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Regulatory finance in alternative models of regulation
European
Journal
of Political
REGULATORY
Economy
6 (1990) 519-529.
North-Holland
FINANCE IN ALTERNATIVE REGULATION
MODELS
OF
General Fund Financing Versus Earmarked Taxation Mwangi (iniversity
Robert
qf Mississippi,
D. TOLLISON
George Mason Accepted
S. KIMENYI
(iniversiry,
Lqfayrte,
and Richard
Universiry,
Fait-fas,
for publication
MS 38677, USA
E. WAGNER
VA 22030, USA
October
1, 1990
Nowhere in studies of regulation does one confront the issue of how to account for the costs of the regulator’s services. In this paper we treat the cost of the regulator as an integral component of the positive theory of regulation. In particular, we examine what difference it makes whether the cost of the regulator is financed through general-fund appropriations or through special charges imposed upon the regulated activity.
1. Introduction The economic analysis of regulation has undergone a substantial transformation over the past two decades. The earlier, general-interest approach envisioned regulation as a means of controlling monopoly for the benefit of consumers. In contrast, the positive theory of economic regulation developed by Stigler (1971) and Peltzman (1976) characterizes the regulator as an agent of the producer and politically dominant blocs of consumers. In this positive approach regulatory outcomes result from competition between well organized groups demanding wealth transfers and less well organized groups who ‘supply’ those transfers, and with the regulator acting as a broker of those transfers. This positive theory has proven successful in explaining the origin and distributional effects of various regulatory programs [Tollison (1989)]. Nonetheless, there has been something left out of these efforts to analyze regulation - the regulator. Nowhere in these studies does one confront the issue of how to cover the cost of the regulator’s services. And note that we are talking about the cost of the regulator and not the cost of regulation, which has been studied extensively. In this paper we treat the cost of the regulator as an integral component of the positive theory of regulation. In 017~2680/91/$03.50
0
1991-Elsevier
Science Publishers
B.V. (North-Holland)
520
M.S. Kimenyi et al., Regulatoryjinance
in alternative
models of regulation
particular, we examine what difference it makes whether the regulator is financed through general-fund appropriations or through special charges imposed upon the regulated activity. We shall focus in particular on the method used to finance state public utility commissions in the United States. First, we shall consider how the method of finance is likely to affect regulatory outcomes when regulation is characterized as a general-interest process for the promotion of consumer welfare. Then we shall examine how the method of finance is likely to exert a different impact on regulatory outcomes within a special-interest model. More specifically, we explain that general-fund financing is likely to increase regulatory activity under a general-interest model but to decrease it within a special-interest model. Subsequently, we will examine empirically the impact of the method of funding on the budgets of state public utility commissions, and find further support for the special-interest model of regulation. 2. Regulatory
finance in a general-interest
world
In the general-interest perspective, the regulator is seen as an agent of consumers, as illustrated by the standard model where the regulator forces a monopolist to produce the competitive output at the competitive price. But how does the regulator do this? Rate-of-return regulation is commonly thought to be a technique for doing this. By selecting an allowable rate of return that is thought to correspond to what a competitive rate would be, and by pushing price down or letting it rise, depending on whether the monopolist’s actual rate of return is above or below the permitted rate, it would seem as though the competitive outcome would result, provided only that the monopolist continues to produce with the least-cost combination of inputs. But why would the monopolist continue to produce in this least-cost fashion? If regulation represents a 100% tax on monopoly rents, would not the monopolist dissipate those rents through expenditures that produce some positive utility to the monopolist? Recognition of this simple point was, of course, behind Alchian and Kessel’s (1962) well-known formulation of how regulation would lead to the selection of more expensive processes of production. Indeed, Tollison and Wagner (1990) explain that the elementary logic of rate-of-return regulation gives the monopoly outcome, only with the monopoly rents captured through less valuable forms represented by more costly expenditures rather than being captured directly in take-home profits or pay.’ ‘This ‘preference for expenses’ should not be confused with the Averach-Johnson (1962) effect that posits a possible tendency to employ an excessively large capital stock. This possibility arises if the allowable rate of return exceeds the cost of capital to the regulated firm. But even if there is no such incentive to pad the rate base, the ‘preference for expenses’ would exist under rate-of-return regulation.
MS. Kimenyi et al., Regulatory
finance in alternative models
ofregulation
521
To promote consumer welfare, the regulator must be actively involved in the adjudication of expenses. But such adjudication is costly, and once this is recognized it is necessary to ask to what extent this cost adjudication should be undertaken. If the answer is ‘zero’, the monopoly price will prevail. With a sufficiently high expenditure on cost adjudication, the competitive price could perhaps be achieved - ignoring the cost of cost adjudication, which, of course, is an uneconomical thing to do [McKean and Minasian (1966)]. The regulated monopolist will have an incentive to escalate cost to justify the monopoly price. To counteract that incentive, the regulator will have to investigate the details of expenses and challenge some of them. The more intensively the regulator gets involved with the details of cost adjudication, the greater the number of claims for expense disallowance the regulator will be able to press. But that increase in regulatory intensity increases the regulator’s costs. It also increases the monopolist’s cost of complying with the regulator’s efforts, for compliance does not mean passive acquiescence in the regulator’s efforts to disallow expenses. Rather compliance includes the efforts of the firm to dispute the regulator and to defend the observed expenses as reasonable. The more tenacious and determined the firm is to defend the propriety of its claims about cost, the higher will be the cost to the regulator of trying to push the firm’s expenses downward. From a general-interest perspective, the regulator is the agent of consumers, who, in effect, hire the regulator to pull the price down from its monopoly level. The amount of regulatory services consumers hire will depend both on the price they have to pay for those services and the productivity of those services. Consumers will be able, in the best of circumstances, to achieve a price that is an epsilon above the competitive level. And this will result only if the monopolist makes no effort to resist paying the 100% tax on monopoly rents, and even then only if the regulator acts as a perfect agent in representing consumer interests. With perfect agency, consumers will hire regulatory services only up to the point where the marginal addition to consumer welfare resulting from the lower price achieved by the regulator equals the marginal cost of achieving that price reduction. With a positive cost of regulatory services, the purchase of regulatory services will stop short of that necessary to bring about the competitive price. How far short will depend on the intensity with which the monopolist seeks to evade, avoid, or otherwise resist the regulator’s efforts. And in this regard there are many margins along which resistance can occur. Indeed, Tollison and Wagner (1991) argue that the resistance put up by a rational monopolist will generally be sufficient to lead rational consumers to hire zero regulatory services. But regardless of the quantity of regulatory services consumers might hire when they pay the full cost of those services, they would surely hire more when they can shift part of the cost onto others. This can happen when the
522
MS. Kimenyi et al., Regulatoryfinance
in alternative
models qfregulation
cost of regulation is financed through general-fund appropriations, as against being financed through charges imposed directly on consumers. Whether regulation is financed through general-fund appropriations or through charges upon the consumers, the marginal benefit of regulatory activity is the same. But the marginal cost to consumers is less under general-fund financing, so consumers will choose a larger amount of regulatory activity, provided only that they exercise decisive influence over collective choices pertaining to regulation.
