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Three Ways to Level the Economic Playing Field

Matthew Mitchell — Wed, 28 Jan 2015 14:16:31 -0500

Expert Commentary

President Barack Obama recently extolled the virtues of what he called "middle-class economics" or "the idea that this country does best when everyone gets their fair shot, everyone does their fair share, and everyone plays by the same set of rules." The president is on to something.

Ours is not a country where everyone plays by the same set of economic rules. Many longstanding federal and state policies privilege some businesses and not others. This tilted playing field isn't just unfair; it's grossly inefficient. It undermines competition, discourages innovation, and prompts businesses to expend billions of dollars in socially wasteful efforts to win the favor of politicians. But it need not be this way.

A serious agenda to level the economic playing field appeals to both the progressive impulse to stick up for the powerless and the conservative urge to check government's scope and power. The president and Congress will soon deliver more detailed agendas. Here are three ways they could level the economic playing field:

First, end corporate bailouts: The first time the federal government rescued a single private company (Lockheed Aircraft) was in 1971. It bailed out a railroad and Chrysler by the end of the '70s; Continental Illinois National Bank in the '80s; and the savings-and-loans in the late '80s/early-'90s. But the big bailouts came in 2008-9 when the government rescued hundreds of insurance companies, financial institutions, and auto manufacturers. These bailouts give corporations the (correct) impression that politicians in Washington will rescue them if they get into trouble. That encourages risky behavior, making bailouts a self-fulfilling prophecy.

The Dodd-Frank regulatory overhaul may have strengthened this perception by directing the Federal Reserve to designate certain firms "systemically important financial institutions," broadcasting the federal government's belief that these firms are important enough to save. A good first step would be to repeal this designation.

A next step could be a constitutional amendment prohibiting bailouts. With the knowledge that they alone bear the costs of their mistakes, firms would be more prudent, and the entire financial system would be more secure.

Second, end trade protectionism: Scientific consensus can be elusive. But the closest we get in economics is the consensus view that barriers to trade are bad for an economy. Tariffs, quotas, and domestic subsidies stand in the way of competition, of lower prices, and of higher standards of living. These barriers pad the pockets of a few favored firms at the expense of millions of consumers and businesses who must pay more for the protected products.

The typical congressperson is generally in favor of freer trade but wants to make exceptions for hometown industries. For the better part of a century, the way to get around congressional parochialism has been to give the president "fast track" trade negotiating authority: Congress lets the president negotiate trade agreements and agrees to simply vote up or down without amendments. Democrats first came up with this idea. They should embrace it once again.

Congress can end protectionism in other ways. They could start by letting the Export-Import Bank's authorization expire this summer. Taxpayers shouldn't guarantee a loan that J.P. Morgan makes to Air India to buy a Boeing. Then-Senator Obama was right to call this corporate welfare, and he is wrong to have abandoned that view.

Third, eliminate the grab bag of subsidies to agribusiness: Everyone loves farmers. Many of us have some in the family. But that's no reason to favor them with special privileges, especially since the average farm household makes 53 percent more than the average U.S. household. But agribusinesses enjoys a host of special privileges: price supports, tariffs, quotas, insurance subsidies, overseas marketing subsidies, and favorable tax treatment.

All of this should go.

There's much more. Congress could end both traditional and "green" energy subsidies; it could reform corporate taxes by closing loopholes; and it could shut down programs that promote specific industries like tourism, shipping, and air travel.

It's easy to oppose "special interest" politics. It's much harder to get down to specifics and recommend that particular programs go. With a detailed and specific agenda to level the playing field, we could turn the president's words into deeds.

What Australia Can Teach Us About Regulatory Hoarding

Hester Peirce — Wed, 28 Jan 2015 14:06:21 -0500

Expert Commentary

Monday was Australia Day. To celebrate, the United States ought to take a page from Australia's regulatory reform book. Australia is in the midst of a red-tape cutting initiative, which includes discarding unnecessary regulations and taking greater care in adopting new ones. The United States would greatly benefit from a similar regulatory reform effort.

Australia's prime minister, in announcing the round of regulatory reforms, noted that "Red tape is what officials wrap people in when they think that government knows best." To loosen that overly constrictive regulatory wrapping, on two "repeal days" during 2014, the government identified thousands of pages of regulation and legislation fit for the trash pile. The government promised that repeal days would become a semi-annual tradition.

To prevent the replacement of the bad old regulations with bad new regulations, the government published a guide "intended to be read by every member of the Australian Public Service involved in policy making-from the most junior member of the policy team to the departmental secretary." The guide emphasizes that regulation is "a means of last resort," not the "default option." The guide reminds policymakers that "regulation cannot eliminate risk entirely," and should not seek to do so. If a contemplated regulation will impose greater costs on people and businesses than the benefits it offers, it may be better to do nothing at all. In assessing a potential regulation, rule writers should take the time and trouble to "walk in the shoes of the people, business decision makers and community groups affected by [their] policy proposal." To do this, regulators need to employ transparent and inclusive processes in crafting regulation.

The United States, like Australia, is knee-deep in regulations. Rather than cutting rules that have outlived (or never manifested) their worth, the United States is adding more rules at a terrifying clip thanks to massive new statutory mandates like Dodd-Frank. Politically driven efforts to repel any changes to regulations once they are in place mean that rulebooks will only keep growing.

To make matters worse, American policymakers are not taking the careful, deliberative approach laid out in the new Australian guidelines to prevent the rules from doing unnecessary harm. Financial regulators, insisting optimistically that the new rules' benefits surely outweigh their costs, rarely deign to engage in serious economic analysis. Their optimism is consistent with the Australian guidance's observation that "many studies have shown that humans habitually over-estimate potential benefits and under-estimate potential costs."

Procedural protections to ensure that public input is received and considered are also falling by the wayside. The Securities and Exchange Commission's Daniel Gallagher pointed out several instances of procedural laxity earlier this month in connection with Dodd-Frank rulemakings related to derivatives data reporting. Commissioner Gallagher called his agency out for failing to propose certain regulatory provisions before adopting them. The commissioner also faulted the SEC for asking for information on forms without first considering whether the benefits of obtaining the information outweigh the costs of providing it. Gallagher's colleague, Michael Piwowar, also objected to the rules because they incorporated last-minute changes without consideration for their "real-world implications." The SEC's procedural shortcuts mean people will have to comply with requirements about which they did not have an opportunity to comment.

The SEC is not the only agency taking shortcuts that deprive it of critical input about the consequences of its rulemaking. Commissioner Christopher Giancarlo of the Commodity Futures Trading Commission called his agency out in a speech earlier this week for failing adequately to consider the effect of its rules on farmers, non-financial companies, and ultimately the general public. Mark McWatters, a member of the National Credit Union Administration board, in a dissent earlier this month from a proposed change to the credit union net worth rule, took issue with the agency's lack of legal authority, flawed rulemaking process, and inadequate endeavor to understand the costs of its proposal.

It is time that we follow Australia's example and recognize that we have a serious regulatory hoarding problem. We cannot bear to let go of the regulations we already have for fear of adverse consequences. And we cannot resist the impulse to indiscriminately add new regulations to our already over-stuffed rulebooks. The resulting regulatory clutter hampers our economy's ability to grow and adapt to meet the needs of everyday Americans.

Options for Corporate Capital Cost Recovery: Tax Rates and Depreciation

Jason J. Fichtner, Adam Michel — Wed, 28 Jan 2015 23:08:12 -0500

Publication

The US tax code is excessively complex and riddled with special-interest loopholes. Tax rates that treat similar activities unequally can distort consumer and investor decisions, which damages the economy. The current tax system’s treatment of corporate capital investments is emblematic of these problems.

A new study for the Mercatus Center at George Mason University reviews the tax code’s requirement that businesses use “depreciation”—the process of writing off a capital purchase over time—and explains how this treatment leads to unequal tax rates across industries.

Shifting to “full expensing”—allowing business to write off all expenditures in the year they are purchased—would offer an even ground for capital investments. It would also simplify the tax code, increase investment, and reduce the ability of politically favored industries to gain targeted tax benefits. While expensing would likely reduce related government revenue in the short run, over the longer run it would likely be revenue-neutral or even growth- and revenue-enhancing.

