Why Government Fails So Often: And How It Can Do Better (24 page)

Sometimes moral hazard applies to government units that seeks to maximize federal dollars at little or no cost to themselves (depending on the federal program’s cost-sharing formula). States, for example, have powerful fiscal incentives to expand food stamp eligibility as much as possible because the federal government pays 100 percent of the costs, which helps to explain, as discussed in
chapter 11
, why the states are partly responsible for the program’s dramatic expansion in recent years far above what one would have expected from the Great Recession. Local governments encourage home-building in fire-prone areas, knowing that federal taxpayers will bear most of the fire-fighting and cleanup costs.
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The vast inefficiencies of urban transit spending, detailed in
chapter 8
, also reflect the practice of federal matching dollars that make local projects seem far cheaper than they really are. Medicaid, under which the federal government has borne a much smaller share of costs than in these other programs, thus has weaker participation incentives for states. This largely explains why many states resist its expansion.
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(Whether the Affordable Care Act can change this calculus will depend on whether the states believe Washington’s promise to pay almost all program costs in the long run–a credibility issue discussed in
chapter 6
.)

This same intergovernmental incentive structure, added to the moral hazard of individual beneficiaries, helps to explain the explosion in the costs of the federal disability insurance (SSDI) program.
States pay for a laid-off worker’s temporary welfare and unemployment benefits, but if they can get him instead on the disability rolls, the federal government pays 100 percent—indefinitely.
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For the worker, the average annual SSDI benefit level is only $2000 less than the full-time return to a minimum-wage job, and Medicare benefits kick in after two years on SSDI. Moreover, over half of SSDI’s beneficiaries now qualify because of easily claimed conditions like mood disorders and back pain, and the program makes it easy to stay on the rolls. Not surprisingly, SSDI has higher claim rates and lower return-to-work rates than comparable private disability insurance.
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These incentives help to explain why SSDI recipients have
tripled
just since 1990
despite a much healthier working age population
; much of the expansion occurs among young people. The CBO finds that the program expanded nearly sixfold since 1970 to 8.8 million in January 2013 (10.9 million, including benefits to their spouses and dependent children), and that the SSDI trust fund will be exhausted in 2016, only three years hence.
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Nicholas Eberstadt, a leading demographer, has analyzed the reasons for this stunning growth. First, the ratio of workers to those receiving disability benefits has plummeted from 134:1 to only about 16:1 (or, by another measure, 11:1). Second, the age at disability has dipped significantly. In 1960, about 6 percent of beneficiaries were in their thirties or early forties; by 2011, over 15 percent were that young. As Eberstadt dryly notes, “more Americans [seem to be] making the securing of disability status their life-long career.” Third, over 15 percent are now granted disability for “mood disorders,” and another 29 percent for musculoskeletal and connective tissue conditions—both of which are almost impossible to disprove and lend themselves to fraud.
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Fourth, little of the increase in disability awards is caused by the Great Recession. Between 2001 (also a recession year) and 2011, private nonfarm jobs rose by 828,000 while beneficiaries increased by over three million.
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According to leading students of the program, “It is difficult to overstate the role that [SSDI] plays in discouraging employment among these young people.”
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Fortunately, we do not lack for promising reform proposals.
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Other federal disability programs also create moral hazard.
Thus, the Railroad Retirement Board waited five years to terminate disability benefits based on fraudulent medical evidence—and did so reluctantly.
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Rapid expansions of food stamps, Pell grants, and other benefit programs have also reduced labor force participation beyond the recession’s effect (although Pell Grants may improve recipients’ long-term employability).
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The usual remedies for moral hazard are for potential
risk-bearers
to improve their information about the risk (at some cost) so that they can manage it better, or to make potential
risk-takers
bear some or all of the costs of their risk-taking through contract or public policy, which will increase their incentives to do so. But government finds it harder than private insurers to do these things. To woo beneficiaries, it is less likely to use co-pays, deductibles, and other provisions to assure that the insured has enough uninsured exposure to loss (“skin in the game”) to act in risk-reducing ways. It is also less likely to gather and analyze information in order to quantify and monitor risks so that they can screen out those who pose high risks of claiming or defaulting, and can charge risk-related premiums for coverage. Knowing that the insurer (the taxpayers) will pay for losses in the event of default, they have even less reason to weigh risks and benefits carefully. Sometimes a program seeks to benefit precisely those who it thinks are too poor to share the costs, or it wants to avoid political flak for charging those who could afford it for its risk-bearing service. Moreover, officials eager to expand a program may soft-pedal the risks posed by the new participants.

The Mental Health Parity Act of 1996, for example, requires that insurance coverage for federally funded mental health services be treated like physical health coverage even though mental health claims tend to be harder to verify than physical health claims and, for a variety of reasons, are more prone to moral hazard.
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A similar mandate now applies to all policies regulated under the Affordable Care Act.
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The Medicare Prescription Drug Improvement and Modernization Act of 2003, which provides a prescription drug benefit for seniors under Medicare Part D, is another costly expansion of programmatic moral hazard by inducing excess use of low-benefit drugs.

Nonmarket failure, like market failure, is a systematic, incentives-based tendency of government policies
. Charles Wolf, an economist at RAND, has elaborated a theory of “nonmarket” failures to supplement the better-developed theory of market failures.
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Government is not the only nonmarket entity that exhibits such failures but it is certainly the most important, so I shall (as his theory does) focus on it. Wolf begins by identifying the four most salient differences between the supply and demand characteristics of government outputs (i.e., the effects of programs) and of private market outputs. On the supply side: “the ‘products’ of nonmarket activities are usually hard to define in principle, ill-defined in practice, and extremely difficult to measure independently of the inputs which produce them.” Evidence of output quality is elusive, in part because the information that in the market would be transmitted by consumer behavior is missing. (I shall defer discussion of the information factor until the next section of this chapter.) Government outputs are almost always produced, often by legal mandate, by a single agency provider, eliminating competition. These outputs are also hard to evaluate because no profit criterion or other reliable mechanism exists for assessing their effectiveness, as there is with markets. On the demand side: politicians’ electoral incentives and short time horizons lead them to support government programs with infeasible objectives and rising costs as a response to (or instigation of) public dissatisfaction with the shortcomings of market outcomes.