3. Incentive-compatibility
and regulatory budgets
The normative literature on regulation implicitly adopts the perspective of the regulator as an agent of consumers. In contrast, the positive literature characterizes the regulator not as a unified agent of consumers but as a fragmented agent whose allegiance is generally split between the firm being regulated and particular groups of consumers. From this positive perspective the purpose of regulation is not to pull prices down for consumers in general, but rather is to benefit some people at the expense of others. For example, the regulator could actually be an agent of the producer, pushing prices upward, much as Jarrell (1978) describes. Alternatively, the regulator could be an agent for particular consumer groups, enforcing some regime of crosssubsidization. The regulator could also serve dual principals, as in pushing for higher prices, though not as fully as would a regulator who was an agent only of the producer, and at the same time forcing the monopolist to provide subsidized service to a particular subset of consumers. Peltzman (1976) considers the behavior of regulators in engaging in cross-subsidization to be integral to the regulatory process. But whatever the regulator does carries with it a price tag in terms of the cost of the regulator. A regulator true to the dictates of a special-interest theory must act differently than one true to the dictates of a general-interest theory. In turn, the promotion of such a different course of action will require some method for creating incentives to induce the regulator to act differently. As we shall try to explain below, the method used to tinance the regulator can influence the regulator’s incentives. A special-interest regulator will generally incur higher costs of operation than a general-interest regulator, because cross-subsidization, an important element in the special-interest model, is particularly costly to enforce. Crosssubsidization creates incentives, both for the regulated firm and for consumers, to undermine the regulation. For one thing, the regulated firm would have an incentive to restrict its output to the subsidized groups of consumers, so the regulator must undertake efforts to prevent this from happening. Furthermore, subsidized consumer groups would also have incentives to resell to the subsidy-supplying groups of consumers. The
MS. Kimenyi et al., Regulatoryfinance
in alternative
models of regulation
523
prevention of such activities will likewise require additional regulatory effort. For these reasons, a regulator who enforces special-interest deals arranged by the legislature should generally require a larger budget than would be required by a general-interest regulator. But incentive compatibility is also vital for the promotion of specialinterest regulation. The legislature must prevent shirking by the regulator, and the more successfully it is able to do so, the higher will be the value of the regulation to those special interests that purchase it. The earmarking of tax revenues for the support of the regulator promotes incentive compatibility with the special-interest character of regulation more fully than does general-fund financing. There is good reason to think that earmarked financing will produce larger budgets than would general-fund financing, at least in the context of specialinterest regulation. With general-interest regulation, the reverse should result: a shift from user charges to general-fund financing seems likely to increase spending. In this case the beneficiaries of regulation form a majority subset, if not the near entirety, of the relevant political unit. A shift to general-fund financing would be a means by which this majority subset could reduce its costs of regulatory services by passing a portion of the cost onto those who do not benefit - though the set of non-beneficiaries may well be small, as would the possible price reduction. But special-interest models of regulation refer to situations where the beneficiaries constitute a minority subset of the relevant political unit, perhaps even a quite small subset. By creating a form of property right in tax revenues, earmarking is likely to accommodate itself more fully to Niskanentype budget maximization [Niskanen (1977)] than would be possible under general-fund financing. When revenues go into a general fund, any lobbying effort by some interest group that leads to increased taxation provides general benefits for all claimants on the public treasury. But with an earmarked tax, any increase in tax revenues is captured by the particular interest group or groups for which the tax is earmarked.’ Furthermore, the size of the earmarked tax base is, at least in many cases, likely to vary directly with the extent to which the regulator is able to implement the pattern of cross-subsidization envisioned by the specialinterest theory of regulation. In many respects cross-subsidization operates as a form of price discrimination. Utility regulation may lead to a shift in prices in favor of industrial and commercial users at the expense of residential *Our argument here would seem to oppose that of Wyrick and Arnold (1989) who argue that earmarking would lead to larger expenditures. But the opposition is not so strong as it might seem. For their comparison was similar to the general-interest framework we discussed in section 2, and stressed the ability of earmarking to concentrate costs on beneficiaries. Our point about special interests and the ability of earmarking to create property rights in tax bases places tax earmarking in a different context.
524
MS. Kimenyi et al.,
Regulatoryfinance in alternative models of regulation
users. At the same time, those favored users are likely to have more elastic demands than the residential users. The more fully the regulator is able to enforce this pattern of price discrimination, the larger will be both the revenues received by utility companies and the earmarked revenues from a utility tax. Thus, dedicating revenues from the regulated industry to finance the cost of the regulator creates institutions in which the incentive of the regulator to maximize revenues from the regulated service is compatible with cross subsidization. The regulator is therefore able to serve special interests and increase his budget at one and the same time.
