakers know better than the private sector what is best for society. It also assumes that these public goals are sufficiently important even though private demand for them in the marketplace is weak.

A better approach

Government involvement should reflect the type of market imperfection that the law seeks to redress. As much as possible, intervention should be limited to rebalancing or adjusting the workings of the private markets, allowing normal market forces to determine the final outcome. A central weakness of current reform efforts is that they often concentrate on the symptom rather than the cause of government inefficiency and allow little flexibility for future innovations. Too often, poorly designed laws yield bad regulation. The traditional approach to government has been to override market forces by imposing an outcome irrespective of economic reality and having government agencies handle many activities better performed by the private sector. Rather than rebalancing the legal and economic resources of individuals participating in the market and then stepping back to allow the normal bargaining process to work, laws have created complex structures within which markets have limited freedom to operate. This approach requires a much greater degree of regulatory intervention, since the government must now make many of the decisions that are normally made by suppliers and customers. These statutory structures are usually unable to adapt to rapid technological, social, and economic change, causing the industries to lose competitiveness.

Statutes are often poorly worded and leave the agency with a vague mandate and tremendous discretion. As a result, agencies rather than Congress conduct the delicate balancing of public interests that democracy normally reserves for the elected representatives of the people. Under the Administrative Procedures Act (apa), courts may not overturn agency regulations unless they are arbitrary or capricious. The courts have applied this test even when the agency is interpreting the scope of its own powers.2

Wherever possible, government intervention should harness rather than override market forces. Where there is no clear market failure, government involvement should cease. For example, since there is no evidence that agricultural markets cannot operate efficiently on their own, the federal government should stop regulating prices and quantities through commodity programs and marketing orders.

Where the problem is an imbalance in the power of competing interests, the government should attempt to redress this balance by increasing the relative financial or legal powers of underrepresented interests. Vouchers for food, housing, and education give low-income individuals the purchasing power to meet their needs without depending upon the often shoddy operation of government housing and schools. The final outcome, however, should be left to market forces and the normal dispute resolution powers of the civil courts.

Where high transaction or information costs impede the normal operation of private markets, government should concentrate on serving as a focal point for market forces. Many have argued that the federal government should extend the Federal Employees Health Benefits Program and the Thrift Savings Plan to all workers. Each model provides good service and individual choice at competitive costs. Extension would ensure that every employee had at least one good option available. But care must be taken to ensure that the government is truly adding value to the market. This is best done by allowing private and nonprofit entities to compete on equal terms.

Finally, if private markets prove incapable of meeting important social goals, the government may have to mandate their achievement. In many areas, there is a level of air and water quality that society is unwilling to go below, no matter how much the polluting industries pay. In general, the market should be allowed to discover the best way of achieving this mandate, however.

Activities for the private sector

Government has often intervened even in the absence of any underlying defect in market forces. If government ended its involvement in these markets, the markets would operate more efficiently and overall social welfare would be higher, not lower. In such cases, regulatory reform of the type often advocated by congressional Republicans misses the point. A better solution is to repeal the authorizing statutes and end the government’s involvement entirely.

Improper involvement can take several forms. In some cases the government is a direct participant in the markets, providing services that are traditionally supplied by the private sector. For example, federal agencies provide electricity (the Tennessee Valley Authority and Power Marketing Administrations) and run hospitals (the Veterans Affairs clinics). Even in cases where government support is necessary, such as prisons, highway maintenance, and education, many if not most of the services can be turned over to the private sector, provided that good market rules are in place to ensure competition, choice, and the proper balance of costs and benefits. Privatization or contracting out of services can increase efficiency, reduce the size of government, and often, but not always, reduce government outlays.

In other cases, the government heavily regulates the free operation of market forces, influencing their outcome. Peanut and tobacco markets are both inhibited by federal laws that prohibit new farmers from competing on a level playing field. Sugar growers benefit from high tariffs that allow domestic prices to exceed world prices. Davis-Bacon legislation and restrictions on hiring permanent replacement workers both limit competition in labor markets, raising the cost of public projects.

