[Economic Report of the President (1998)]
[Administration of William J. Clinton]
[Online through the Government Printing Office, www.gpo.gov]

[DOCID: f:erp_c5._]
Economic Report of the President - - - - - - - - - - - - H. Doc. 105-176
[From the online service of the the U.S. Government Printing Office]
[wais.access.gpo.gov]



CHAPTER 5 -- Improving Economic Efficiency: Environmental and Health Issues

THE U.S. ECONOMY RELIES PRIMARILY on market forces and price signals
to allocate economic resources efficiently. Economists have long
recognized that a system of decentralized, competitive markets in
which businesses and households act in their own best interest
promotes economic growth and well-being. Market prices signal how
resources should be used to produce goods and services of the highest
value, and facilitate the distribution of these goods and services to
those willing and able to pay the most for them. In a well-functioning
market the price of a good or service reflects both its marginal value
to the consumer and its marginal cost to the producer. So long as
there is no divergence between the private and the social values and
costs of these goods and services, the market system is likely to
bring about the most efficient allocation of economic resources.
Although economic efficiency is not the only concern of policymakers,
it is important because it largely determines the total quantity of
goods and services available. However, economists also recognize that
sometimes prices might be distorted and that a market economy may fail
to allocate resources efficiently. When market failures occur,
appropriate government action may be able to improve upon market
performance and enhance overall economic well-being. Examples of such
action include protecting the environment, promoting health and
safety, providing intellectual and physical infrastructure, and
promoting competition.

Potential sources of market failure are:

 Externalities. An externality arises when production or
consumption by one person or group provides a benefit to others (for
example, by revealing a useful scientific discovery) without receiving
compensation equal to the benefit, or imposes a cost on others (for
example, by polluting the environment) without paying compensation for
the full cost.

 Incomplete or asymmetric information. When two parties to an
economic transaction do not have complete information, or do not have
the same information, about the goods or services being exchanged,
they may face distorted incentives that prevent markets from supplying
the amount or the type of products most desired. These information
problems are especially prevalent in the market for health care, where
incomplete or asymmetric information about a patient's health status
or the value of a provider's services can adversely affect the
decisions of both provider and consumer.

 Public goods. A public good is one that many people can use
simultaneously without reducing its availability to others, and whose
benefits are such that one person cannot exclude others from enjoying
them. An example of a public good is national security, which, once
provided, cannot be denied to anyone residing in the protected nation.

 Imperfect competition. Imperfect competition may result when a
few suppliers or buyers can exercise market power to limit supply,
keep prices high, and prevent new competitors from entering the
market.

Economics provides important insights into the circumstances in which
governments can act to improve upon market performance, how they can
do so in a cost-effective manner, and how the costs and benefits of
such actions are likely to be distributed. Economics has shown that
market mechanisms can be a powerful instrument for achieving desired
policy outcomes without incurring unnecessary costs. A prime example
is the use of tradable pollution permits in environmental policy,
described in detail later in this chapter.

This chapter presents several examples of market failures in the areas
of environmental protection and health care and discusses new
approaches to addressing them. Recent environmental initiatives
include policies to improve air quality, address global climate
change, and reduce non-point source water pollution from agriculture.
These policies are designed to build upon the considerable success of
past efforts in improving the quality of our environmental resources.
In the domain of health care and consumer safety, rules governing
health insurance and drug approval have been reformed, and new
policies are being proposed to improve the performance of health
maintenance organizations and reduce teenage smoking. These policies
are intended to further enhance the health and well-being of our
Nation's people. Recent antitrust reforms designed to increase market
competition are discussed in Chapter 6.

COST-EFFECTIVE ENVIRONMENTAL PROTECTION

Achieving environmental targets at the lowest possible cost is an
important policy objective. The President's Executive Order 12866,
issued in 1993, directs Federal agencies to design regulations in the
most cost-effective manner to achieve the regulatory objective and to
propose or adopt a regulation only upon a reasoned determination that
its benefits justify its costs. Further, the 1995 Unfunded Mandates
Reform Act requires agencies either to certify that the regulatory
approaches they adopt to achieve policy goals are the least
burdensome, the most cost-effective, or the least costly among
available alternatives, or to state the reasons for choosing an
alternative approach.

TRADABLE EMISSIONS PERMITS

In implementing environmental policy, economists often advocate the
use of market-based mechanisms such as tradable emissions permits for
environmental pollutants, to encourage emissions reduction from those
sources where the cost of emissions reduction is lowest and to foster
innovation in emissions control technology. Tradable permits can be
especially useful in achieving quantitative targets for emissions
control or abatement.

Under the traditional regulatory approach to environmental protection,
a regulatory agency may specify an allowable emissions level for each
firm or facility or require firms to use specific technologies to
reduce emissions. This is often inefficient because the cost of
reducing emissions by a given amount differs from firm to firm. A
tradable permit system instead caps total emissions from all firms but
neither places limits on emissions by any one firm nor dictates how
the reduction in emissions must be achieved. Instead the regulatory
agency issues permits for emissions in a total amount equal to the cap
and prohibits emissions without a permit. After their initial
allocation (methods for which are discussed below), firms may freely
buy and sell permits among themselves. Any firm that can reduce its
emissions for less than the going price of a permit has an incentive
to do so and then sell its unused permits to other firms for which
emissions reduction is more costly. With tradable emissions permits,
firms thus have more choices and can meet environmental standards at
lower cost than under traditional regulation.

