In all societies, governments intervene to control and influence market decisions and their outcomes. Governments usually intervene in two ways: taxation and regulation. Economists believe the burden of regulation on society is much greater than taxation because the economic inefficiencies are much greater.


Regulations effectively take private resources from one group to pay another. This can give rise to a problem that is particularly acute inHong Kongin which politicians use regulation to advance the interests that support them or that they represent.Hong Kong’s Basic Law does not permit legislators to propose bills that would have budgetary consequences. But since regulatory interventions do not have direct budgetary consequences, they provide an alternative means for politicians to gain votes to maintain their political power and office.


Such a situation makes it logical for politicians to target their regulations at “big” corporations. This is firstly because “big” corporations are the sources of large economic surpluses that can be extracted through regulations or additional regulations; and secondly because extracted rents can be redistributed to favorite constituencies designated by the politician or the regulator. In a way this is taxation by another name. Politically it is often necessary to first demonize the corporations as a prelude to redistributing their surpluses. This is not difficult to do and sometimes such demonizing may have an objective basis.


On Limited Government


To fully understand the workings of regulations, it helps to go back to the basics of why Governments intervene in the first place. Usually such interventions have laudable public objectives. For many centuries there has been disagreement among thinkers and activists about what should be included in the list of tasks that a government should perform. Should government intervene to promote a more egalitarian society in terms of either equality of opportunities or outcomes? Should government provide a social safety net to support individuals who suffer from misfortune through no fault of their own? Should government ensure the sustainability of its society and economy by defending itself against attacking enemies and promoting prosperity?


A limited government is one whose interventions are constrained in scope and degree and limited to performing only those tasks that are absolutely necessary for a free society to function properly. For many the most critical task in a complex society is the protection of individual rights, including private property rights, so long as this does not interfere with the exercise of such rights by others.


Taxation generally involves the coercive expropriation of privately owned resources, which government then spends in two ways. The first is to purchase goods and services for either consumption or investment purposes. The second is to provide subsidies that are simply transfers from one segment of the population to another. The burden of taxation in an economy is the amount of taxation net of subsidies. This represents the asset side of the government budget.


Government consumption and investment expenditures are the liability side of the government budget and have to be financed by either taxation or public debt. Public debt in turn has to be financed by future taxation or taxes to be borne by future generations. Government consumption and investment expenditures therefore are financed by either current or future taxation. When these expenditures are low as a proportion of the economy’s gross domestic product (GDP), we often say that the size of government in the economy is small.


Politicians, Bureaucrats and Self-Interest


But measuring the size of the government in an economy is an inadequate way of gauging whether government activity is limited or extensive in an economy. Government regulation is an increasingly important form of government intervention that often does not appear in the fiscal budget or on government balance sheets.


Public regulation is not taxation as such, but nevertheless it involves the coercive expropriation of privately owned resources. Private individuals or corporations are mandated to pay other private individuals or corporations. For example, a regulation mandating the use of automobile seatbelts imposes a cost on the owners, drivers and passengers of automobiles for purchasing, installing and using the seatbelts. The intention of the regulation is to improve automobile accident safety. Whether such an outcome materializes depends on whether the expected benefits exceed the costs. If the net expected benefits are positive then we have what economists call an economic efficiency-improving regulation. In any case, the financial effects of such public regulations are equivalent to taxation because they are a coercive requirement.


The above reasoning can of course be applied to other government regulations. For example, prohibitions on smoking in public places, labeling of consumer products, building safety codes, town planning rules, nature conservation rules, drug safety regulations, product safety regulations, etc – the list is endless in a modern economy. 


For many years, public finance economists held the view that these regulations were adopted by governments out of public interest. In other words, the stated intentions of a regulation and its actual consequences were assumed to coincide. This reasoning generally assumed that the expected benefits of a regulation would necessarily exceed its costs. The idea that governments could only propose good regulations became the basic working assumption of the public finance economist. 

But what is the evidence? Could the assumption be wrong?


Nobel Laureate George Stigler developed an economic theory of regulation that challenged this assumption. Stigler assumed politicians and bureaucrats like everyone else are motivated by self-interest in securing and maintaining political power and office. Interest groups seek to influence the outcome of the regulatory process by providing them with two things they need: votes and finances.