Using IRS Statistics of Income data for active corporations from 1998 to 2010, the study estimates which industries would be most sensitive to changes in depreciation and how the removal of existing depreciation policies would affect the tax rates of 11 industries. Industries more sensitive to changes in capital cost recovery would likely benefit the most from full expensing, but all industries would receive some benefit.

To read the study in its entirety and learn more about its authors, Mercatus senior research fellow Jason J. Fichtner and MA fellow Adam N. Michel, please see “Options for Corporate Capital Cost Recovery: Tax Rates and Depreciation.”

SUMMARY

The US tax code requires most new purchases of capital, such as machines and buildings, to be deducted from total revenue over the course of many years. This is called “depreciation” or “capital cost recovery.”

The Advent of Depreciation
Depreciation was first instituted as an accounting practice when businesses reported earnings to shareholders. Without depreciation, years with large investment purchases could show negative profits while years with no investments showed high profits, all else being equal. To reduce these swings in reported earnings and convey a company’s true position, accountants now distribute the cost of each investment over the number of years it will be in service.

Problems with Depreciation
While depreciation helps communicate profitability to shareholders, it distorts the profitability of capital investments when applied to the tax code. This is because businesses make investment decisions based on after-tax profitability, which is directly impacted by how an asset is depreciated.

Determining how a capital asset is to be depreciated depends on its estimated “useful life.” Estimating useful lives for all possible assets is nearly impossible, which allows current depreciation rules to be arbitrarily set and manipulated.

Accelerated Depreciation
One way depreciation rules can be manipulated is through “accelerated depreciation.” Accelerated depreciation allows more of the cost of the asset to be deducted closer to the time of purchase.

One specific type of accelerated depreciation is “bonus depreciation,” which allows a one-time deduction of 30–100 percent of the initial cost in the year of purchase. This has become a favored policy tool in recent years to stimulate investment and the economy.
Accelerated depreciation, including bonus depreciation, has also received attention because it is the largest corporate tax expenditure. As a result, depreciation is a much-discussed candidate for tax reform, with various advocates arguing for manipulating the timeline in order to lower the statutory corporate tax rate, increase federal revenue, or further stimulate investment.

KEY FINDINGS

Expensing is a better alternative than depreciation for the following reasons:

Zero effective tax rate. Expensing lowers the effective corporate tax rate on new equity financed capital assets to zero, while leaving the statutory rate unchanged. A zero effective rate on capital increases the after-tax rate of return on new investments, making new investments more attractive under expensing.
Greater asset profitability. Tax depreciation decreases asset profitability by diminishing the value of the tax write-off. The decrease in value is felt disproportionately on investments that have long useful lives, such as buildings and other infrastructure. This problem is compounded by uncertainty stemming from unknown long-run expectations about inflation.
Less bias against equity-financed capital. The current tax code is biased in favor of debt-financed investment. Although expensing will not fix this disparity, it will move the effective tax rate on equity-financed capital to zero.
Equal treatment of all investments. Expensing treats all investments similarly. Depreciation will always favor certain investments over others. Even within the same industry, tangible investments can be treated differently from intangible investments and investments in equipment from investments in structures. Expensing removes these inequities. The ability to manipulate depreciation for special tax breaks also opens the door to corporate lobbying and special treatment.
Long-term economic growth. If an expensing policy were enacted today, there would likely be small revenue losses in the short run and modest revenue increases in the long run. Moreover, because expensing makes investment relatively more attractive, it can be reasonably assumed that there would be some economic growth effects from the tax change.

CONCLUSION

Expensing would be a more efficient tax rule than depreciation. Switching from depreciation to expensing could lower public and private administrative costs by simplifying the tax code. Because expensing makes investment relatively more attractive, switching to expensing would promote positive economic growth.

Five Uses for the Distinction between Direct and Overall Liberty

Daniel Klein — Wed, 28 Jan 2015 14:54:51 -0500

Video

In November 2014, Daniel Klein gave a talk to the GMU Center for the Study of Public Choice’s Wednesday Seminar Series. In this lecture, Prof. Klein argues that the five uses for the distinction between direct and overall liberty include: (1) Addressing whether liberty talk and classical liberalism are coherent; (2) Exploring the tensions between libertarians and conservatives; (3) Articulating why I find anarchy talk dissatisfying; (4) Clarifying and distinguishing political theories; (5) Teaching libertarians to see the brighter side of nation-states. The Powerpoint presentation slides are here.

Regulatory Analysis and Regulatory Reform: An Update

Jerry Ellig, Sherzod Abdukadirov — Tue, 27 Jan 2015 18:44:38 -0500

Publication

Congress and the executive branch have attempted to improve the quality of regulatory decisions by adopting laws and executive orders that require agencies to identify the problem they are trying to address and assess its significance, examine a wide range of alternatives to solve the problem, assess the costs and benefits of the alternatives, and choose to regulate only when the benefits justify the costs. A research team from the Mercatus Center at George Mason University has assessed the quality and use of regulatory analysis accompanying every economically significant, prescriptive regulation proposed by executive branch regulatory agencies between 2008 and 2012.

The team found that, while it varied widely, the quality of regulatory analysis was generally low and did not alter much with the change of administrations. For 60 percent of the regulations, agencies failed to provide any significant evidence that any part of the regulatory analysis helped inform their decisions. Improving the quality and use of regulatory analysis will require institutional reforms to ensure that regulatory impact analysis is required, objective, and used to inform decisions about whether and how to regulate.

What Is Regulatory Impact Analysis?

Somewhere along the line, most people learn a few basic steps to take before making a major decision. These steps include:

Understand the root causes of the problem,
Define the goal to achieve,
Develop a list of alternative ways to solve the problem, and
Assess the pros and cons of each alternative.

Call these steps “Decision-making 101.”

For nearly four decades, presidential administrations have required executive branch agencies to follow these steps when they conduct Regulatory Impact Analyses (RIAs) that accompany major regulations. In 1993, President Clinton’s Executive Order 12866 laid out the fundamental requirements that have governed regulatory analysis and review ever since. In January 2011, President Obama’s Executive Order 13563 reaffirmed the principles and processes in the Clinton executive order:

Our regulatory system must protect public health, welfare, safety, and our environment while promoting economic growth, innovation, competitiveness, and job creation. It must be based on the best available science. It must allow for public participation and an open exchange of ideas. It must promote predictability and reduce uncertainty. It must identify and use the best, most innovative, and least burdensome tools for achieving regulatory ends. It must take into account benefits and costs, both quantitative and qualitative. It must ensure that regulations are accessible, consistent, written in plain language, and easy to understand. It must measure, and seek to improve, the actual results of regulatory requirements.

Analytical requirements are especially rigorous for economically significant regulations, defined as regulations that have a material adverse effect on the economy or have an annual effect on the economy of $100 million or more.

Assessing the Quality and Use of Regulatory Analysis

The Mercatus Center at George Mason University has developed a qualitative framework to assess both the quality and use of regulatory analysis in federal agencies. The scoring process evaluates the quality of regulatory analysis using twelve criteria grouped into three categories:

Openness: how easily can a reasonably informed, interested citizen find the analysis, understand it, and verify its underlying assumptions and data?
Analysis: how well does the analysis define and measure the outcomes or benefits the regulation seeks to provide, define the systemic problem the regulation seeks to solve, identify and assess alternatives, and evaluate costs and benefits?
Use: how much did the analysis affect decisions in the proposed rule, and what provisions did the agency make for tracking the rule’s effectiveness in the future?

A research team evaluated each economically significant, prescriptive rule between 2008 and 2012—a total of 108 regulations. For each criterion, the evaluators assigned a score ranging from 0 (no useful content) to 5 (comprehensive analysis with potential best practices). Thus, each analysis has the opportunity to earn between 0 and 60 points.