Sometimes the government allows private markets to operate but delivers large subsidies to some participants in order to skew the final result. Public transportation is heavily supported by federal subsidies, as is low-income housing. Usually, these subsidies are delivered not to consumers who lack purchasing power, but to suppliers of services that the government thinks are in short supply. Because their consumers continue to lack the purchasing power to shop elsewhere, suppliers continue to lack an incentive to deliver the services efficiently and in good quality. A private monopoly has replaced a government one. Centralizing the delivery of subsidies also allows political favoritism rather than market forces to guide the distribution of funds. To try to prevent this, the government often heavily regulates the use of these subsidies, introducing further complexity. The delivery of vouchers to those who lack purchasing power gives recipients direct market power and allows other suppliers to enter the market, providing greater choice. It also reduces the need for heavy regulation.

In some cases government involvement, though originally justified, is no longer needed. Technological advances in the electricity and telecommunications industries have dramatically reduced the need for government regulation of what were once considered natural monopolies. Previous deregulation of the natural gas, trucking, and airline industries has produced significant social benefits even though the remaining markets are not perfect.

Finally, in some cases the government has skewed market forces in a way that prevents normal checks and balances from operating. The resulting market failures then create a need for further government regulation. An example is the heavy regulatory burden placed on employers who offer health or pension plans. Employers first began to offer these plans in order to circumvent wage controls during World War II. A unilateral decision by the Internal Revenue Service that these benefits did not constitute taxable income continued to skew market forces in favor of employer-provided plans even after wage controls were lifted. Because employees would rather save and purchase medical services with pre-tax rather than post-tax dollars, employers have become heavily involved in both the savings and health care markets. Complex legislation such as the Employee Retirement and Income Security Act (erisa) was then required to ensure that employers live up to their promises and to minimize the resulting tax loss. If the government taxed these benefits as income, the role of employers and the need for government regulation would fall dramatically. As markets evolved, employees would have more choices and a greater opportunity to choose the plans that are best for them.

In each of these cases, the underlying test for continued government involvement should be whether there are sufficient incentives for the private sector to deliver goods and services at an acceptable price. Usually, when all consumers have sufficient purchasing power, the answer is yes. When some participants lack purchasing power, the best approach is to explicitly redistribute income to those in need, allowing recipients to choose the services that are best for them. This makes the immediate effect of government intervention more transparent and maintains the market’s ability to respond to new opportunities.

Privatization will not necessarily make markets less complex. Even private companies have complicated internal control mechanisms and standard operating procedures. These private regulations do not have the force of law behind them, however. Other suppliers are allowed to experiment with different rules. And because they are subject to market pressures, private rules are likely to be more flexible and efficient than are government regulations.

The greatest impediments to reform in these programs are the vested interests that benefit from the current pattern of government regulation. Almost any public intervention, no matter how poorly executed, benefits someone, even if overall welfare is reduced. The beneficiaries of government intervention have strong incentives to resist any reform that would reduce their benefits. Because they have developed an expertise in the complexities of current programs, they also have an informational advantage over reformers.

High transaction or information costs

Private markets are neither perfect nor without cost. Efficient markets require information and coordination so that buyers and sellers can enter into agreements with a minimum of effort. In many cases the government, by reducing market uncertainty, can lower the cost of doing business. This is especially true in setting market standards. The vast body of contract law makes the implementation and enforcement of written agreements much more predictable. Intelligent bankruptcy statutes quickly redeploy capital to more productive uses and make it possible for owners to borrow using their assets as collateral.

There are many ways to intervene in markets. The costs and benefits of government policy in a given area depend upon the exact form of regulation it pursues. In general, government should try to intervene as little as possible while still accomplishing its goals. In setting goals, policymakers should not try to achieve specific outcomes but should respect the market’s power as a mechanism to search for the best results.

In many cases, a product’s quality matters a great deal to buyers. Both the producer and the consumer have an interest in certifying that the product meets certain standards, even if the standards are relatively low. Because they have different interests, however, it can be difficult to measure quality accurately without an objective standard.

The government has a strong interest in ensuring minimum standards in areas such as food safety, airline inspection, accounting, and technology. These standards help reduce the cost of communication and increase the level of confidence among buyers. Because they help assure consumers, good standards can increase market demand and allow producers to obtain a premium when they offer higher quality. They also protect producers from being undercut by sellers who deceive buyers with products of inferior quality. Several points should be kept in mind about the government’s role in setting standards, however.