4. Empirical model and results The empirical predictions of the foregoing analysis are straightforward. Other things equal, regulatory bureaus in which the costs of the regulator originate from dedicated revenues will have larger budgets than those that rely on general-fund appropriations. Moreover, the services of regulators will be more valuable to special interests in the presence of earmarking because there will be more cross-subsidization and multipart-pricing schemes3 Or at least these conclusions would follow if regulation were aptly characterized by the special-interest theory of regulation. But should regulation be more accurately characterized by the general-interest theory, we should expect to find the opposite result: regulatory budgets will be smaller when regulation is financed through earmarked revenues. Hence, an examination of the relation between earmarking and regulatory budgets can also serve as a different form of test of the comparative merits of these alternative characterizations of regulation. The public utility regulatory agencies in the 50 American states provide a convenient setting to test the predictions of our conceptual framework. While the various agencies by and large perform similar functions, there are significant differences in the sizes of the regulatory budgets - whether expressed in absolute or per capita terms. More importantly, and relevant to the present study, there are wide variations in the extent to which individual states rely on general tax funds to meet the costs of the regulator. In 1983, for example, only 17 of the 50 state regulatory agencies received 100% of their funding from general tax funds. The other agencies received some or all of their funding from levies and charges made against the regulated activities. 3Normally, earmarked revenues for regulatory bureaux derive from a tax on regulated services. The revenue-maximizing hypothesis presented above is compatible with an ad valorem system of excise taxation. Where per-unit excise taxes are used, special interests will have to cover one more margin of regulator behavior to make earmarking compatible with optimal prices. The per-unit tax gives the regulatory institution an incentive to maximize output rather than revenue.
MS. Kimenyi et al., Regulatory finance
in alternativemodels0J regulation
525
The size of the regulatory budget (which measures the cost of the regulator) is influenced by demographic variables, such as state income and the size of state government, as well as by such characteristics of the regulatory commission as the number of commissioners and the method of selecting commissioners. In addition, our theoretical framework suggests that the method by which the regulatory budget is financed should affect the size of the budget. Specifically, regulatory budgets in those states that rely more heavily on dedicated revenues should be larger than budgets in states that rely more heavily on general tax funds. To test this proposition empirically, we constructed a regression model of the following general form: BUDGET
= f(PGFUND, FTIMED),
INCOME,
GOVSIZE,
NC, ELECT,
BEYOD,
where BUDGET
PGFUND INCOME (PINCOME) GO V/SIZE NC ELECT BEYOD
FTIMED
= the annual budget of the regulatory agency; two measures of the budget are used: the absolute level of spending (REGBUD), and per capita spending (PREGBUD); = percent of regulatory budget that originates from general tax funds; = two measure of income, the state’s income and per capita income (PINCOME); = the size of the government defined in absolute (GOVSPEND) and per capita terms (PGVSPEND); = number of commissioners of the regulatory agency; = a binary variable equal to 1 if the commissioners are elected, and equal to 0 if they are appointed; = a binary variable equal to 1 if the agency’s activities extend beyond electric, gas, and telecommunications, and equal to 0 otherwise; and = a binary variable equal to 1 if the state’s commission operates part-time, and equal to 0 if full-time.
The rationale for the inclusion of most of the variables in the model is straightforward. States that have larger governments (whatever may be the cause of such large sizes) are expected to have larger regulatory budgets, given that regulation is one of the governmental activities. Thus, we expect the size of the regulatory budget to be positively related to the size of government. Likewise, regulatory budgets are expected to be larger in states with higher incomes. Several characteristics of the regulatory commission are included to control for variations in commission characteristics across states that may influence the budget. The number of commissioners may reflect a larger,
526
M.S. Kimenyi et ul., Regulatory
finance
in alternatioe models ~Jregulation
more bureaucratic agency, or one required to perform more extensive reporting by the legislature. Thus, agencies with more commissioners would be expected to have larger budgets. On the other hand, however, if regulators are agents of consumers, a small number of commissioners may be easily captured by powerful producers or a segment of consumers. Under such circumstances the regulators would be rewarded with large budgets in return for their preferential treatment of the capturing interest group. If there are more commissioners, it may be more difficult for any group to capture a majority of commissioners, in which case the commissioners are likely to act as agents of consumers in general by pulling price down. Thus, the larger the number of commissioners, the more likely that regulation will be enforced in the interests of consumers in general, with consequent lower regulatory budgets. The method of selecting commissioners - elected or appointed - may influence the regulatory budget in various ways. First, if commissioners are elected, they may want to reward some campaign workers by providing them employment in the agency, which is likely to translate into larger budgets. But elected commissioners are directly confronted by the electorate, which may imply that they have an incentive to keep costs low. In this case regulatory commissions in which the commissioners are elected are likely to have smaller budgets. This analysis, however, ignores the fact that in the case of elected commissioners, the free-riding incentive among voters may make monitoring by the general public weak, so that elected commissioners are able to increase costs which translates into larger budgets. Appointed commissioners do not face the public directly, and so it may appear that they can incur higher costs which are borne by the public who have no direct way of removing the commissioners. But the appointed commissioners are directly monitored by an elected ofticial (such as the governor) or by an elected body (such as the legislature), in which case there is less free-riding, and the commissioners are therefore monitored more closely. In this case regulatory commissions in which commissioners are appointed are likely to have lower operating costs. We are therefore not able to predict a priori how the method of selecting commissioners will influence the regulatory budget. Some state regulatory commissions not only regulate public utilities but are also involved in other regulatory activities. The binary variable BEYOD was included to control for the wider scope of activities by some regulatory commissions. We would expect commissions whose regulatory activities go beyond the standard regulation of utilities to require larger budgets. Finally, we included a dummy variable (FTZMED) to control for whether a commission works full-time or part-time. Full-time commissions would be expected to be involved more intensively in the regulatory process and would thus require larger budgets. The main test of the role of the method of financing the cost of the
MS. Kimenyi et al.,
Regulatoryfinance in alternative Table
Regression Intercept PGFUND GO VSPEND INCOME NC ELECT BEYOD FTIMED R2
models of regulation
527
1
results for the determinants of REGBUD (1983), N = 50.” ~~~ 3,781.46 3.617.30 3J79.00 3,592.45 (1.77)* (2.05)* (1.78)* (2.01)* - 36.33 -36.10 - 34.28 - 34.40 (-2.54)** (- 2.44)** (-2.83)*** (2.68)** 0.90 0.92 (10.43)*** (10.15)*** 2 12.06 216.60 (8.68)*** (9.01)* -319.89 -214.07 -391.68 -281.24 (-0.42) (-0.71) ( - 0.87) (-0.57) 1,43 1.43 1,3 19.06 1,453.65 1,316.50 (1.11) (0.93) (1.12) (0.93) 2,721.32 2,201.82 2,118.07 1,840.06 (1.03) (1.26) (1.00) 0.88) 2,971.57 2,415.55 (1.20) (0.88) 0.75 0.68 0.74 0.68
at-statistics in parentheses, R-’ is the adjusted coefficient of multiple determination. Asterisks denote significance at the 1% (***), So/; (**), and 10% (*) levels, respectively.
