Federal Government Failure

TOP-DOWN COERCION

The driving force behind market economies is that voluntary exchanges are mutually beneficial. Millions of buyers and sellers pursuing their own interests engage in billions of exchanges, each creating value on both sides. These transactions generate market prices, which help guide people and businesses toward the best use of their efforts and resources. The price system allows for the synchronization of vast amounts of production and consumption across the nation and around the globe.

Markets generate cooperation between people with different values and goals, and create an environment open to innovation. Markets thrive on diversity and allow for people to pursue different lifestyles, careers, and consumption choices. F. A. Hayek said that the market “reconciles different knowledge and different purposes which, whether the individuals be selfish or not, will greatly differ from one person to another.”[i] Economist Thomas Sowell noted that “the diversity of tastes satisfied by a market may be its greatest economic achievement.”[ii]

Decisions Are Guesswork

The government does not work like this. Rather than voluntary exchange, it generally relies on coercion to pursue its ends. One consequence is that we cannot be sure that government actions generate net value. Because the government’s activities are not based on mutually beneficial coordination, there is no sure source of information indicating whether or not they are useful. This is a fundamental weakness of government.

Federal agencies impose more than 3,000 new regulations each year.[iii] Total federal regulations now span 168,000 pages.[iv] The government will spend about $4 trillion this year and distribute benefits to people through more than 2,300 programs.[v] Needless to say, the federal government is making a vast number of decisions affecting every aspect of our lives.

In making its spending and regulatory decisions, the government is flying blind. Regulations are top-down requirements for action or restraint, not efforts at finding voluntary agreement. Federal spending relies on compulsory taxation, not customer revenue. Without voluntary agreement behind its actions, the government faces a large information void. There is no system of supply and demand, prices, and profits to inform policymakers if their activities are generating net benefits to society. Policymakers may believe that their interventions make sense, but that is usually wishful thinking based on guesswork.

Consider the purchase of aircraft. In the private sector, an airline chooses the number of planes to buy on the basis of demand for air travel, which is aggregated from individual preferences expressed in the marketplace. By contrast, when the Pentagon buys aircraft, the number chosen is decided by political factors and guesswork regarding threats. No market generates information about the benefits of a threat reduction.

More broadly, no reliable mechanism exists to help the government make efficient choices across alternative uses of funds. Would fighter jets, farm subsidies, or food stamps be the best use of added funds? In markets, tradeoffs are made with the help of prices. If the price of air travel goes up, consumers reduce their air travel and increase their automobile travel. But in the government, decisions on allocating its vast budget are not based on solid metrics.

In theory, government decisionmaking could be aided by cost-benefit analysis.[vi] Experts could try to tally up all the monetary and nonmonetary costs and benefits of proposed actions, and the government could choose those options with the highest net returns. Since 1981, federal agencies have been required to perform such analyses for major regulatory actions.[vii] However, these analyses have often been of low quality because of a lack of accurate data and the use of dubious assumptions.[viii] Furthermore, experience shows that regulatory cost-benefit analyses are often biased in favor of the predetermined answers that government leaders favor.[ix] As a result, these analyses have often been paperwork exercises that have not improved decisionmaking.

With spending programs, some agencies perform cost-benefit analyses for some programs, but there is no broad requirement to do so.[x] To the extent that such analyses are performed, the process shows similar shortcomings as regulatory analyses. The Army Corps of Engineers, for example, has long performed cost-benefit analysis on projects. But outside experts have complained that the agency’s analyses are biased in favor of project approval—the Corps tends to overestimate the benefits of projects and underestimate the costs.[xi] Investigations “have repeatedly caught the Corps skewing its analyses to justify wasteful and destructive projects that keep its employees busy and its congressional patrons happy.”[xii] A Government Accountability Office report in 2006 found that the analyses supporting some Corps’ projects were “fraught with errors, mistakes and miscalculations, and used invalid assumptions and outdated data.”[xiii]

Perhaps federal cost-benefit analyses could be insulated from politics and made more rigorous. If so, the technique could be used for more spending decisions within agencies.[xiv] The Department of Homeland Security, for example, needs more rigor in its decisionmaking process for capital investments.[xv] However, it seems unlikely that such analyses would ever be used for broad allocation decisions by Congress, such as divvying up the budget between defense, housing, transportation, and other categories.[xvi]

In sum, decisionmaking in the market is a reality-based system rooted in individual preferences and trade-offs. By contrast, government decisions are based on guesswork. That is one reason why there is so much failure in Washington—and also why there is so much bickering. Everybody has a strong opinion about how to carve up spending and impose regulations, but nobody has hard data.