Quality of Analysis Is Low

The average total score was just 31.2 out of 60 possible points—barely 50 percent—the equivalent of a grade of “F.” Figure 1, below, shows that the majority of regulations, slightly over 60 percent, scored below 36 points—the equivalent of a “D.” No RIA did an excellent job on all aspects of regulatory analysis. The highest total score ever achieved was 48 out of 60 possible points (80 percent), equivalent to a “B−.” This was the joint Environmental Protection Agency-National Highway Traffic Safety Administration regulation proposed in 2009 that revised Corporate Average Fuel Economy standards.

Greatest Weaknesses: Retrospective Analysis

Table 1, below, shows the average scores on each of the 12 criteria. The two final criteria relating to retrospective analysis score particularly low. Few regulations or analyses set goals, establish measures, or establish protocols to gather data so that the effects of the regulation may be evaluated after it is implemented.

For each Report Card criterion, there are a few examples of reasonably good quality or use of analysis. But best practices are not widespread.

Analysis Rarely Used to Inform Decisions

Table 1 shows that most of the lowest scores are for criteria measuring the use of analysis. The broadest Report Card criterion measuring use of analysis (criterion 9) asks whether the agency claimed or appeared to use any part of the analysis to guide any decisions. As figure 2 demonstrates below, agencies often fail to provide any significant evidence that any part of the RIA helped inform their decisions. Perhaps the analysis affects decisions more frequently than these statistics suggest, but agencies fail to document this in the Notice of Proposed Rulemaking or the RIA. If so, then at a minimum there is a significant transparency problem.

Improving the Quality and Use of Regulatory Analysis

Average scores for prescriptive regulations are relatively low, earning slightly more than 50 percent of the total possible points. Clearly, agency regulatory analysis is often incomplete and seldom used in decisions. This pattern persists across administrations, indicating that the source of the problem is institutional, not political. Fundamental institutional reforms are necessary to ensure that agencies conduct high-quality regulatory impact analysis and use it in decisions. In short, regulatory impact analysis should be:

Required: Congress should require federal agencies to conduct thorough regulatory impact analysis before they write and propose significant regulations. Agencies tend to pay attention to what the law says they should do, because otherwise a court might vacate the regulation. The congressional requirement should include independent agencies that are not currently subject to the executive orders on regulatory analysis and review. Scholarly research has found that many independent agencies conduct even less thorough economic analysis than executive branch agencies. Requiring independent agencies to conduct regulatory impact analysis and explain how they used it in decisions would likely improve their quality and use of analysis.
Objective: All too often, regulatory analyses read as an afterthought. Agencies should be required to publish analysis of the systemic problem they seek to solve and alternative solutions (along with all underlying data and research) for public comment before making decisions about proposed regulations. Agency economists should have the independence to conduct objective analysis instead of simply justifying decisions that have already been made. Public hearings on regulations after they are proposed would give agencies an incentive to produce better analysis because they would have to defend it publicly. Expanding the resources of the Office of Information and Regulatory Affairs, which reviews all major regulations, can also help to improve the quality and use of analysis.
Used: Congress should require all agencies to explain, when proposing regulations, how the major elements of regulatory analysis affected decisions about the regulation. Consistent with the Government Performance and Results Modernization Act of 2010, agencies should also be required to explain how major regulations advance their high-priority goals and establish measures to track the regulation’s actual results.

Conclusion

Regulatory impact analysis assesses the need for, alternatives to, and benefits and costs of proposed regulations. Although administrations of both political parties have required regulatory impact analysis, the quality of that analysis has generally been low. To make matters worse, agencies often fail to provide any evidence that regulatory analysis, however imperfect, informed their decisions. In addition, agencies rarely establish plans for retrospective analysis to evaluate the effectiveness of their regulations. To be genuinely effective, regulatory impact analysis should be required by statute, objective, and used by federal agencies.

Health Care Innovation Through Less Regulation

Richard Williams — Wed, 28 Jan 2015 14:30:35 -0500

Expert Commentary

The next big wave of innovation, if it is allowed, is in health. The only question is whether we will embrace the new pioneers of health innovation or smother them in wet woolen blankets of regulation. The choices are fairly stark: We can settle for the status quo of turning everything into a “policy” or embrace policy-less innovation.

There are four big areas where we can improve health in order to prevent or ameliorate disease and injury: 1) nutrition; 2) medicine; 3) medical devices; and 4) exercise. Given the surplus of information freely available to inventors online, new ideas in each of these areas are springing up like wildflowers.

Making the Case for Free Trade

Veronique de Rugy — Mon, 26 Jan 2015 10:16:32 -0500

Expert Commentary

The president’s lukewarm embrace of truly unfettered international trade leaves a lot to be desired.

In his State of the Union address, the president told us he wants to craft a trade policy agenda fit for the 21st Century. If only!

A true free trade agenda should be the cornerstone of any “middle class economics” platform. Open international markets lower domestic prices for consumers, increase export opportunities for small and big business alike, and induce formerly-protected manufacturers to improve and compete on a global stage. But we shouldn’t expect Obama to embrace the benefits of free trade just yet.

So far, Obama has only been “pro-trade” when it serves interests defined by business lobbies and other pro-export mercantilists. But when it comes to the pro-trade policies that benefit U.S. consumers by introducing entrenched U.S. exporters to more competition, the president consistently falls back on basic protectionist instincts.

It’s not that Obama opposes all trade liberalization. His announcement that he would work to create a Trade Promotion Authority (TPA) was a high note of Tuesday’s speech. The TPA would empower the executive branch to negotiate trade pacts with our foreign trading partners—thereby fast-tracking foreign open markets upon congressional approval.

But even this proposal is far less than ideal. The TPA could merely become a device to streamline special interest policies. As Cato Institute Director of Trade Policy Studies Dan Ikenson explained to me over email, “While free trade agreements have protectionism baked into them and are thus definitely not free trade, they tend to make us more economically free.” A successful TPA would require strict discipline from Congress and the president to resist the strong pull of protectionist interests.

Flawed though it may be, the president’s TPA proposal is still a clear departure from the last six years of passivity on trade policy issues. After all, strong hostility from his base and the Democratic leadership toward trade makes change quite politically costly.

The President did begrudgingly lend support to completed agreements with South Korea, Colombia, and Panama after the GOP took control of the House in 2011—but, as Ikenson noted, even this was more “out of necessity than conviction.”

That was true on Tuesday, too. His sole lukewarm justification provided for a TPA was that it would benefit American companies to sell their goods and services beyond our borders. “Ninety-five percent of the world’s customers live outside our borders, and we can’t close ourselves off from those opportunities,” said the president. What a snoozer. If the president harbored a true and unimpeded understanding of the true benefits of trade liberalization, he’d make a much sexier pitch.

Increasing exports is only one of the many benefits of expanding trade. Imports are in many ways more beneficial for middle class growth. The more imports, the better, as it leads to greater consumer choices and varieties at lower prices.

As George Mason University economist Donald Boudreaux points out (PDF), “Prices are held down by more than two percent for every one-percent share in the market by imports from low-income countries like China.” Fearing cheaper imports from China, as the president does, is not a part of any middle class platform grounded in good economics. We should welcome lower prices!

Consumers aren’t the only beneficiaries of expanded trade. U.S. manufactures within our borders benefit from lower input good prices. At least half of U.S. imports are not consumer goods; they are inputs for US-based producers, according to Boudreaux.

Freeing trade reduces imported-input costs, thus reducing businesses’ production costs and promoting employment possibilities and economic growth. We should welcome U.S. business and employment growth!

Free trade also benefits the U.S. in incredibly effective ways that are harder to see. Opening trade barriers improves efficiency and innovation. It shifts workers and resources to more productive uses and allows more efficient industries to prosper. Over time, Boudreaux explains “higher wages, investment in such things as infrastructure, and a more dynamic economy that continues to create new jobs and opportunities”. Free trade also drives competitiveness which fuels long-term growth, higher quality of good and services—and still lower prices.

President Obama should be singing these praises of free trade from the rooftops, but instead he mumbles of its necessity like he’s feeding us mashed broccoli.