regulator on the size of regulatory budgets centers upon the estimated coefficient of PGFUND (the percentage of regulatory budget originating from general tax funds). According to our incentive-compatibility hypothesis, we expect the regulatory budget to be small in those states that rely more heavily on general tax funds. Thus, we expect the coefficient on PGFUND to be negative. Tables 1 and 2 report the regression results of estimating the models outlined above using ordinary least squares. In all specifications the size of government and income variables affect the size of the regulatory budget as expected. The coefficient for the number of commissioners (NC) is negative in all specifications, but only statistically significant for specifications in table 2. This suggests, at least to some extent, that larger commissions are more proconsumer in general than smaller ones. The remainder of the regulatory commission variables are not significant. The coefficients on the variable for the share of the regulatory budget originating from general tax funds is negative in all specifications and statistically significant at the loo/, level or higher. These results offer support for our theoretical model of incentive compatibility between regulators and the regulated interest groups under a system of dedicated revenues.
5. Conclusion This paper has extended the cost of the regulator.
the positive theory of regulation to the analysis of While the positive theory offers several testable
528
MS.
Kimenyi
et al., Regulatoryfinance
in alternative
models of regulation
Table 2 Regression Intercept PGFUND PGOVSPEND
results for the determinants 1.52 (2.73)* - 0.01 (-2X8)*** 0.0011 (5.77)***
PINCOME NC ELECT BEYOD FTIMED R2 “See footnote
-0.24 (-2.18)** 0.55 (1.57) 0.58 (0.99) 0.48 (0.71) 0.4 1
of PREGBUD
- 0.06 I ( - 0.03) - 0.0066 ( - 1.76)* _ 0.0006 (2.23)** -0.31 (- 2.00)” 0.42 (0.86) 0.84 (1.10) 0.27 (0.30) 0.23
(1983). N = 50.”
1.51 (2.73)* -0.009 ( - 2.84)*** 0.001 I (5.79)*** _ -0.31
( - 2.00)** 0.55 (0.35) 0.48 (0.85)
0.42
-0.149 (0.098) -0.0065 (- 1.75)*
_
0.0006 (2.36)** 0.25 ( - 2.25)** 0.43 (0.89) 0.78 (1.07) _ 0.25
table 1.
predictions about the behavior of regulators, it has nothing to say about how the method of meeting the cost of the regulator may affect such behavior. In this paper we have demonstrated that the incentive of the regulator to adopt revenue-maximizing, cross-subsidizing pricing schemes is greater when the costs of regulation originate from dedicated revenue from the regulated services. Such incentive-compatibility leads directly to larger regulatory budgets. Earmarking of tax revenues is commonly associated with efficient outcomes. The evidence provided in this paper, however, suggests that earmarking allows regulators not only to serve special interests by using discriminatory pricing, but also provides them with favorable circumstances to choose those prices that increase their own budgets.
References Alchian, A.A. and R.A. Kessel, 1962, Competition, monopoly and the pursuit of money, Aspects of labor economics (Princeton University Press, Princeton) 157-175. Averach, H. and L.L. Johnson, 1962, Behavior of the firm under regulatory constraint, American Economic Review 52, 1052-1069. Hilton, G.W., 1972, The basic behavior of regulatory commissions. American Economic Review 62 (Papers and Proceedings) 47-54. McKean, R.N. and J.A. Minasian, 1966, On achieving Pareto optimality regardless of cost, Western Economic Journal 5, 1423. Jarrell, G.A., 1978, The demand for state regulation of the electric utility industry, Journal of Law and Economics 21, 2699295. Meyer, R.A., and H.E. Leland, 1980, The effectiveness of price regulation, Review of Economics and Statistics 62, 5555566. Niskanen, W.A., 1971, Bureaucracy and representative government (Aldine, Chicago, IL).
MS. Kimenyi et al., Regulatory finance in alternative models
of regulation
529
Peltzman, S., 1971, Pricing in public and private enterprises: Electric utilities in the United States, Journal of Law and Economics 14, 109-147. Peltzman, S., 1973, An evaluation of consumer protection legislation: The 1962 drug amendments, Journal of Political Economy 81, 1049-1091. Peltzman, S., 1976, Toward a more general theory of regulation, Journal of Law and Economics 19, 21 l-240. Stigler, G., 1971, The theory of economic regulation, Bell Journal of Economics and Management Science 3, 3-21. Tollison, R.D., 1989, Regulation and interest groups, Unpublished manuscript. Tollison, R.D. and R.E. Wagner, 1991, Romance, realism and economic reform, Kyklos, to appear. Tollison, R.D. and R.E. Wagner, 1990, The monopolistic logic of natural monopoly regulation, Unpublished manuscript, Wyrick, T.L. and R.A. Arnold, 1989, Earmarking as a deterrent to rent-seeking, Public Choice 60. 283329 1.