Funding Guaranteed

In markets, individuals and businesses often make bad decisions. But if they continue down the wrong path, their resources get depleted. A business making misguided investments will be punished by financial losses and may face bankruptcy or a takeover. About 10 percent of all U.S. companies go out of business each year, which is a remarkably high exit rate.[xvii] But losses and business failures prompt the beneficial reallocation of resources to more promising activities.

If government leaders are no more skilled than business leaders, their efforts will also have a high failure rate. But government activities that create no value can live on forever because the funding comes from a mandatory source: taxes. In theory, policymakers could rigorously analyze programs and then reallocate spending based on informed judgments about the successes and failures. But that usually does not happen in the federal government for reasons discussed in subsequent sections.

How about successful activities? Businesses that do a good job serving customers will earn high profits, at least until the profits are eaten away by competition. The quest for profits guides businesses toward generating net value. In government, there is no such guide. Federal subsidy programs may attract many recipients, or “customers,” but that is not an indicator of success—or net value creation—because it does not take into account program costs.

People might assume that government has an advantage in tackling society’s problems because it is a powerful institution that can use coercion. Actually, the fact that government has a compulsory revenue stream is a huge weakness that leads it astray. In markets, strong feedback mechanisms prompt rapid adjustments when failures arise, but in government there is usually too much inertia to make needed changes. To a large extent, government failure is baked into the cake because its misguided actions are not self-limiting the way that private actions are.

Winners and Losers

People in markets generally act in their own self-interest in pursuing their goals and trading with others. At first blush, that seems like an anti-social bias—an environment that creates winners and losers. But the opposite is true. In his 1776 classic, The Wealth of Nations, Adam Smith described how people in markets acting in their self-interest end up promoting the broader public good. An individual “intends only his own gain, and he is … led by an invisible hand to promote an end which was no part of his intention.… By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.”[xviii] People who work hard and allocate their resources to benefit themselves end up supporting overall prosperity. Their personal actions are socially beneficial.

F. A. Hayek expanded on Smith’s observations. He noted that in markets people “are induced to contribute to the needs of others without caring or even knowing about them.”[xix] And in markets, Hayek said, people “following their own interests, whether wholly egotistical or highly altruistic, will further the aims of many others.”[xx] Markets are a win-win proposition for participants, a positive-sum game.

It is a similar situation with all sorts of private activity, such as pursuing friendships, supporting charities, and promoting social projects. In such voluntary activities, people engage with others in mutually beneficial ways. Individuals, of course, make mistakes and sometimes pursue harmful activities, but in those situations the damage will be limited because others are not compelled to go along.

Governments do not work that way. Their activities tend to create winners and losers. Consider that in markets individuals choose their own levels of each good and service to consume. Markets allow for diversity. But government tends to have one-size-fits-all activities. That creates winners and losers because the chosen level of a government activity will differ from many people’s individual preferences. Economist James Buchanan called this loss caused by forced uniformity a “political externality” of government interventions.[xxi]

This suppression of individual choices in favor of top-down choices destroys value, and it is a key reason why every citizen should want to keep the sphere of government activities limited. Supporters of government control of activities seem to think that “people can be made better off by reducing their options.”[xxii] But rather than making people better off, government interventions often lead to unhappiness and social conflict.