This is not a partisan issue. Economists of all ideological backgrounds agree that the net effect of free trade is positive and endures even if other countries continue in their protectionist ways. It will surprise no one that Milton Friedman was a fervent advocate of tearing down all protectionist policies. But did you know he is rivaled in this by none other than Paul Krugman? In a seminal Journal of Economic Literature article in 1997, Krugman wrote “the case for free-trade is essentially a unilateral case.”

The president doesn’t quite see it. His talk about the need for “fair” trade and for “leveling the playing field” is a strong signal that he intends to tilt the playing field in the home market against consumers and in favor of politically connected producers. Just look at his new and unfortunate support for the protectionist Export-Import Bank.

Politicians reveal their prioritization of entrenched exporters over average consumers and businesses in their irrational hysteria over China and other governments subsidizing their countries’ exports. Supporters of export credit subsidies claim that they are “leveling the playing field” against foreign competition, but basic economics says otherwise.

In fact, countries that receive the artificially cheap imports benefit far more than the protectionist country: recipient countries get more output for less input, and more imports for fewer exports. Let me make that clear: U.S. consumers of subsidized imports benefit by getting cheap goods at the cost of foreign taxpayers. That’s the closest thing to a “free lunch” in economics as you’ll ever find.

Do U.S. companies welcome this competition? For the most part, yes. But not always. Either way, politicians should never give into protectionist instincts to shelter U.S. companies, lest we end up doing more damage to our prosperity in the process.

Obama’s turn toward trade liberalization is both a good start and a missed opportunity. There is no need to give in to the pressures and fears of business lobbyists. The president should take a page out of Bill Clinton’s book and embrace free trade for all that it is. When you free markets, you free people to buy whatever goods and services he or she wishes irrespective of geographical location. And that is a freedom that ultimately benefits everyone.

March Madness Reception

contact@mercatus.org (Mercatus.org) — Sun, 25 Jan 2015 23:43:46 -0500

Events

Please join us for a casual reception where you can take a break from March Madness and meet some of our scholars who can provide the kind of practical information you need to be most effective in your work.

Drinks and “game day” hors d'oeuvres will be served. There is no charge to attend this event.

This event is open to all full-time congressional and federal agency staff. This event is not open to the general public.

Questions? Please contact Caitlyn Van Orden, Event Coordinator, at cvanorden@mercatus.gmu.edu or (703) 993-4925.

Score One for Science

Sherzod Abdukadirov — Fri, 23 Jan 2015 16:21:25 -0500

Expert Commentary

Bisphenol A is safe for all consumers, declared the European Food Safety Authority (EFSA) this week. Thus, the EU agency re-affirmed its 2006 decision declaring the chemical safe. In its statement, the agency justified its decision to revisit Bisphenol A (BPA) by pointing to a great deal of new research on the chemical’s health impacts. What it failed to mention in the official announcement was that its decision to re-examine BPA was also driven by the recent politically motivated French ban on BPA in food containers, which took effect on January 1 this year.

BPA is a chemical compound that is commonly used to produce plastic. At high levels, BPA could potentially be harmful. The main cause for concern stems from the ubiquitous use of plastic in food and cosmetic packaging. When plastic is used in packaging, trace amounts of BPA can leak into the food and cosmetic products and can be ingested or absorbed through skin.

The most crucial factor in trying to determine whether a chemical is harmful is correctly measuring the exposure level. The exposure level indicates the amount of a chemical that finds its way into human body. Since “the dose makes the poison,” it is important to determine whether the amount of chemical that consumers are exposed to is high enough to cause any harm. For many substances, there is typically a safe level of exposure, below which the substance is harmless.

The EFSA’s decision to declare BPA safe rested largely on its measurements of exposure levels for various consumer groups. The agency found that exposure levels were extremely low, about four to 15 times lower than the safe level. The finding held true despite the fact that the agency lowered the threshold for safe level of BPA from 50 micrograms per kilogram of body weight per day to only four.

Concerns over BPA’s impact are not new. In 2011, EU banned the use of BPA in baby bottles. In 2012, the Food and Drug Administration followed suit. Yet, as the FDA pointed out, its decision simply codified the steps that the industry has already taken to phase out BPA in baby bottles and sippy cups. Crucially, the FDA maintained that it considered the chemical safe at its current exposure levels. The agency issued the ban at the industry’s request in order to allay concerns that some parents may have, even though it found no evidence that BPA’s use in baby bottles caused any harm. The FDA’s position was confirmed by the EFSA’s announcement, which found BPA to be safe for all age groups including infants.

Yet, it was the French that took the unsubstantiated panic over BPA to the new heights. In 2012, the French government issued a law to ban BPA from all products that come into contact with food. The law went into effect at the start of this year. The French government’s actions set it up for a conflict with the other EU members, who argued that the ban amounted to an internal trade barrier. The EFSA and its French counterpart began discussions to resolve their differences.

By refusing to give in to the anti-BPA hysteria, the EFSA allowed companies to avoid the unnecessary costs of replacing BPA. It also saved European consumers money, as the additional costs of BPA phase out would be ultimately passed on to consumers—though French consumers would still have to pay the price for their government’s ban. Most importantly, the EFSA reaffirmed the principle that safety regulation ought to be driven by scientific evidence, not politics.

Bitcoin Financial Regulation: Securities, Derivatives, Prediction Markets, and Gambling

Jerry Brito, Houman Shadab, Andrea Castillo — Fri, 23 Jan 2015 13:58:01 -0500

Publication

The next major wave of Bitcoin regulation will likely be aimed at financial instruments, including securities and derivatives, as well as prediction markets and even gambling. While there are many easily regulated intermediaries when it comes to traditional securities and derivatives, emerging bitcoin-denominated instruments rely much less on traditional intermediaries. Additionally, the block chain technology that Bitcoin introduced for the first time makes completely decentralized markets and exchanges possible, thus eliminating the need for intermediaries in complex financial transactions.

In this article we survey the type of financial instruments and transactions that will most likely be of interest to regulators, including traditional securities and derivatives, new bitcoin-denominated instruments, and completely decentralized markets and exchanges. We find that Bitcoin derivatives would likely not be subject to the full scope of regulation under the Commodities and Exchange Act to the extent such derivatives involve physical delivery (as opposed to cash settlement) or are nonfungible and not independently traded. We also find that some laws, including those aimed at online gambling, do not contemplate a payment method like Bitcoin, thus placing many transactions in a legal gray area.

Following the approach to virtual currencies taken by the Financial Crimes Enforcement Network, we argue that other financial regulators should consider exempting or excluding certain financial transactions denominated in Bitcoin from the full scope of their regulations, much like private securities offerings and forward contracts are treated. We also suggest that to the extent that regulation and enforcement becomes more costly than its benefits, policymakers should consider and pursue strategies consistent with that new reality, such as efforts to encourage resilience and adaptation.

Matthew Mitchell Discusses State of the Union on CNBC Asia

Matthew Mitchell — Thu, 22 Jan 2015 14:18:30 -0500

Video

Matt Mitchell and Paul Krake talk about what to expect from President Barack Obama’s State of the Union address.

Embed Code:

Letter to House Committee on Energy and Commerce Concerning Television Regulation

Brent Skorup — Thu, 22 Jan 2015 10:12:30 -0500

Publication

January 22, 2015

Representatives Fred Upton and Greg Walden
Energy and Commerce Committee
United States House of Representatives

Dear Chairman Upton and Chairman Walden:

Thank you for the opportunity to respond to the Committee’s December 2014 questions on video regulation. The Technology Policy Program of the Mercatus Center at George Mason University is dedicated to advancing knowledge about the effects of regulation on society. As part of its mission, the program conducts careful and independent analyses that employ economic and legal scholarship to assess legislation and regulation from the perspective of the public interest. Therefore, this response does not represent the views of any particular affected party but is designed to assist Congress as it explores these issues.

Please find attached a research paper by technology scholar Adam Thierer and me about the history of television regulation. This is an age of content abundance and competitive distribution, and we recommend paring down existing video regulations. While the paper was published a few months before the committee’s request for comment, it is responsive to the questions posed about industry developments and possible reforms. We show that the labyrinthine communications and copyright laws governing video distribution are now distorting the market and therefore should be made rational. Congress should avoid favoring some distributors at the expense of free competition. Instead, policy should encourage new entrants and consumer choice.