Journal
of Political
REGULATORY
Economy
6 (1990) 519-529.
North-Holland
FINANCE IN ALTERNATIVE REGULATION
MODELS
OF
General Fund Financing Versus Earmarked Taxation Mwangi (iniversity
Robert
qf Mississippi,
D. TOLLISON
George Mason Accepted
S. KIMENYI
(iniversiry,
Lqfayrte,
and Richard
Universiry,
Fait-fas,
for publication
MS 38677, USA
E. WAGNER
VA 22030, USA
October
1, 1990
Nowhere in studies of regulation does one confront the issue of how to account for the costs of the regulator’s services. In this paper we treat the cost of the regulator as an integral component of the positive theory of regulation. In particular, we examine what difference it makes whether the cost of the regulator is financed through general-fund appropriations or through special charges imposed upon the regulated activity.
1. Introduction The economic analysis of regulation has undergone a substantial transformation over the past two decades. The earlier, general-interest approach envisioned regulation as a means of controlling monopoly for the benefit of consumers. In contrast, the positive theory of economic regulation developed by Stigler (1971) and Peltzman (1976) characterizes the regulator as an agent of the producer and politically dominant blocs of consumers. In this positive approach regulatory outcomes result from competition between well organized groups demanding wealth transfers and less well organized groups who ‘supply’ those transfers, and with the regulator acting as a broker of those transfers. This positive theory has proven successful in explaining the origin and distributional effects of various regulatory programs [Tollison (1989)]. Nonetheless, there has been something left out of these efforts to analyze regulation - the regulator. Nowhere in these studies does one confront the issue of how to cover the cost of the regulator’s services. And note that we are talking about the cost of the regulator and not the cost of regulation, which has been studied extensively. In this paper we treat the cost of the regulator as an integral component of the positive theory of regulation. In 017~2680/91/$03.50
0
1991-Elsevier
Science Publishers
B.V. (North-Holland)
520
M.S. Kimenyi et al., Regulatoryjinance
in alternative
models of regulation
particular, we examine what difference it makes whether the regulator is financed through general-fund appropriations or through special charges imposed upon the regulated activity. We shall focus in particular on the method used to finance state public utility commissions in the United States. First, we shall consider how the method of finance is likely to affect regulatory outcomes when regulation is characterized as a general-interest process for the promotion of consumer welfare. Then we shall examine how the method of finance is likely to exert a different impact on regulatory outcomes within a special-interest model. More specifically, we explain that general-fund financing is likely to increase regulatory activity under a general-interest model but to decrease it within a special-interest model. Subsequently, we will examine empirically the impact of the method of funding on the budgets of state public utility commissions, and find further support for the special-interest model of regulation. 2. Regulatory
finance in a general-interest
world
In the general-interest perspective, the regulator is seen as an agent of consumers, as illustrated by the standard model where the regulator forces a monopolist to produce the competitive output at the competitive price. But how does the regulator do this? Rate-of-return regulation is commonly thought to be a technique for doing this. By selecting an allowable rate of return that is thought to correspond to what a competitive rate would be, and by pushing price down or letting it rise, depending on whether the monopolist’s actual rate of return is above or below the permitted rate, it would seem as though the competitive outcome would result, provided only that the monopolist continues to produce with the least-cost combination of inputs. But why would the monopolist continue to produce in this least-cost fashion? If regulation represents a 100% tax on monopoly rents, would not the monopolist dissipate those rents through expenditures that produce some positive utility to the monopolist? Recognition of this simple point was, of course, behind Alchian and Kessel’s (1962) well-known formulation of how regulation would lead to the selection of more expensive processes of production. Indeed, Tollison and Wagner (1990) explain that the elementary logic of rate-of-return regulation gives the monopoly outcome, only with the monopoly rents captured through less valuable forms represented by more costly expenditures rather than being captured directly in take-home profits or pay.’ ‘This ‘preference for expenses’ should not be confused with the Averach-Johnson (1962) effect that posits a possible tendency to employ an excessively large capital stock. This possibility arises if the allowable rate of return exceeds the cost of capital to the regulated firm. But even if there is no such incentive to pad the rate base, the ‘preference for expenses’ would exist under rate-of-return regulation.
MS. Kimenyi et al., Regulatory
finance in alternative models
ofregulation
521
To promote consumer welfare, the regulator must be actively involved in the adjudication of expenses. But such adjudication is costly, and once this is recognized it is necessary to ask to what extent this cost adjudication should be undertaken. If the answer is ‘zero’, the monopoly price will prevail. With a sufficiently high expenditure on cost adjudication, the competitive price could perhaps be achieved - ignoring the cost of cost adjudication, which, of course, is an uneconomical thing to do [McKean and Minasian (1966)]. The regulated monopolist will have an incentive to escalate cost to justify the monopoly price. To counteract that incentive, the regulator will have to investigate the details of expenses and challenge some of them. The more intensively the regulator gets involved with the details of cost adjudication, the greater the number of claims for expense disallowance the regulator will be able to press. But that increase in regulatory intensity increases the regulator’s costs. It also increases the monopolist’s cost of complying with the regulator’s efforts, for compliance does not mean passive acquiescence in the regulator’s efforts to disallow expenses. Rather compliance includes the efforts of the firm to dispute the regulator and to defend the observed expenses as reasonable. The more tenacious and determined the firm is to defend the propriety of its claims about cost, the higher will be the cost to the regulator of trying to push the firm’s expenses downward. From a general-interest perspective, the regulator is the agent of consumers, who, in effect, hire the regulator to pull the price down from its monopoly level. The amount of regulatory services consumers hire will depend both on the price they have to pay for those services and the productivity of those services. Consumers will be able, in the best of circumstances, to achieve a price that is an epsilon above the competitive level. And this will result only if the monopolist makes no effort to resist paying the 100% tax on monopoly rents, and even then only if the regulator acts as a perfect agent in representing consumer interests. With perfect agency, consumers will hire regulatory services only up to the point where the marginal addition to consumer welfare resulting from the lower price achieved by the regulator equals the marginal cost of achieving that price reduction. With a positive cost of regulatory services, the purchase of regulatory services will stop short of that necessary to bring about the competitive price. How far short will depend on the intensity with which the monopolist seeks to evade, avoid, or otherwise resist the regulator’s efforts. And in this regard there are many margins along which resistance can occur. Indeed, Tollison and Wagner (1991) argue that the resistance put up by a rational monopolist will generally be sufficient to lead rational consumers to hire zero regulatory services. But regardless of the quantity of regulatory services consumers might hire when they pay the full cost of those services, they would surely hire more when they can shift part of the cost onto others. This can happen when the
522
MS. Kimenyi et al., Regulatoryfinance
in alternative
models qfregulation
cost of regulation is financed through general-fund appropriations, as against being financed through charges imposed directly on consumers. Whether regulation is financed through general-fund appropriations or through charges upon the consumers, the marginal benefit of regulatory activity is the same. But the marginal cost to consumers is less under general-fund financing, so consumers will choose a larger amount of regulatory activity, provided only that they exercise decisive influence over collective choices pertaining to regulation.