In light of these features of government activity, Wolf develops a typology of nonmarket failures that very roughly parallels the set of market failures cited in standard economic theory. The most important category of nonmarket failure is what he calls “internalities” (corresponding to the “externality” problem in private markets). Internalities are the private goals that apply within nonmarket organizations to guide, regulate, and evaluate the performance of agencies and their personnel. These goals are “ ‘private’ … because they—rather than, or at least in addition to, the agency’s ‘public’ purposes—provide the motivations behind individual and collective behavior. This
structure of rewards and penalties constitutes what Kenneth Arrow refers to as ‘an internal version of the price system.’ ”

The most obvious internality conducing to government failures and distortions is budgetary growth, which substitutes for the profit criterion as a measure of performance. The dynamics that conduce to budgetary growth include not only bureaucratic self-interest but also external political pressures to expand the coverage of benefits and the bureaucratic capacity to deliver them. This is not always the case—government sometimes reduces benefits, especially those for politically impotent groups, and agencies occasionally seek to limit their responsibilities so as to protect their core mission—but bureaucratic expansion is a very powerful tendency indeed even when, as often occurs, it actually impairs the agency’s effectiveness (for example, by diluting its resources and management focus or by saddling it with conflicting incentives). I shall return to this point in the last section of this chapter, which discusses government credibility.

Perhaps the most pervasive and dangerous internality, however, is the disconnect between a policy’s public costs and private costs. The true cost of a government program is not limited to that which appears on the program’s budget, which is a notoriously misleading document (except to the cognoscenti). Among other gimmicks, a vast amount of government cost and debt is kept off-budget, especially the activities of the government-sponsored enterprises (GSEs) like Fannie Mae, Freddie Mac, Farmer Mac, the Federal Home Loan Banks, the Farm Credit institutions, and some others. The true costs also include the
private costs
that private compliance with the programs requires. These costs may vastly exceed the public outlays, yet they do not appear on any public budget and thus are unlikely to be fully considered by federal officials—unless officials are somehow forced to do so. The significance of this obvious fact for the design and cost-effectiveness of public programs can hardly be overstated. Indeed, if we assume that these private costs produce
any
positive benefit for the official’s program, her incentive is to ignore the private costs that produce that benefit regardless (perhaps literally so) of how large
those private costs may be. A public budget that does not include these private costs encourages policy makers to neglect them. Only by compelling systematic attention to the private costs of public programs through the kinds of analytic requirements discussed in
chapter 2
can we accomplish this. Alternatively, we might imagine that the private cost-bearers will mobilize to demand attention before the policy is in place and the damage is done is, but their ability to foresee and measure those costs before the policy is fully elaborated and implemented is likely to be severely limited. (This timely knowledge-of-private-costs problem may help to explain why industry claims about the effects of proposed rules often seem reflexive, poorly supported, and lacking in credibility.)

Another type of nonmarket failure is what Wolf calls “derived externalities” unanticipated side effects, often in an area remote from that in which the public policy was intended to operate. Derived externalities are exacerbated by government’s tendency to operate through large organizations using blunt instruments. The last nonmarket failure category worth mentioning here is a maldistribution of influence and power, which must be compared to the maldistribution of income and wealth that private markets often generate.

We shall see in later chapters that Wolf’s theoretical account of nonmarket failures helps to explain a regrettably large number of government failures. This account, however, cannot itself determine whether the market or government (or some hybrid form) can best deal with perceived social problems. Each kind of system has some advantages and disadvantages relative to the other. As Wolf puts it, theory provides no clear bottom line: the answer will depend on the specifics of particular cases.

Incentives can distort policymaking in other ways, which we can get at by asking the question: why, or how much, would an official actually care about the soundness of policy? Political scientists Alan Gerber and Eric Patashnik, whose work was mentioned in
chapter 1
, provide one approach to an answer in their notion of “zero credit policymaking.” They first review some of the significant obstacles that any conscientious policymaker would confront, such as convincing
others that some objective social condition constitutes a “problem” requiring governmental intervention; overcoming disagreement over the best solution to that problem; deliberating, bargaining, and compromising to develop a politically viable proposal; seeking to create public demand for the policy; and so forth. They then consider what happens if this political effort and creativity begin to bear fruit:

In a commercial setting, such an investment often enjoys legal protections such as patents and trademarks. In a political setting, however, there is nothing to stop an opportunistic opponent who observes the changes in public opinion produced by a rival’s hard work from proposing a substantively similar proposal of his own. If this effort at political mimicry is successful, the policy innovator will capture, at best, a small share of the credit for the results of his efforts. Worse, the second politician, by hanging back until political conditions become more favorable and observing how opinion unfolds, may generate more support for his alternative scheme, a copycat plan better tailored to public opinion. In the ruthlessly competitive world of democratic politics, the policy innovator could end up worse off for his effort…. [A “zero-credit policy” is] a government intervention or activity that offers no captureable political returns even though it has large social benefits…. If policy innovators anticipate that the political benefits from proposing novel solutions to public problems will be quickly appropriated, the effect will be to discourage the entrepreneurial investments in the first place.
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