The focus of the committee’s white paper on how to “foster” various television distributors, while understandable, was nonetheless misguided. Such an inquiry will likely lead to harmful rules that favor some companies and programmers over others, based on political whims. Congress and the FCC should get out of “fostering” the video distribution markets completely. A light-touch regulatory approach will prevent the damaging effects of lobbying for privilege and will ensure the primacy of consumer choice.

Some of the white paper’s questions may actually lead policy astray. Question 4, for instance, asks how we should “balance consumer welfare and the rights of content creators” in video markets. Congress should not pursue this line of inquiry too far. Just consider an analogous question: how do we balance consumer welfare and the interests of content creators in literature and written content? The answer is plain: we don’t. It’s bizarre to even contemplate.

Congress does not currently regulate the distribution markets of literature and written news and entertainment. Congress simply gives content producers copyright protection, which is generally applicable. The content gets aggregated and distributed on various platforms through private ordering via contract. Congress does not, as in video, attempt to keep competitive parity between competing distributors of written material: the Internet, paperback publishers, magazine publishers, books on tape, newsstands, and the like. Likewise, Congress should forego any attempt at “balancing” in video content markets. Instead, eliminate top-down communications laws in favor of generally applicable copyright laws, antitrust laws, and consumer protection laws.

As our paper shows, the video distribution marketplace has changed drastically. From the 1950s to the 1990s, cable was essentially consumers’ only option for pay TV. Those days are long gone, and consumers now have several television distributors and substitutes to choose from. From close to 100 percent market share of the pay TV market in the early 1990s, cable now has about 50 percent of the market. Consumers can choose popular alternatives like satellite- and telco-provided television as well as smaller players like wireless carriers, online video distributors (such as Netflix and Sling), wireless Internet service providers (WISPs), and multichannel video and data distribution service (MVDDS or “wireless cable”). As many consumers find Internet over-the-top television adequate, and pay TV an unnecessary expense, “free” broadcast television is also finding new life as a distributor.

The New York Times reported this month that “[t]elevision executives said they could not remember a time when the competition for breakthrough concepts and creative talent was fiercer” (“Aiming to Break Out in a Crowded TV Landscape,” January 11, 2015). As media critics will attest, we are living in the golden age of television. Content is abundant and Congress should quietly exit the “fostering competition” game. Whether this competition in television markets came about because of FCC policy or in spite of it (likely both), the future of television looks bright, and the old classifications no longer apply. In fact, the old “silo” classifications stand in the way of new business models and consumer choice.

Therefore, Congress should (1) merge the FCC’s responsibilities with the Federal Trade Commission or (2) abolish the FCC’s authority over video markets entirely and rely on antitrust agencies and consumer protection laws in television markets. New Zealand, the Netherlands, Denmark, and other countries have merged competition and telecommunications regulators. Agency merger streamlines competition analyses and prevents duplicative oversight.

Finally, instead of fostering favored distribution channels, Congress’ efforts are better spent on reforms that make it easier for new entrants to build distribution infrastructure. Such reforms increase jobs, increase competition, expand consumer choice, and lower consumer prices.

Thank you for initiating the discussion about updating the Communications Act. Reform can give America’s innovative telecommunications and mass-media sectors a predictable and technology neutral legal framework. When Congress replaces industrial planning in video with market forces, consumers will be the primary beneficiaries.

Sincerely,

Brent Skorup
Research Fellow, Technology Policy Program
Mercatus Center at George Mason University

Read Related Research

Wars in the Middle East Have Cost Taxpayers Almost $1.7 Trillion

Veronique de Rugy — Wed, 21 Jan 2015 14:50:09 -0500

Publication

A recent report from the Congressional Research Service, which examines the cost of Iraq, Afghanistan, and other global “War on Terror” operations since 9/11, calculates a cumulative (fiscal year 2001 through fiscal year 2014) nominal price tag of $1.6 trillion. Adding the war funding for fiscal year 2015 that was passed in December pushes the total to almost $1.7 trillion. When it comes to funding national defense, policymakers tend to ignore war costs so an accurate assessment on the burden on taxpayer of overseas military ventures is increasingly important as pressure mounts to increase the Pentagon’s regular “base” budget.

As the following chart shows, the vast majority of the funding has been allocated to the Department of Defense ($1.562 trillion). The State Department and related foreign aid efforts received $101 billion and the Department of Veterans’ Affairs, $17 billion.

Looking at the cost of the post-9/11 wars is important because policymakers have a habit of citing the Pentagon’s base budget, which excludes war funding, when debating and discussing funding for national defense. But, as I discuss in a separate chart, using base Department of Defense figures severely understates the total cost to taxpayers for national defense. War funding, which is budgeted under the title “Overseas Contingency Operations” (OCO), is also exempt from the spending caps implemented by the Budget Control Act of 2011. Policymakers have been rightly criticized for evading the caps by designating funds as OCO that should arguably be in the Pentagon’s base budget.

With the Republicans now in complete control of Congress, there is growing speculation that the GOP will seek to bust the caps on defense funding. And the president’s upcoming Pentagon budget request is expected to propose the same. On top of the on-going fighting in Afghanistan, Iraq, and Syria, the recent high-profile attacks by ISIS and al-Qaeda affiliates in Europe are being cited by hawkish members of Congress as justification for additional funding. Before doing so, policymakers should consider whether our heavy military presence in the Middle East, and the $1.7 trillion allocated in war funding since 9/11, have created more problems than they have eliminated. Indeed, a strong case could be made that what taxpayers are actually paying for is national offense rather than national defense—and the former is driving the latter.

Ohio's Energy Efficiency Fiasco

Robert J. Michaels — Wed, 21 Jan 2015 13:47:16 -0500

Expert Commentary

Winter is here, and Americans are coping with more than just the cold -- many are dealing with a yearly spike in their energy bills. As rational consumers, they can be trusted to make efficient choices, and they benefit from doing so. Unfortunately, misguided policies often get in the way. Take, for example, Ohio's recent attempt to reduce energy use.

According to my research, a 2008 law drove utility bills in the state higher -- even as the law's energy-efficiency goals were in doubt. As of late last year, most energy-industry reports indicated that SB 221 was on track, but the evidence said otherwise. Accordingly, at the beginning of 2015, SB 221 was suspended for two years pending evaluation of its effects by an independent panel.

If it desires, the state will restore the law's efficiency requirements when the evaluation is finished. Before doing so, lawmakers should carefully note the key problems with the legislation as it was written and implemented.

Under SB 221, the Public Utilities Commission of Ohio (PUCO) must enforce an "Energy Efficiency Resource Standard" on Ohio's utility companies (municipal and cooperative systems are exempt). By 2022, utilities are required to facilitate a 22 percent reduction in energy use.

To accomplish this, they can spend up to 3 percent of their annual revenue on efficiency programs such as rebates on energy-efficient appliances, tune-ups of HVAC systems, or energy-efficient light-bulb subsidies, and then recover what they spend through customers' bills. To date, Ohio customers have paid more than $1 billion.

Aside from light-bulb subsidies (which cannot be tied to specific consumers and are addressed below), few of these programs are affecting very many consumers. In April 2013, for example, only 2 percent of FirstEnergy's business customers participated in its efficiency programs, leaving the remaining 98 percent to shoulder the costs. Only 7 percent of its residential users benefited from programs aimed at them.

Energy efficiency is important, and advocates of the law might argue that it's worth the billion-dollar public expense. They started with high hopes that innovative programs would benefit Ohio and the nation. But, expensive or not, the law doesn't appear to be working.

Utilities have complied largely by subsidizing retail sales of energy-efficient light bulbs. In 2012, lighting programs accounted for 83 percent of Dayton Power and Light's alleged energy savings, a lower percentage than some other utilities. Among the company's residential customers, lighting was 88 percent of the total.