First, the value of having standards depends upon how well they are set. To add the greatest value, standards should carefully reflect actual market needs. Appropriate standards must take into account both current demand and supply conditions and available technology. Both consumers and producers should have a strong role in helping the government choose standards. The National Institute of Standards and Technology is a good example of how the government can add value by coordinating efforts among private parties to set technical standards. To take an obvious example, it helps to have a central and controlling definition of an inch that all parties can turn to when disagreements arise. Often the mere presence of a well-known standard ensures that disagreements are rare.

Second, in cases such as food safety and building codes, there should be more than one quality standard. The existence of multiple standards allows consumers to trade off different levels of quality for price. It gives producers the opportunity to establish a reputation for superior quality and to command a premium for doing so. And it eases the introduction of new technology into the marketplace by allowing quality to improve at a faster pace than do the standards. There should be at least one “stretch” standard to create a market for new technology that allows superior quality.

The federal government establishes several standards for beef quality ranging from Choice to Lean. Unfortunately, there is only one federal standard regulating meat safety. As a result, poultry continues to suffer from a high incidence of salmonella contamination even though current technology permits its elimination and most consumers would probably be willing to pay for the cost of more thorough protection. Producers who might choose to meet a higher quality have no way of certifying this fact, however, and thus no way of recovering their higher costs.

In some cases the government may be justified in setting minimum standards below which products are deemed unsafe. Usually, however, there is no inherent need for a minimum as long as consumers are informed about the quality they are getting. If the government is careful to establish clear procedures for testing and labeling, there is unlikely to be a demand for products of clearly inferior quality. More often, minimum requirements such as energy efficiency standards allow policymakers to impose their preferences over those of consumers, rather than to correct any market deficiency. Other standards, such as some fruit and vegetable marketing orders enforced by the Agricultural Marketing Service, are little more than supply controls designed to raise market prices and discourage new entrants.

While good reasons exist to have the government involved in setting and enforcing standards, there is no inherent need for the government to conduct or subsidize inspections. In a number of areas such as grain sales, accounting, and bond ratings, private companies bear the burden of certifying that their products meet relevant standards and the cost of inspection is considered a normal cost of doing business. In areas such as meat quality, the government role in conducting and subsidizing quality tests should be phased out. Instead of actually conducting and paying for inspections, the government should make sure that the standards are clear and that violations are punished through either government enforcement or private lawsuits. It should also help educate consumers about the standards in order to ensure that producers face constant pressure to provide higher quality.

Finally, although an agency should not deliver hidden subsidies to producers or consumers, it also should not tax them for its services. Wherever possible, inspections ought to be done by the private sector. In some cases such as the awarding of patents and trademarks, only government can serve as a neutral arbitrator. In these cases, user fees rather than taxes should be used to pay for the services. But the government role should not be used, as it sometimes is, to charge the private sector for more than the cost of providing the services. Private interests should also have a strong say in making sure that the government agency delivers services that the private sector needs at an efficient price. Provided that the private sector has such an oversight role to ensure accountability, these agencies are better run as independent government corporations removed from political arguments over policy and funding. The Securities and Exchange Commission and the Federal Reserve provide good models of this type of regulation, except for the fact that the mandatory fees they charge are higher than the cost of delivering their services.

The contrast between the Occupational Safety and Health Administration (osha) and the Food Safety Inspection Service (fsis) on one hand and the National Institute of Standards and Technology (nist) and the Securities and Exchange Commission (sec) on the other is striking. Each agency is engaged in setting detailed standards that guide their respective markets. The nist and the sec are primarily guided by the needs and circumstances of the markets they regulate and do not deliver hidden subsidies to producers. They are widely respected for their professional expertise, and their standards enjoy broad approval. In contrast, osha standards, though complex, often bear little relationship to their ultimate goal: the prevention of workplace injuries. The fsis delivers almost $600 million in annual subsidies to meat producers even though its standards discourage the use of modern inspection technology. Neither of the latter two agencies is especially known for the market expertise of its staff.

In summary, government can play a valuable role in helping private markets set and enforce standards. These standards can increase customer confidence and reduce the cost of doing business. This role requires neither rigid rules nor public subsidies, however. It does require a sophisticated knowledge of the market and an appreciation of the difficulty faced by both producers and consumers operating in it. Indeed, the more market-oriented government is, the more effective and helpful its standards are likely to be.