The Downside of Cross-Subsidization


The politician prefers regulatory decisions that directly elicit favorable votes and indirectly elicit campaign contributions, help in getting out the vote, occasional bribes, or well-paid jobs in their political afterlife. Bureaucrats wishing to remain in office or be promoted also need political support even though they may not need votes.


Following from this argument, public regulations can be seen as the result of successful lobbying activities by interest groups whose purpose is to capture benefits for themselves. Politicians are willing to deliver regulatory benefits to those interest groups that can deliver votes and finances that help politicians and bureaucrats improve their chances of maintaining political power and office. 


A critical analytical result first shown by Italian economist Vilfredo Pareto in 1896 and later rediscovered by Mancur Olson in 1965 was that small well-organized groups have a disproportionate advantage over larger groups in securing regulatory benefits for themselves for two reasons. First, the organizational costs are lower for smaller groups as large groups often face prohibitive such costs. Second, the per capita benefit is higher for smaller groups for any given amount of the transfer. Larger groups have to share the same transfer among a larger population. The best exposition of this logic is given by Pareto in Cours d’Economie Politique, 1896:


Let us suppose that in a country of thirty million inhabitants it is proposed to get each citizen to pay out one franc a year, and to distribute the total amount amongst thirty persons. Every one of the donors will give up one franc a year; every one of the beneficiaries will receive one million francs a year. The two groups will differ very greatly in their response to this situation. Those who hope to gain a million a year will know no rest by day or night. They will win newspapers over to their interest by financial inducements and drum up support from all quarters. A discreet hand will warm the palms of needy legislators, even of ministers. On the other hand, the despoiled are much less active. A great deal of money is needed to launch an electoral campaign. Now there are insuperable material difficulties militating against asking each citizen to contribute a few centimes. One has to ask a few people to make substantial contributions. But then, for such people, there is the likelihood that their individual contribution to the campaign against the spoliation will exceed the total amount they stand to lose by the measure in question. When election day comes, similar difficulties are encountered. Those who hope to gain a million apiece have agents everywhere, who descend in swarms on the electorate, urging the voters that sound and enlightened patriotism calls for the success of their modest proposal. They will go further if need be, and are quite prepared to lay out cash to get the necessary votes for returning candidates in their interest. In contrast, the individual who is threatened with losing one franc a year-even if he is fully aware of what is afoot-will not for so small a thing forego a picnic in the country, or fall out with useful or congenial friends, or get on the wrong side of the mayor or the préfet! In these circumstances the outcome is not in doubt: the spoliators will win hands down.


As this scenario illustrates, public regulations can end up transferring resources from a large population of the despoiled to a small number of spoliators. The political lobbying process inherently favors producers (who are fewer in numbers) over consumers (who are larger in numbers). But this generalization should not be pushed so far as to become the sole explanation of public regulation.


Managing perceptions in politics is necessarily complex. Often a regulated industry is expected to share some of its spoliation (known in economics as producer rents) with a sub-group of selected consumers in order to provide cover for regulatory spoliation. For example, services are provided to children, disabled individuals, the elderly and other favorite groups at below-cost prices in order to mobilize greater political support. The use of “cross-subsidies” as a means to harness public goodwill provides politicians, bureaucrats, and regulators with needed political cover so they avoid being seen as “captured” by producer interests alone. The fact that producers now share some of their rents with organized interest groups does not mean that the resulting balance of interests necessarily leads to economic efficiency. Those invited to share the rents are a sub-group of selected consumers who generate maximum effective political support for the regulator and the regulated. For this reason, it is somewhat misleading to call such “cross-subsidies” as acts of pure corporate social responsibility. 


Nobel Laureate James Buchanan and his colleague Gordon Tullock offer an insightful explanation for a paradox in environmental regulation. Theoretical economic analysis of negative externalities has clearly recommended the use of a corrective tax measure, called the Pigovian tax, to address the misalignment of social and private incentives for reducing polluting activities to a socially acceptable level. The tax is named afterCambridgeUniversityeconomist Arthur Cecil Pigou, who proposed that it be set at a level sufficient to eliminate the difference between the private and social marginal cost of the pollution damage.