Here's the catch: Most of those energy-efficient bulbs would have been purchased with or without SB 221. If you buy a subsidized bulb but would have paid full price, the industry calls you a "free-rider." Most other states account for free-riders in their measurement; Ohio does not. (A few years ago, PUCO, with the backing of utilities, ruled that free-riding is a form of saving, claiming that "gross" rather than "net" effects are what matters.) California calculates that about 70 percent of bulb buyers free-ride, and there is no reason to assume that Ohio is much different. It's clear that the great bulk of Ohio ratepayers' $1 billion has wound up in the pockets of free-riders.

If SB 221 is reinstated in its original form, these problems will become bigger, and quickly. PUCO rules require each utility to retain a consultant for its program. In 2013, most of their reports found the same thing: Opportunities for additional efficiency are rapidly diminishing. Dayton Power and Light's consultant reports that cost-effective programs are likely to run out before it achieves half of the law's required 2022 savings. The American Council for an Energy Efficient Economy acknowledges a need to devise new programs.

No one wants to break one of the biggest secrets in Ohio: Its energy-savings figures thus far are grossly in error, and opportunities to make up for it look scarce. The future belongs to the energy-efficient, but Ohio will never get there until its policymakers understand the difference between free-riding and true efficiency.

Fundamentals of Budget Process

contact@mercatus.org (Mercatus.org) — Wed, 21 Jan 2015 02:04:47 -0500

Events

As budget season gets underway, what do you need to know to navigate the process?

The Mercatus Center at George Mason University invites you to join David Primo, Associate Professor at the University of Rochester and senior scholar for the Mercatus Center, and Patrick Louis Knudsen, a former long-time policy director for the House Budget Committee, for a discussion of the congressional budget process.

This program will include:

An overview of the 1974 Budget Act, and subsequent laws and rules guiding the budget process;
A discussion of how and why the budget process has largely been abandoned in past years, and the potential implications of failing to follow a regular budget process; and
An outlook for the Fiscal Year 2016 budget season, including a review of key budgetary dates and events.

This event is free and open to all congressional and federal agency staff. This event is not open to the general public. Food will be provided. Due to space constraints, please no interns. Questions? Please contact Samantha Hopta, Event Associate, at shopta@mercatus.gmu.edu or (703) 993-4967.

Federal Cybersecurity Breaches Mount Despite Increased Spending

Eli Dourado, Andrea Castillo — Tue, 27 Jan 2015 23:15:21 -0500

Publication

In the wake of the high-profile cybersecurity breach at Sony Pictures Entertainment in December, President Obama unveiled reform proposals that would increase the federal government’s ability to direct American cybersecurity practices. These proposals, which include increased federal funding, a cybersecurity summit, and legislative changes to encourage information-sharing among private sector organizations and government bodies, are only the most recent efforts in a long line of government attempts to nationalize and influence private cybersecurity practices. Despite years of increased cybersecurity spending, the federal government already has a poor track record in maintaining good cybersecurity and information-sharing practices for its own information technology (IT) systems.

This week’s charts use data from the Congressional Research Serviceand the Government Accountability Office to display total federal cybersecurity spending required by the Federal Information Security Management Act of 2002 (FISMA) with the total number of reported information security incidents of federal systems from 2006 to 2013. The first chart shows that the number of federal cybersecurity failures has increased every year since 2006, even as investments in cybersecurity processes and systems have increased considerably.

FISMA was intended to strengthen federal IT systems by requiring agency leaders to develop and implement information security protections with the guidance of offices such as the National Institute of Standards and Technology (NIST), the Office of Management and Budget (OMB), and the Department of Homeland Security (DHS). In addition to authorizing the sums necessary for agencies to invest in cybersecurity technologies and infrastructure, FISMA compels agencies to proactively assess and reduce systematic risks, actively train personnel to meet and improve information security standards, improve cybersecurity risk reporting and information sharing capabilities, and develop contingency plans to respond to cyber-breaches.

Total FISMA information security spending reported by the OMB from FY 2006 to FY 2013 measured in real 2013 dollars is displayed on the chart in light green bars and measured on the left axis. The chart shows that federal spending on information security investments exhibited moderate growth over much of the period. Both the dramatic increase in FISMA spending from $7.4 billion in FY 2009 to $12.8 billion in FY 2010 and the dramatic decrease in FISMA spending from $14.8 billion in FY 2012 to $10.3 billion in FY 2013 are partially attributable to OMB’s decision to change its FISMA spending calculation methodology in those years. Even with this caveat on inter-year comparisons, the chart shows that the federal government has invested billions of dollars to improve its internal cybersecurity defenses in recent years. Altogether, the OMB reports that the federal government spent $78.8 billion on FISMA cybersecurity investments from FY 2006 to FY 2013.

Increased federal spending on cybersecurity, however, is not reflected in the rate of cyber-breaches of federal systems reported by the GAO. The total number of federal information security incidents reported from 2006 to 2013 is displayed by the blue line on the chart and measured on the right axis. The number of reported federal cybersecurity incidents increased by an astounding 1,012% over the selected years, from 5,503 in 2006 to 61,214 in 2013.

It is troublingly that many of these breaches exposed the personally identifiable information of federal personnel, veterans, and even civilians stored in federal systems to potential access by external groups. The second chart displays the proportion of all reported federal information security incidents that involved the exposure of personally identifiable information from 2009 to 2013. Federal information security failures that expose sensitive details about individuals’ lives—including data such as contact information and even Social Security numbers and financial information—have constituted roughly a third of all cybersecurity failures and is an increasing problem. By 2013, more than 40 percent of all reported cybersecurity failures involved the potential exposure of private data to outside groups.

Increased federal spending on cybersecurity investments do not seem to have stemmed the rate of federal information security failures. Despite first sounding the alarm about poor government information security practices in 1997, the GAO reported in April 2014 that federal agencies systematically fail to meet federal security standards owing to poor implementation of key FISMA practices outlined by the OMB, NIST, and DHS. After more than a decade of billion dollar investments and government-wide information sharing, in 2013 “inspectors general at 21 of the 24 agencies cited information security as a major management challenge for their agency, and 18 agencies reported that information security control deficiencies were either a material weakness or significant deficiency in internal controls over financial reporting.”

The federal government’s own failure to improve internal cybersecurity practices after years of increased spending and information-sharing among agencies calls into question the effectiveness of President Obama’s proposals to extend these policies to the private sector. While cybersecurity vulnerabilities and data breaches remain a considerable problem in the private sector as well as the public sector, policies that failed to protect the federal government’s own information security are unlikely to magically work when applied to private industry. The federal government’s own poor track record of increasing data breaches and exposures of personally identifiable information renders its systems a dubious safe house for the huge amounts of sensitive data affected by the proposed legislation. The federal government should focus on properly securing its own IT systems before trying to exert more control over private systems.

Laws Protecting Auto Franchises Are Bad for Consumers and Innovation

Jerry Ellig, Jesse Martinez — Tue, 20 Jan 2015 23:41:35 -0500

Expert Commentary

U.S. automobile sales at the end of 2014 hit their highest level since the first quarter of 2006, according to data compiled from industry analysis source Wards Auto. While auto sales have climbed back to pre-recession levels, another aspect of the industry has continued to expand as well: The number of laws that protect auto dealers from competition.

Almost every state regulates three aspects of auto dealer franchising. These regulations: prohibit manufacturers from terminating franchises with existing dealers unless they prove they have a “good cause” to do so, require auto manufacturers to sell new cars through franchised dealers, and protect dealers from competition by awarding exclusive territories. In 1979, fewer than half of the states regulated all three of these aspects of auto dealer franchising. Today, every state regulates all three of these aspects with the exception of Maryland, the only state which does not force manufacturers to give dealers exclusive territories.

Sixty Years Since the Administrative Procedure Act: Necessary Improvements

Jerry Ellig — Wed, 21 Jan 2015 01:58:20 -0500

Events

Congress has a diverse array of proposed regulatory reforms vying for attention, from targeted reforms aimed at providing relief to small businesses to broad-based reforms of the rulemaking process. Though the proposals are diverse, they have a clear, shared objective: solving more problems at a lower cost with fewer regulations.