Voluntary standards

The problem with many government standards is that nothing equivalent to the profit motive constantly drives them to add value to society or ensures that they respond to new developments. Making compliance voluntary is the best way to ensure that quality standards reflect improvements that consumers are willing to pay for. Often the main benefit to having a standard depends very little on the actual standard chosen. Most of the benefits come from the mere fact that a single standard or set of standards improves market coordination by giving everyone the same set of expectations.

Many experts have stated that a common set of health insurance forms could save millions of dollars in administrative costs. The federal government could play a role in developing such a form. Making use of the form voluntary would be the best way to ensure that it is sensibly written and truly adds value. The gains from using the common form would cause most insurers to use it voluntarily. Yet the freedom to use alternative forms would serve as a check against introducing too much complexity or collecting outdated and unnecessary information. Voluntary standards also increase the government’s incentive to carefully consult consumers and producers both before the standard is set and during its enforcement.

One objection to voluntary standards is that producers would not follow them unless forced to do so. This is unlikely to be true if the standards reflect a strong consumer demand for quality. Even with voluntary standards, manufacturers could still be sued if they violate the common law standard of negligence. Usually this standard arises out of individual jury verdicts. Although these can often be arbitrary and unpredictable, with careful judicial supervision they can be used to set a consistent minimum standard. A company that failed to meet the government’s voluntary standard would presumably have a tougher time convincing a jury that any harm that resulted from its products was not the result of negligence. Compliance with the standards could create a rebuttable presumption that the manufacturer’s conduct was reasonable.

If the standards were voluntary, government would have a stronger incentive to make sure that they reflected community standards. Both producers and consumers should have a large role in shaping these regulations. Standards that were overly stringent would not be followed. But producers would have strong incentives to comply with reasonable standards in order to protect themselves in civil suits. Those that did not comply would have to justify their decision to a jury if their products hurt someone. The government could periodically increase the standards to reflect technological innovations and a greater willingness on the part of the public to pay higher costs for higher quality.

Surprisingly, voluntary standards can actually increase the ability of regulatory agencies to influence markets. The political power of interested parties often makes it difficult to pass or strengthen mandatory standards. Groups that are adversely affected by an agency’s proposed action often exercise political influence to delay tougher regulations. Once the regulations are published, they can be challenged on a variety of procedural and substantive grounds, delaying their impact. These limitations are required because with mandatory standards greater protections are needed to prevent an agency from abusing its power. The ergonomics standards issued by the Clinton administration and repealed by Congress offer a good example. Proponents of the regulations were dismayed that it took several years to issue any standard. Opponents believed that the final standards imposed unnecessary costs on employers and were poorly written.

With voluntary standards, agencies can propose and implement standards much more quickly. Those negatively affected by new standards have fewer causes for complaint since compliance is not coerced. Producers can refuse to follow standards that are too strict, especially if they feel that consumers do not value the higher quality. On the other side, consumer groups are free to propose their own alternatives to standards that they feel are too lax. By advertising alternative standards, consumer groups can hope to place market pressure on producers to adapt them. By reconciling the differences between these two groups, the agency can set up a series of standards that meet market needs and more easily change them as market conditions and technology change.

Achieving policy goals

Many government regulations are designed to achieve social goals that are not fully valued in the private market. Environmental laws represent a classic example. Most observers agree that until the 1970s too little emphasis was placed on environmental quality. Individual consumers were unwilling or unable to pay higher prices for products produced with less pollution.

Today most producers and consumers would agree that a cleaner environment should be encouraged. The problem with current environmental laws is not their goal, but their methods. By distrusting market forces, the government has left itself little alternative other than to control the methods of production in order to achieve its goals. The result has been a series of complex and costly laws that have increased environmental quality, but often at an extremely high price. Moreover, as progress has been made on the major sources of pollution, regulation has often been extended to other areas where its benefits do not clearly outweigh its costs. A private business making such investments would lose money and eventually go out of business. The government faces no such constraint.