Environmental Groups Neglect Economic Efficiency


Many observers have noted, however, that in practice politicians and bureaucrats do not follow this model, but instead favor command-and-control instruments for correcting environmental problems, which involve explicit limitations on allowable levels of pollution or require the use of specified abatement technologies. Who is wrong here: economists or politicians? Neither, according to Buchanan and Tullock. They show that the profits of polluting firms are usually higher under a direct regulation regime and hence it is in their interests to put pressure on politicians to work with regulatory rather than price instruments.


Consider the cap-and-trade environmental protection scheme favored by US President Obama after he came to office. Under the scheme, the environmental agency would set emission standards and issue emission permits that allowed these standards to be reached. A permit would give a polluter the right to pollute. These permits would be bought and sold on a permit market. The market price for a permit would, in the ideal case, reflect the social opportunity cost of pollution.


Incumbent polluting firms recognized immediately that a permits scheme provided them with a device to set up a barrier-of-entry against prospective firms who would have to secure permits now in order to enter the industry. If rules could be devised to put up more hurdles for new firms to get permits as against incumbent firms, then the latter would gain a competitive advantage over them. President Obama originally opposed such a two-tier program but reversed his campaign position and agreed to let incumbent firms secure permits at discounted fees for many years; the discount was not extended to new firms. The more efficient Pigovian tax would have treated all firms equally and would not have conferred an advantage upon incumbent firms.


The Buchanan and Tullock analysis explains the apparent contradiction between an economically efficient policy and a politically acceptable one. Politicians and bureaucrats set regulations that reflect the political power of incumbent regulated firms. Environmental advocacy groups are concerned with reducing pollution but not with whether it is accomplished in an economically efficient manner. They do not mind whether regulatory or price instruments are used to reduce pollution so long as it is reduced.


As a consequence regulation results in a huge amount of inefficiency. Unfortunately the burden of regulation is not well recognized compared with the burden of taxation. All too often when people see a low ratio of government expenditure to GDP they are misled into believing that government is quite limited.


Foreign Practices May Be Problematic


Certain forms of regulation are commonly found in many countries. Consider the popularity of minimum wage legislation currently enacted in over 80 nations. The minimum wage affects only a relatively small percentage of workers who earn below the minimum threshold. Although their numbers are low, their voting leverage can be quite substantial as family members are likely to vote in support of a low wage member. Given that minimum wages are likely to be adjusted from time to time, they provide politicians with an ideal regulation to drum up votes. The additional number of votes required to win an election is usually not large. However, workers affected by the minimum wage are usually highly concentrated in a countable number of industries and occupations making it easy for politicians to organize them.


In fact, the minimum wage may lead to higher unemployment among some workers, but their numbers are likely to be even smaller. The unemployment fallout can also be minimized if the politicians learn not to push for very high wage increases so that there is more sound and fury then actual blood and tears in the campaign for votes. The impact of increases is likely to be most adverse among smaller employers that hire low wage workers. Should these employers fail, then the remaining larger employers in the same industry may increase their market position even though they would now have to pay higher wages. This means pro-business politicians who normally pay more attention to larger employers, would not have to resist minimum wage increases too forcefully.


There is a more natural solution to achieving the stated purpose of the minimum wage of supporting low wage workers: provide a wage subsidy or a negative income tax. But this has been rejected in almost all advanced societies where politicians are free to pass such legislation. Why? The advantage of minimum wage legislation is that it is politically easier to adopt than a wage subsidy or a negative income tax precisely because its scope and scale is more limited and it delivers the requisite votes at an affordable mobilization cost. It is one of those ideal pieces of legislation on political grounds.


It is often argued thatHong Kongshould follow the example of many developed nations in adopting certain pieces of legislation or regulation because these countries presumably are more advanced and experienced in these things. But it is useful to pause and consider whether there is an alternative explanation for why so many developed nations have adopted such measures. Could it be that their popularity is not so much due to the stated intentions of these laws and regulations, but rather that they serve the interests of politicians, bureaucrats, regulators and the regulated?

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