In the 1840s, economist Frédéric Bastiat argued against France’s subsidies for religion, education, arts, and other activities because of the discord they created. He said, “All these vital forces of society should develop harmoniously under the influence of liberty and that none of them should become, as we see has happened today, a source of trouble, abuses, tyranny, and disorder.”[xxiii] Milton Friedman similarly argued that the use of government to try and solve problems “tends to strain the social cohesion essential for a stable society.”[xxiv] By contrast, he said, “the widespread use of the market reduces the strain on the social fabric by rendering conformity unnecessary with respect to any activities it encompasses.”[xxv]

When the government grows, divisions within society grow because more resources are distributed by coercive means rather than voluntary means. But with America’s increasingly pluralistic society, the last thing we need is more division being sown by one-size-fits-all federal policies. As “our society is becoming more diverse, the range of activities by the national government should be logically narrowed.”[xxvi]

All that said, federal activities can generate net value in some situations. The government can provide “public goods,” which are items we all benefit from, but that are underprovided by markets.[xxvii] National defense is a good example. And the government can generate value by fixing “externalities,” such as pollution.[xxviii] When it addresses these and other market failures, federal policies can be a win-win proposition that improves economic efficiency and increases welfare.[xxix] The challenge is to keep the government narrowly focused on these roles, and to tackle them effectively with a minimum of failure.

Taxes Create Deadweight Losses

When evaluating spending programs, policymakers should take into account the full costs of funding them. The direct cost of any program is the tax revenues the government will need to extract from the private sector. But another cost is created by the extraction process itself. Since taxes are compulsory, they induce people to try and avoid them by changing their working, investing, and consumption activities. Such responses harm the economy, a harm called a “deadweight loss.”

Suppose the government imposes a new tax on wine. Wine drinkers would be harmed because part of their money would be confiscated. But an additional cost, the deadweight loss, would be created as people cut back their wine consumption. Because of the tax, people would enjoy less wine and lose some amount of welfare or happiness.

Consider the damage caused by a wine tax of $1 per bottle. Before the tax is imposed, people consumed 100 million bottles at $10 per bottle. With the tax, the price rises and people reduce their consumption to 90 million bottles. A deadweight loss is caused by people reducing their consumption by 10 million bottles.[xxx]

While the tax revenue amount represents a loss for the private sector and a gain for the government, the deadweight loss is a loss to society as a whole. The government has blocked 10 million bottles worth of mutually beneficial exchanges from taking place. Every federal tax causes this sort of damage by hindering market exchanges. Income taxes, for example, reduce the working and investing efforts of millions of families and businesses.                      

How large are the deadweight losses of federal taxes? They vary depending on the tax rate, the type of tax, and other factors. But for the federal income tax, studies have found that, on average, the deadweight loss of raising taxes by a dollar is roughly 50 cents.[xxxi] Based on his pioneering work, Harvard University’s Martin Feldstein thinks that the loss may be higher, perhaps exceeding “one dollar per dollar of revenue raised, making the cost of incremental governmental spending more than two dollars for each dollar of government spending.”[xxxii] Other estimates are, however, lower than Feldstein’s.

Suppose that Congress is considering spending $10 billion on an energy subsidy program. Putting aside whether the program is ethical or constitutional, does the program make any economic sense? The program’s benefits would have to be higher than the total cost of about $15 billion, which includes the $10 billion direct cost to taxpayers plus another $5 billion in deadweight losses.[xxxiii]

Currently, federal lawmakers do not consider deadweight losses when they make spending decisions, but they should. The scorekeeper of Congress, the Congressional Budget Office (CBO), generally does not include deadweight losses in its analyses. Federal agencies generally do not consider deadweight losses either, even though the Office of Management and Budget has recommended that they be included in program evaluations.[xxxiv]

The absence of deadweight loss information biases policymakers in favor of approving programs.[xxxv] Consider the debate over the Affordable Care Act (ACA) in 2010. Health scholar Chris Conover estimated that ACA-imposed taxes would create up to about $500 billion of deadweight losses during the law’s first decade, which was in addition to the bill’s official cost of about $1 trillion.[xxxvi] If such an estimate had been provided to Congress by the CBO in 2010, it might have changed the debate over the legislation.

To see why deadweight losses can result in government failure, let’s compare a private charitable project to a government program. Suppose that a philanthropist creates a $10 million project to help disadvantaged individuals, and the program generates $12 million in benefits. It would be a success. Now suppose a similar program is run by the government. It would be a failure because it would use tax funding and thus generate deadweight losses. The government program would cost $10 million directly plus another $5 million or so in deadweight losses, for a total cost that was higher than the benefits. Since government projects are funded by compulsory taxes, they are more costly than private projects. Coercion is not free.