3. Incentive-compatibility
and regulatory budgets
The normative literature on regulation implicitly adopts the perspective of the regulator as an agent of consumers. In contrast, the positive literature characterizes the regulator not as a unified agent of consumers but as a fragmented agent whose allegiance is generally split between the firm being regulated and particular groups of consumers. From this positive perspective the purpose of regulation is not to pull prices down for consumers in general, but rather is to benefit some people at the expense of others. For example, the regulator could actually be an agent of the producer, pushing prices upward, much as Jarrell (1978) describes. Alternatively, the regulator could be an agent for particular consumer groups, enforcing some regime of crosssubsidization. The regulator could also serve dual principals, as in pushing for higher prices, though not as fully as would a regulator who was an agent only of the producer, and at the same time forcing the monopolist to provide subsidized service to a particular subset of consumers. Peltzman (1976) considers the behavior of regulators in engaging in cross-subsidization to be integral to the regulatory process. But whatever the regulator does carries with it a price tag in terms of the cost of the regulator. A regulator true to the dictates of a special-interest theory must act differently than one true to the dictates of a general-interest theory. In turn, the promotion of such a different course of action will require some method for creating incentives to induce the regulator to act differently. As we shall try to explain below, the method used to tinance the regulator can influence the regulator’s incentives. A special-interest regulator will generally incur higher costs of operation than a general-interest regulator, because cross-subsidization, an important element in the special-interest model, is particularly costly to enforce. Crosssubsidization creates incentives, both for the regulated firm and for consumers, to undermine the regulation. For one thing, the regulated firm would have an incentive to restrict its output to the subsidized groups of consumers, so the regulator must undertake efforts to prevent this from happening. Furthermore, subsidized consumer groups would also have incentives to resell to the subsidy-supplying groups of consumers. The
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prevention of such activities will likewise require additional regulatory effort. For these reasons, a regulator who enforces special-interest deals arranged by the legislature should generally require a larger budget than would be required by a general-interest regulator. But incentive compatibility is also vital for the promotion of specialinterest regulation. The legislature must prevent shirking by the regulator, and the more successfully it is able to do so, the higher will be the value of the regulation to those special interests that purchase it. The earmarking of tax revenues for the support of the regulator promotes incentive compatibility with the special-interest character of regulation more fully than does general-fund financing. There is good reason to think that earmarked financing will produce larger budgets than would general-fund financing, at least in the context of specialinterest regulation. With general-interest regulation, the reverse should result: a shift from user charges to general-fund financing seems likely to increase spending. In this case the beneficiaries of regulation form a majority subset, if not the near entirety, of the relevant political unit. A shift to general-fund financing would be a means by which this majority subset could reduce its costs of regulatory services by passing a portion of the cost onto those who do not benefit - though the set of non-beneficiaries may well be small, as would the possible price reduction. But special-interest models of regulation refer to situations where the beneficiaries constitute a minority subset of the relevant political unit, perhaps even a quite small subset. By creating a form of property right in tax revenues, earmarking is likely to accommodate itself more fully to Niskanentype budget maximization [Niskanen (1977)] than would be possible under general-fund financing. When revenues go into a general fund, any lobbying effort by some interest group that leads to increased taxation provides general benefits for all claimants on the public treasury. But with an earmarked tax, any increase in tax revenues is captured by the particular interest group or groups for which the tax is earmarked.’ Furthermore, the size of the earmarked tax base is, at least in many cases, likely to vary directly with the extent to which the regulator is able to implement the pattern of cross-subsidization envisioned by the specialinterest theory of regulation. In many respects cross-subsidization operates as a form of price discrimination. Utility regulation may lead to a shift in prices in favor of industrial and commercial users at the expense of residential *Our argument here would seem to oppose that of Wyrick and Arnold (1989) who argue that earmarking would lead to larger expenditures. But the opposition is not so strong as it might seem. For their comparison was similar to the general-interest framework we discussed in section 2, and stressed the ability of earmarking to concentrate costs on beneficiaries. Our point about special interests and the ability of earmarking to create property rights in tax bases places tax earmarking in a different context.
524
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users. At the same time, those favored users are likely to have more elastic demands than the residential users. The more fully the regulator is able to enforce this pattern of price discrimination, the larger will be both the revenues received by utility companies and the earmarked revenues from a utility tax. Thus, dedicating revenues from the regulated industry to finance the cost of the regulator creates institutions in which the incentive of the regulator to maximize revenues from the regulated service is compatible with cross subsidization. The regulator is therefore able to serve special interests and increase his budget at one and the same time.