The Mercatus Center at George Mason University invites you to a Regulation University presentation with Dr. Jerry Ellig, senior research fellow, on what causes regulatory “decision-making in the dark” today, and what cornerstone reform can start us on the path of objective, informed decision-making about regulation.

The program will:

Describe what regulatory analysis is and how agencies underutilize it today.
Explain how regulatory impact analysis can inform regulatory decision-making if it is properly done and used.
Outline the value of improved regulatory impact analysis to Congress and the courts.

State Franchise Law Carjacks Auto Buyers

Jerry Ellig, Jesse Martinez — Tue, 20 Jan 2015 10:03:08 -0500

Publication

Virtually all states require auto manufacturers to sell new vehicles through local franchised dealers, protect dealers from competition in Relevant Market Areas (RMAs), and terminate franchises with existing dealers only after proving they have a “good cause” to do so. These state laws harm consumers by insulating dealers from competition and forestalling experimentation with new business models for auto retailing in the twenty-first century. A pro-consumer policy would make franchising, exclusive territories, and termination protections voluntary rather than mandatory. Under voluntary contracting, these business practices could still survive when their benefits to consumers exceed the costs.

The Ubiquity of Dealer Protection Laws

The first automobile franchise was established by William Metzger, who purchased the right to sell steam engine cars by General Motors in 1898.¹ What started as a voluntary agreement between a manufacturer and a retailer has turned into a mandatory requirement in all 50 states and in US territories.² State auto franchise laws extensively regulate the contractual obligations between manufacturers and dealers. They prevent manufacturers from selling new vehicles (and related services) directly to the public, often mandate exclusive territories for dealers, and make it difficult for manufacturers to terminate dealers.

State auto franchising regulations have become ubiquitous during the past three decades. As figure 1 shows, all three types of laws—franchise licensing requirements, exclusive territories, and dealer termination provisions—became more common between 1979 and 2014. During those 30 years, states enacted 31 new laws on those topics. In 1979, fewer than half of all states regulated all three aspects mentioned above. By 2014, all but one state regulated every single one of these aspects.

Recent Controversies over Dealer Protection Laws

Although states have ramped up dealer protection, two recent policy controversies have called these laws into question. Electric automaker Tesla has sought to sell automobiles directly to the public, and federal supervisors of the Chrysler and General Motors bailout pressured the automakers to terminate numerous dealerships.

Tesla: Uprooting the Traditional Franchise System

Tesla’s direct sales model runs completely counter to the traditional franchise model: Tesla (in states where it has been granted statutory exceptions to operate)³ manufactures, prices, and services its own cars. CEO Elon Musk is betting that Tesla employees can learn about the car’s new technology and sell more effectively than traditional independent dealers paid on commission.⁴ Regardless of whether he’s right, so far state laws prevent him from finding out. Tesla’s reluctance to operate franchises has led to legislative battles with states across the nation, including Michigan, New Jersey, Arizona, and West Virginia.⁵

Dealer Terminations after the 2008 Financial Crisis

The recession following the 2008 financial crisis highlighted the troubled relationship between US auto manufacturers and franchise dealers. New vehicle sales plummeted from 16,460,315 in 2007 to just 13,493,192 in 2008.⁶ Following the imminent financial insolvency of Chrysler and GM, President Bush authorized emergency funding under the Troubled Asset Relief Program to aid the auto industry. The Obama administration further stipulated that these funds would only be released if Chrysler and GM restructured their operations to achieve “long-term viability.”⁷

The administration woefully underappreciated the complexity of the manufacturer-dealer relationship. Chrysler’s final restructuring plans submitted to the president’s Auto Task Force called for shedding 789 dealers, while General Motors planned to cut more than 1,100 dealerships.⁸ Chrysler and GM claimed that these dealers were unproductive and unprofitable.⁹

Dealers wasted no time petitioning Congress to reverse the planned dealer terminations. The 2010 Consolidated Appropriations Act (H.R. 3288) included a provision, Section 747, which provided the opportunity for “covered dealerships” to reacquire franchises terminated on or before April 29, 2009 through an arbitration process.¹⁰ The provision affected all 2,789 dealerships slated for termination; however, the total count of dealers who decided to file paperwork to enter the process was 1,575. Of the cases that went to hearings, arbitrators allowed the manufacturers to close 111 dealerships and ruled in favor of 55 dealers. The other cases were settled or withdrawn.¹¹

Dealer Protection: Voluntary vs. Mandatory

The state-mandated restrictions in new car markets are part of a larger class of business arrangements between producers and retailers known as “vertical restraints.” Economic research finds that voluntarily adopted vertical restraints often benefit consumers, but state-mandated vertical restraints virtually always harm consumers.¹²

Benefits of Voluntary Vertical Restraints

Franchising, exclusive territories, and dealer protection from termination can benefit consumers when they are adopted voluntarily by manufacturers and dealers. Auto dealers provide valuable services to consumers that some manufacturers are unwilling or unable to provide. These services include holding inventory, offering test drives, accepting trade-ins, and auto servicing and maintenance.

By contracting with franchised dealers instead of opening dealerships with their own employees, automakers create a powerful profit incentive for dealerships to undertake these efforts. Exclusive territories can further encourage dealers to invest in sales and service efforts by making it harder for consumers to visit a high-service dealer to learn about the vehicle but then buy it from a low-service dealer who can offer a lower price because he has not made a similar investment in sales and service efforts. Restrictions on termination can also spur dealer investment in both physical location and customer service by removing the risk that the manufacturer will demand further concessions from the dealer after the dealer has made the investments. Dealer sales and service efforts do not just benefit manufacturers; they also benefit consumers.¹³

Costs of Mandatory Vertical Restraints

When franchising, exclusive territories, and restrictions on termination become mandatory, however, manufacturers can no longer adopt other business models if circumstances change. Consumers suffer higher prices and less convenience as a result. Since most states now have these laws, it is difficult to estimate their effects by comparing prices in states with and without the laws. A study using data from 1972, when fewer states imposed these restrictions, found that the combined effect of all state auto franchise restrictions was to raise new car prices by about 9 percent.¹⁴

Preventing Direct Sales: Mandatory Franchising

Since state laws require manufacturers to sell new vehicles through franchised dealers, manufacturers cannot sell directly to the public.¹⁵ This requirement prevents new manufacturers, such as Tesla, from establishing factory-owned dealerships.

Tesla’s direct sales model could improve the dealership experience for consumers interested in purchasing an electric vehicle. A McKinsey analysis of the auto industry estimates the percentage of consumers who purchased a new vehicle and left the dealer dissatisfied with their experience at a relatively low 25 percent.¹⁶ Researchers at the UC Davis Institute of Transportation Studies, however, found that 83 percent of customers in California who purchased an electric vehicle were dissatisfied with their dealer experience.¹⁷ While it may work fine for many customers buying traditional vehicles, the franchise system may not provide a satisfactory experience for a significant number of consumers hoping to purchase an electric vehicle.

Mandatory franchising also prevents established manufacturers from selling directly to the segment of consumers who might prefer to avoid the dealership and simply order a car from the manufacturer, the same way many consumers buy built-to-order computers from manufacturers. Gary Lapidus, formerly a US auto industry analyst for Goldman Sachs, estimated that a build-to-order system could save consumers $2,225 on the price of a new car, based on an average price of $26,000 per car.¹⁸ A position paper prepared for the National Automobile Dealers Association (NADA) disputes this figure, labeling it “a math exercise that assumed that such expenses would vanish in a direct distribution model.”¹⁹ Since manufacturer direct sales are illegal in all 50 states, neither manufacturers nor consumers have the opportunity to find out.