When intervening in the market, the government can generally regulate either the quantity (or quality) of a product or its price, but not both. A law requiring utility vans to average at least 25 miles per gallon is fairly easy to enforce. It is not clear how much it will cost society to achieve this standard, however. Conversely, a carbon tax of $50 on every ton of carbon dioxide emitted by a generator of electricity would never cost power plants more than the tax, but the exact amount of emission reductions it would produce is unknown, as is the amount of revenue it would raise. Over time, well-drafted laws create incentives for private entrepreneurs to discover ways to achieve policy goals at lower costs. One of the best examples of the use of market mechanisms is the Clean Air Act’s creation of a private market in sulfur emissions. The act set a ceiling on total emissions but allowed utilities to trade the right to these emissions with each other. It also allowed conservation groups to purchase emission rights and retire them, thereby reducing pollution. The result has been a dramatic decline in the cost associated with reduced emissions and an increase in economic efficiency. Utilities have an ongoing incentive to improve performance, since pollution reductions can be sold to others, adding revenues to the bottom line. And environmental groups have the opportunity literally to buy cleaner air by purchasing emissions credits themselves.

It is generally more efficient for the government to alter prices through carefully selected taxes than to mandate the use of certain technology or to place firm ceilings on emissions. Taxes give firms an incentive to meet policy goals and reward companies that demonstrate superior performance. By translating directly into business costs and prices, they permeate all layers of management, even those that remain unaware of or unconcerned about environmental effects. And because technological progress often occurs relatively quickly, a tax is also likely to be more effective in reducing pollution over time even as it eases the fear that new standards will impose unexpectedly high costs in the short term. Federal excise taxes on gasoline automatically influence the cost of driving without any emissions trading by station owners or drivers. Taxes also require less government interference with market operations. Moreover, if government spending is kept under control so that any additional tax revenue is used to reduce less efficient taxes, there can even be a net gain in overall economic efficiency.

Alternative approaches can also be less burdensome to the private sector. Giving municipalities and states the right to enforce certain air quality standards against each other in court would reduce the need for federal intervention while forcing different governments to carefully weigh the near-term tradeoffs between fewer emissions and faster growth. Such a move would be more effective if it was preceded by legal reforms that reduced the cost of litigation.

Limiting agency discretion

Not all regulations are directed at the private sector. Many are meant to prevent abuses of agency discretion. Having created a large bureaucracy, elected officials must try to control it. Private firms know from experience that good management requires a delicate balance between supervisory control and employee initiative. Most of the knowledge that an organization possesses remains with its front-line workers. Especially in a changing environment, competitive firms are forced to give employees freedom to take advantage of this knowledge on their own initiative.

On the other hand, employees quickly build up bureaucratic interests that can conflict with those of the broader organization. Thus, every business has management controls that either limit the freedom of workers or provide them with incentives that link their well-being to that of the company. In recent decades, companies have pushed profit and loss responsibility down to lower management levels while creating internal auditing departments that ensure corporate directives are followed. A key component of these controls is the careful design of performance measurements linked to pay incentives such as stock options and profit-sharing plans to reward employees according to their contribution to the overall success of the firm.

The problems faced by government are more extreme. First, even without pay incentives, employees in private firms face two important checks on how they act. Their positions are subject to ongoing competition by other individuals within and outside the firm and can be terminated with relatively few formalities. In addition, if the firm ceases to be competitive, its operations will shrink and workers are likely to lose their jobs.

Government employees face neither of these pressures to the same degree. Although promotions are competitive and agencies are increasingly subject to tighter budget constraints, government workers still enjoy a high degree of job security: It is extremely difficult to demote or fire poor performers. This need not be. Encouraging competition among different agencies, especially those charged with offering services to the general public, would increase the tie between job performance and job security. More important, it would increase the pressure to improve performance over time. The growing movement toward housing vouchers and charter schools reflects this trend. Just as important, statutes governing federal employment should be rewritten to allow agencies to weed out nonperformers and reward overachievers. Employment practices that treat everyone the same only encourage mediocrity.

In many areas, deeper government reform will have to occur. Federal purchasing rules are exceedingly complex largely because the government is unwilling or unable to hold individual purchasers accountable for their decisions. Instead, it limits their discretion with regulations that add to the cost of the final items in an effort to reduce the scope for fraud. The fact that the federal government, an entity that holds monopsony purchasing power in many markets, is afraid that smaller suppliers will take advantage of it surely indicates the existence of a structural problem. If the government structured itself more like the purchasing departments of major manufacturing firms, which have often reduced costs by over 25 percent without any reduction in quality, the need for complex regulations would diminish and purchasing costs would fall.