4. Empirical model and results The empirical predictions of the foregoing analysis are straightforward. Other things equal, regulatory bureaus in which the costs of the regulator originate from dedicated revenues will have larger budgets than those that rely on general-fund appropriations. Moreover, the services of regulators will be more valuable to special interests in the presence of earmarking because there will be more cross-subsidization and multipart-pricing schemes3 Or at least these conclusions would follow if regulation were aptly characterized by the special-interest theory of regulation. But should regulation be more accurately characterized by the general-interest theory, we should expect to find the opposite result: regulatory budgets will be smaller when regulation is financed through earmarked revenues. Hence, an examination of the relation between earmarking and regulatory budgets can also serve as a different form of test of the comparative merits of these alternative characterizations of regulation. The public utility regulatory agencies in the 50 American states provide a convenient setting to test the predictions of our conceptual framework. While the various agencies by and large perform similar functions, there are significant differences in the sizes of the regulatory budgets - whether expressed in absolute or per capita terms. More importantly, and relevant to the present study, there are wide variations in the extent to which individual states rely on general tax funds to meet the costs of the regulator. In 1983, for example, only 17 of the 50 state regulatory agencies received 100% of their funding from general tax funds. The other agencies received some or all of their funding from levies and charges made against the regulated activities. 3Normally, earmarked revenues for regulatory bureaux derive from a tax on regulated services. The revenue-maximizing hypothesis presented above is compatible with an ad valorem system of excise taxation. Where per-unit excise taxes are used, special interests will have to cover one more margin of regulator behavior to make earmarking compatible with optimal prices. The per-unit tax gives the regulatory institution an incentive to maximize output rather than revenue.
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The size of the regulatory budget (which measures the cost of the regulator) is influenced by demographic variables, such as state income and the size of state government, as well as by such characteristics of the regulatory commission as the number of commissioners and the method of selecting commissioners. In addition, our theoretical framework suggests that the method by which the regulatory budget is financed should affect the size of the budget. Specifically, regulatory budgets in those states that rely more heavily on dedicated revenues should be larger than budgets in states that rely more heavily on general tax funds. To test this proposition empirically, we constructed a regression model of the following general form: BUDGET
= f(PGFUND, FTIMED),
INCOME,
GOVSIZE,
NC, ELECT,
BEYOD,
where BUDGET
PGFUND INCOME (PINCOME) GO V/SIZE NC ELECT BEYOD
FTIMED
= the annual budget of the regulatory agency; two measures of the budget are used: the absolute level of spending (REGBUD), and per capita spending (PREGBUD); = percent of regulatory budget that originates from general tax funds; = two measure of income, the state’s income and per capita income (PINCOME); = the size of the government defined in absolute (GOVSPEND) and per capita terms (PGVSPEND); = number of commissioners of the regulatory agency; = a binary variable equal to 1 if the commissioners are elected, and equal to 0 if they are appointed; = a binary variable equal to 1 if the agency’s activities extend beyond electric, gas, and telecommunications, and equal to 0 otherwise; and = a binary variable equal to 1 if the state’s commission operates part-time, and equal to 0 if full-time.
The rationale for the inclusion of most of the variables in the model is straightforward. States that have larger governments (whatever may be the cause of such large sizes) are expected to have larger regulatory budgets, given that regulation is one of the governmental activities. Thus, we expect the size of the regulatory budget to be positively related to the size of government. Likewise, regulatory budgets are expected to be larger in states with higher incomes. Several characteristics of the regulatory commission are included to control for variations in commission characteristics across states that may influence the budget. The number of commissioners may reflect a larger,
526
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finance
in alternatioe models ~Jregulation
more bureaucratic agency, or one required to perform more extensive reporting by the legislature. Thus, agencies with more commissioners would be expected to have larger budgets. On the other hand, however, if regulators are agents of consumers, a small number of commissioners may be easily captured by powerful producers or a segment of consumers. Under such circumstances the regulators would be rewarded with large budgets in return for their preferential treatment of the capturing interest group. If there are more commissioners, it may be more difficult for any group to capture a majority of commissioners, in which case the commissioners are likely to act as agents of consumers in general by pulling price down. Thus, the larger the number of commissioners, the more likely that regulation will be enforced in the interests of consumers in general, with consequent lower regulatory budgets. The method of selecting commissioners - elected or appointed - may influence the regulatory budget in various ways. First, if commissioners are elected, they may want to reward some campaign workers by providing them employment in the agency, which is likely to translate into larger budgets. But elected commissioners are directly confronted by the electorate, which may imply that they have an incentive to keep costs low. In this case regulatory commissions in which the commissioners are elected are likely to have smaller budgets. This analysis, however, ignores the fact that in the case of elected commissioners, the free-riding incentive among voters may make monitoring by the general public weak, so that elected commissioners are able to increase costs which translates into larger budgets. Appointed commissioners do not face the public directly, and so it may appear that they can incur higher costs which are borne by the public who have no direct way of removing the commissioners. But the appointed commissioners are directly monitored by an elected ofticial (such as the governor) or by an elected body (such as the legislature), in which case there is less free-riding, and the commissioners are therefore monitored more closely. In this case regulatory commissions in which commissioners are appointed are likely to have lower operating costs. We are therefore not able to predict a priori how the method of selecting commissioners will influence the regulatory budget. Some state regulatory commissions not only regulate public utilities but are also involved in other regulatory activities. The binary variable BEYOD was included to control for the wider scope of activities by some regulatory commissions. We would expect commissions whose regulatory activities go beyond the standard regulation of utilities to require larger budgets. Finally, we included a dummy variable (FTZMED) to control for whether a commission works full-time or part-time. Full-time commissions would be expected to be involved more intensively in the regulatory process and would thus require larger budgets. The main test of the role of the method of financing the cost of the
MS. Kimenyi et al.,
Regulatoryfinance in alternative Table
Regression Intercept PGFUND GO VSPEND INCOME NC ELECT BEYOD FTIMED R2
models of regulation
527
1
results for the determinants of REGBUD (1983), N = 50.” ~~~ 3,781.46 3.617.30 3J79.00 3,592.45 (1.77)* (2.05)* (1.78)* (2.01)* - 36.33 -36.10 - 34.28 - 34.40 (-2.54)** (- 2.44)** (-2.83)*** (2.68)** 0.90 0.92 (10.43)*** (10.15)*** 2 12.06 216.60 (8.68)*** (9.01)* -319.89 -214.07 -391.68 -281.24 (-0.42) (-0.71) ( - 0.87) (-0.57) 1,43 1.43 1,3 19.06 1,453.65 1,316.50 (1.11) (0.93) (1.12) (0.93) 2,721.32 2,201.82 2,118.07 1,840.06 (1.03) (1.26) (1.00) 0.88) 2,971.57 2,415.55 (1.20) (0.88) 0.75 0.68 0.74 0.68
at-statistics in parentheses, R-’ is the adjusted coefficient of multiple determination. Asterisks denote significance at the 1% (***), So/; (**), and 10% (*) levels, respectively.