Finally, in some states mandatory franchising bars manufacturers from direct sales of used vehicles, direct financing of car purchases, or even direct sales of simple accessories.²⁰ For example, a shopper who wants to buy a Ford-branded locking gas tank cap or trunk cargo organizer at the ford.com web site is furnished with a “suggested retail price” and must input a zip code to find a local dealership from which to purchase the item.²¹

Restricting New Dealerships: Relevant Market Areas

Relevant Market Areas (RMAs) grant a dealer or group of dealers exclusive territorial rights by preventing the manufacturer from establishing additional dealerships within a given geographical area. In some cases, manufacturers and dealers may both find RMAs in their interest because they encourage dealers to invest in promotion of the brand. RMAs are mandated by law in every state except for Maryland, where dealerships only have the opportunity to file lawsuits against manufacturers to determine whether a “performance standard or program” based on “demographic” or “geographic” characteristics is unfair or unreasonable.²² These statutes provide dealerships with exclusive territories and require manufacturers to prove a “need” for establishing a new dealership within such an area.²³

RMA statutes help insulate dealers from competition. Without the threat that the manufacturer might open other competing franchises, existing dealers have the opportunity to charge consumers higher prices.²⁴ Since almost all states now have RMA laws, it is difficult to estimate how RMAs affect prices today. In the mid-1980s, when RMAs were less prevalent, Federal Trade Commission economists estimated that they increased the price of new cars by approximately 6 percent.²⁵ The percentage is arguably lower now, because the Internet has increased competition between dealers. A 2001 study found that Internet referral services save consumers about 2 percent on new car purchases²⁶—a figure consistent with the hypothesis that the Internet has reduced, but not eliminated, the price-increasing effects of RMA laws.

Inflating the Cost of Dealership Networks: Termination Laws

Another legal protection provided to dealerships is restrictions on dealer terminations. Currently, every state has laws preventing dealership terminations except for “good cause.”²⁷ The definition of “good cause” varies by state, but it usually focuses on factors like a dealer’s conviction for a felony, fraud, insolvency, or failure to comply with a material term of the franchise agreement. States do not typically regard a manufacturer’s desire to improve the efficiency of its dealer network as “good cause” to terminate dealers. Moreover, once a manufacturer has explained its “good cause,” many termination laws also give the dealership a period of time (often 180 days) to correct the error.²⁸

The arbitration process does not appear to have neatly resolved the issue of dealership terminations following the auto bailouts. Chrysler continues to deal with lawsuits from dealerships that closed following bankruptcy.²⁹ It is also worth noting that the bulk of cases were settled, which often entailed either reinstatement or monetary compensation.³⁰

In the latter part of the twentieth century, state laws inhibited the Big Three US automakers from restructuring their dealership networks as Americans moved from the cities to the suburbs, migrated from the Northeast to the South and Southwest, and started buying vehicles from foreign manufacturers. Foreign manufacturers were less hampered by dealer termination laws because they did not enter the US market and establish their dealer networks until the 1970s.³¹ While we don’t know what the optimal dealership network is, research suggests that auto manufacturers with fewer dealerships require significantly fewer days of inventory, which can reduce costs substantially.³²

Changing Times: Can the industry get back “on the road again?”

Dealer protection laws effectively freeze the retail network. Mandatory restrictions make it difficult for manufacturers to experiment with new methods of auto sales or to close unprofitable and inefficient dealerships, which ultimately prevents any potential cost savings to consumers. And auto dealers vigorously defend these privileges. In a report that noted dealers earned record profits during the past year, a consulting firm that assists in the purchase and sale of dealerships sounded the call to arms:

Since we are supporters of the franchise system that is working so well for all of us, we encourage our dealer friends, particularly those who own luxury stores, to lobby heavily to enforce the state laws that protect local dealers from factory owned dealerships. Customers will want to own Teslas, so maybe the best course of action would be to try to compel Tesla to award franchises to entrepreneurs just as all the other [original equipment manufacturers] have done.³³

In short, state auto franchise regulations institutionalize anticompetitive pathologies.³⁴ We do not claim to know the optimal way of organizing auto distribution and retailing for the industry as a whole or any individual automaker. NADA’s previously mentioned position paper argues strenuously that the current system of franchised dealers will always out-compete a system of manufacturer-owned dealerships.³⁵ If this is true, the current franchise system should not need the legal protection it enjoys in every state.

MetLife Goes to Court

Hester Peirce — Fri, 16 Jan 2015 10:54:14 -0500

Expert Commentary

The following scene (colored by some creative license) took place at MetLife headquarters last month, when the Financial Stability Oversight Council (FSOC) declared MetLife to be a systemically important non-bank financial company. As a consequence, MetLife will be regulated by the Federal Reserve using Dodd-Frank's prescriptive, bank-like regulatory framework.

"Knock, knock."

"Who's there?"

"Your future."

"Our future who?"

"Your future favorite financial regulator."

The door is pushed open by a motley group wearing "FSOC"-emblazoned jackets. With the path thus cleared, the Fed marches in: "We're here to regulate you, MetLife."

"But we already have regulators — lots of them."

"Yes, but we're the Fed, and you're systemic, so now we get to regulate you, too."

"Why are we systemic?"

"Because FSOC says you are, of course."

"But why?"

"FSOC just thinks you are. You're really big. You deal with lots of other companies and have lots of customers. Something really bad might happen to you, which would be really bad for the financial system."

"But the insurance experts on FSOC don't think the council's crisis scenarios are realistic."

"Well, everyone else on FSOC does, including our consumer financial protection and housing finance experts. The international Financial Stability Board — of which your favorite new regulator happens to be an active member — thinks you are systemic, too."

"What do we have to do to be non-systemic in FSOC's eyes?"

"We won't tell you."

"But we don't want to be systemic."

"Then sue us."

And that is exactly what MetLife did earlier this week. MetLife is the first designated entity to take this step. The legal challenge raises important concerns about FSOC — a central part of the post-crisis regulatory framework. MetLife raises important constitutional and procedural concerns about its designation. The complaint, for example, describes FSOC's cavalier approach to assessing the likelihood that the insurer would run into serious problems and the consequences to the broader financial system if it did. At every turn, FSOC appears to have assumed the worst, even when its assumptions flatly contradicted one another.

FSOC's scenarios and assumptions are conveniently imprecise. According to the complaint, FSOC discounted MetLife's evidence and relied instead on vague prophecies of doom. For example, in looking at how exposed other firms are to MetLife, FSOC ignored the collateral these firms hold to protect themselves. The legal challenge explains that FSOC's imprecision and its reluctance to reveal its thinking to MetLife made it difficult for MetLife to prove it is non-systemic.

As the complaint points out, FSOC's rationale for designating MetLife would seem to require "the designation of virtually any large financial company." FSOC's nonvoting state insurance commissioner, Adam Hamm, explained it this way: "Identifying outer boundaries of exposures and claiming they could impact a nebulously defined market is not robust analysis; it simply means the Council has identified a very large company."

MetLife's legal challenge unfortunately does not touch some deeper questions regarding the validity of FSOC and the wisdom of systemic designations. FSOC is an odd and unwieldy agency. It is made up of 10 voting members, some of whom are the heads of commissions or boards. The other politically appointed members of these commissions and boards are not entitled to vote on designations and cannot even attend FSOC meetings. They have less say at FSOC than do staffers in their own agencies. FSOC conducts much of its business behind closed doors. As the Government Accountability Office observed in a November report, FSOC would do well to make its designation process "more systematic and transparent." Also potentially compromising the validity of FSOC's actions, the nonvoting members of FSOC include state (as opposed to presidential) appointees, which raises constitutional concerns.

Systemic designations were part of the Dodd-Frank plan to empower regulators to prevent financial crises. But singling out specific firms in this manner conveys to the markets that the government will not permit these firms to fail. In fact, systemically important financial institutions have begun marketing themselves to customers as super-safe. In this way, the systemic designation skews the competitive landscape and opens taxpayers up to the prospect of future bailouts of these too-important-to-fail firms.

Legal challenges to Dodd-Frank are difficult. The statute was written in an open-ended manner to maximize discretion to regulators. FSOC has taken full advantage of its nebulous congressional permission slip to go forth and designate. But MetLife raises serious procedural and constitutional issues. Even in this age of great deference to agencies, a process as arbitrary and consequential as the one the FSOC employs in singling out financial institutions merits close attention from the courts.