The solutions to these problems require competition among agencies and between agencies and other providers in state and local governments, nonprofit organizations, and the private sector. Although numerous agencies would theoretically increase redundancy, if poor performers were forced to go out of business the total size of government would not be significantly larger. One reason for the relative strength of the U.S. financial markets is the healthy competition among regulatory agencies at the federal and state levels. Depository institutions may arrange to be regulated by state agencies, the Office of Thrift Supervision, the Federal Deposit Insurance Corporation, and the Federal Reserve depending upon how they structure themselves. Each agency must therefore draw a careful balance between the costs and benefits of its regulatory requirements. Competition among agencies would improve the delivery of goods and services. Employees within each competing agency would have incentives to identify their own interests with those of their employer and its customers.

Normal government downsizing efforts miss this argument. It is impossible to say how big government should be or how much of it we should buy without specifying the importance or quality of the services it delivers. The rush to downsize government assumes that current services are either not important or not worth their cost. If, however, the introduction of normal market pressures resulted in a dramatic improvement in efficiency, people may choose to have more, rather than less, government. For an accurate determination to be made, people must have choice. And we must find an organizational structure that finds the true cost, not an inflated cost, of delivering services. An excellent example is the cost of secondary education. Some argue that more resources will improve student performance, but no one really knows how much a good education should cost. Private and parochial schools often provide superior education at far less cost than public schools under similar conditions. And per pupil spending differs widely within and between states, often with no clear correlation with student performance. The shortage of competition among schools means that no one has an incentive to provide the same quality of education for less money. Hence, no one searches for the most efficient cost given current technology. Yet there is no logical reason why secondary schools should not be getting the same level of productivity improvements that the private sector has seen over the past two decades.

In order for government to become more competitive, it must also increase the ability of federal managers to hire and fire employees. When agencies face performance tests similar to those faced by the private sector, market discipline will force managers to adopt responsible personnel policies. Failure to do so would jeopardize their ability to attract financial resources, and hence their own position. With these incentives in place, the need for formal regulation falls dramatically.

Decentralized management

Much of what is wrong with government is structural. The traditional approach to government stresses a top-down management style that may have been appropriate in the 1950s and 1960s but is increasingly obsolete in a world of rapid change and increased competition. Programs that centralize control and limit individual discretion must necessarily resort to complex rules. In the absence of competition, centralization has made it easier to co-opt government agencies and has led to a profound rigidity in bureaucratic structures. It has also prevented important sectors of the economy from responding to market forces.

Modern society is not well suited to traditional government. Economic and social institutions are increasingly complex. The flow of information from the markets is too great and too differentiated to be managed from the top. Government will therefore have to follow the private sector in moving toward a more decentralized management structure. But decentralization of power without decentralization of responsibility often leads to abuses of discretion. In order to prevent officials from abusing their new powers, government reforms must hold them increasingly accountable for the consequences of their actions and must try to increase the choices available to those who deal with agencies. This is what the profit motive and competition accomplish in the private sector. Such reform will require significant structural changes in the way government operates.

Government reform is more likely to be effective if it makes the maximum feasible use of the same competitive pressures that apply to the private sector. Although market forces reduce certainty and increase diversity, there are strong theoretical and empirical reasons for believing that they are more efficient over the medium and long term in fostering economic and social progress. The primary focus of reform efforts should be on making the maximum use of these forces. To do this Congress must rewrite the underlying statutes.


1 Republicans have also used the appropriations process to attach riders that restrict the use of appropriated funds. Depriving an agency of the funds to carry out actions authorized by current statutes is at best a weak alternative to rewriting the laws, however.

2 Congress usually gives the relevant agency explicit power to promulgate regulations to carry out the purposes of the statute. But agencies must often interpret what Congress intended when it passed a statute. This is especially true if the legislation was hastily or poorly drafted. However, neither the statutes nor the apa requires courts to give agencies broad deference in interpreting the scope of legislation. This power should be reserved to the courts, guided by the wording of the statute and its legislative history. Agencies have often used the discretion given to them by the courts to increase their jurisdiction by expanding the interpretation of a statute beyond what Congress intended. There is no constitutional requirement that courts acquiesce in this expansion of powers.

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