regulator on the size of regulatory budgets centers upon the estimated coefficient of PGFUND (the percentage of regulatory budget originating from general tax funds). According to our incentive-compatibility hypothesis, we expect the regulatory budget to be small in those states that rely more heavily on general tax funds. Thus, we expect the coefficient on PGFUND to be negative. Tables 1 and 2 report the regression results of estimating the models outlined above using ordinary least squares. In all specifications the size of government and income variables affect the size of the regulatory budget as expected. The coefficient for the number of commissioners (NC) is negative in all specifications, but only statistically significant for specifications in table 2. This suggests, at least to some extent, that larger commissions are more proconsumer in general than smaller ones. The remainder of the regulatory commission variables are not significant. The coefficients on the variable for the share of the regulatory budget originating from general tax funds is negative in all specifications and statistically significant at the loo/, level or higher. These results offer support for our theoretical model of incentive compatibility between regulators and the regulated interest groups under a system of dedicated revenues.
5. Conclusion This paper has extended the cost of the regulator.
the positive theory of regulation to the analysis of While the positive theory offers several testable
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et al., Regulatoryfinance
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models of regulation
Table 2 Regression Intercept PGFUND PGOVSPEND
results for the determinants 1.52 (2.73)* - 0.01 (-2X8)*** 0.0011 (5.77)***
PINCOME NC ELECT BEYOD FTIMED R2 “See footnote
-0.24 (-2.18)** 0.55 (1.57) 0.58 (0.99) 0.48 (0.71) 0.4 1
of PREGBUD
- 0.06 I ( - 0.03) - 0.0066 ( - 1.76)* _ 0.0006 (2.23)** -0.31 (- 2.00)” 0.42 (0.86) 0.84 (1.10) 0.27 (0.30) 0.23
(1983). N = 50.”
1.51 (2.73)* -0.009 ( - 2.84)*** 0.001 I (5.79)*** _ -0.31
( - 2.00)** 0.55 (0.35) 0.48 (0.85)
0.42
-0.149 (0.098) -0.0065 (- 1.75)*
_
0.0006 (2.36)** 0.25 ( - 2.25)** 0.43 (0.89) 0.78 (1.07) _ 0.25
table 1.
predictions about the behavior of regulators, it has nothing to say about how the method of meeting the cost of the regulator may affect such behavior. In this paper we have demonstrated that the incentive of the regulator to adopt revenue-maximizing, cross-subsidizing pricing schemes is greater when the costs of regulation originate from dedicated revenue from the regulated services. Such incentive-compatibility leads directly to larger regulatory budgets. Earmarking of tax revenues is commonly associated with efficient outcomes. The evidence provided in this paper, however, suggests that earmarking allows regulators not only to serve special interests by using discriminatory pricing, but also provides them with favorable circumstances to choose those prices that increase their own budgets.
References Alchian, A.A. and R.A. Kessel, 1962, Competition, monopoly and the pursuit of money, Aspects of labor economics (Princeton University Press, Princeton) 157-175. Averach, H. and L.L. Johnson, 1962, Behavior of the firm under regulatory constraint, American Economic Review 52, 1052-1069. Hilton, G.W., 1972, The basic behavior of regulatory commissions. American Economic Review 62 (Papers and Proceedings) 47-54. McKean, R.N. and J.A. Minasian, 1966, On achieving Pareto optimality regardless of cost, Western Economic Journal 5, 1423. Jarrell, G.A., 1978, The demand for state regulation of the electric utility industry, Journal of Law and Economics 21, 2699295. Meyer, R.A., and H.E. Leland, 1980, The effectiveness of price regulation, Review of Economics and Statistics 62, 5555566. Niskanen, W.A., 1971, Bureaucracy and representative government (Aldine, Chicago, IL).
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of regulation
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Peltzman, S., 1971, Pricing in public and private enterprises: Electric utilities in the United States, Journal of Law and Economics 14, 109-147. Peltzman, S., 1973, An evaluation of consumer protection legislation: The 1962 drug amendments, Journal of Political Economy 81, 1049-1091. Peltzman, S., 1976, Toward a more general theory of regulation, Journal of Law and Economics 19, 21 l-240. Stigler, G., 1971, The theory of economic regulation, Bell Journal of Economics and Management Science 3, 3-21. Tollison, R.D., 1989, Regulation and interest groups, Unpublished manuscript. Tollison, R.D. and R.E. Wagner, 1991, Romance, realism and economic reform, Kyklos, to appear. Tollison, R.D. and R.E. Wagner, 1990, The monopolistic logic of natural monopoly regulation, Unpublished manuscript, Wyrick, T.L. and R.A. Arnold, 1989, Earmarking as a deterrent to rent-seeking, Public Choice 60. 283329 1.