An emission permit trading system also gives firms an incentive to
innovate. Firms that develop more effective and cheaper pollution
control measures can sell not only their unused permits but the
technology itself. Furthermore, trading systems that allow unused
permits to be saved, or ``banked,'' for future use encourage the early
adoption of unanticipated technological improvements that lower the
cost of emissions controls. These features lower the cost of emissions
reductions still further.

Economists have identified some other key features of successful
emissions permit trading programs. First, firms should perceive that
owning a permit is like owning any other asset. A firm will purchase a
permit only if it expects that the permit conveys a legitimate right
to emit. Similarly, a firm will reduce emissions in order to sell
unused permits only if it believes that the permit will be valuable to
other firms. Thus, if there is a risk that the right to emit or the
right to trade will be revoked, both the trading price and the volume
of permits traded will be depressed, and some of the efficiency gains
from permit trading will be lost. Of course, the government retains
its authority to restrict or revoke trades for legitimate compliance
and enforcement purposes under terms and conditions specified by law.

A second key feature is broad scope: because trading lowers costs, it
should be permitted among all sources of emissions that cause the same
type of environmental harm. Excluding some sources may raise costs if
emissions from these sources can be reduced at relatively low cost.
However, including all sources of a pollutant in the emissions cap may
not always be practical. For example, emissions from natural sources
and from other countries may affect our Nation's environment but be
beyond the control of U.S. regulatory authorities. Even within our
borders, measuring pollutant discharges from all sources may be
prohibitively costly, especially when discharges are dispersed or
affected by weather, as is the case with fertilizer and pesticide
runoff from cropland. One way to broaden the scope of a program is to
offer firms subject to the emissions cap a credit for emissions if
they contract with uncapped sources to reduce their emissions. So long
as a satisfactory means of measuring and verifying these reductions
can be established, this approach can provide further opportunities to
lower the cost of meeting environmental objectives.

To ensure the broadest possible scope for permit trading, permits
should reflect units of environmental damage from emissions, not
necessarily units of emissions. Permit trading then lowers costs by
allowing trades in emissions that differ with respect to location,
time period, chemical, or pathway (by air or by water, for example).
If suitable conversion factors can be devised, trades in different
emissions representing equivalent amounts of environmental damage can
be made. This approach could also help prevent local environmental
``hot spots'' from developing. Suppose, for example, emissions from an
area far upwind of a heavily polluted area have half the environmental
effect there of local emissions of the same quantity of the
contaminant. Then 2 tons of upwind emissions could trade for 1 ton of
local emissions without changing total effects on the environment.
Likewise, to the extent that different chemicals affect the
environment similarly (as, for example, both carbon dioxide and
methane contribute to the global greenhouse effect), the permit
trading system could allow reductions in one pollutant to substitute
for reductions in another by an amount that causes equivalent
environmental effects. Finally, suppose a certain pollutant causes
similar environmental damage whether it is introduced into lakes
through the air or by surface water. Then permits for air emissions
could be tradable for permits for water discharges, again encouraging
reductions from those sources with the least costly control
opportunities.

A final key feature of a successful emissions permit trading system is
an effective compliance mechanism that ensures the integrity and
fairness of the system and at the same time ensures that transaction
costs are relatively low. The compliance mechanism will normally
include monitoring and reporting requirements as well as enforcement
provisions. Transaction costs include the costs of paperwork,
recordkeeping, notification, and prior-approval requirements for
permit trading. Although some requirements are inevitable in operating
a credible trading system, they should be balanced against the need to
keep transaction costs low. High transaction costs could discourage
trading, thus eroding the potential gains from trade, and may make
participation in the program prohibitively expensive for some firms.

Initial Allocation of Permits

A tradable permit system achieves its environmental benefit by capping
pollutant emissions below the level that would otherwise occur. The
costs of reducing emissions are then borne by the firms responsible
for the emissions and (through higher prices) those who buy their
products, as well as by suppliers of inputs such as labor and capital
equipment to these firms. Firms and consumers in related markets, such
as those for substitutes and complements of the goods produced by the
regulated firms, will also be affected.

The government could arrange the initial allocation of permits in any
of a number of ways, for example by auction, by free allocation in
proportion to firms' historical emissions (``grandfathering''), or even
by lottery. Anyone receiving permits may then sell all or some of
them, or use them as needed to keep actual emissions within regulatory
requirements. So long as a permit trading system imposes low
transaction costs, the choice of allocation system does not generally
affect the efficiency with which emissions reductions are achieved;
after the permits are first allocated, the trading of permits itself
minimizes the cost of pollution reduction. However, the choice of
allocation method does have other consequences. If the method chosen
yields revenue to the government, the program presents an opportunity
to lower taxes, such as those on earnings from labor and investments,
without affecting budget balance. Shifting the tax burden in this way,
called ``revenue recycling,'' could enhance economic efficiency and
growth as lower taxes increase incentives to work and save. These
economic benefits can significantly lower the net economic cost of
reducing emissions.

The allocation system has further implications for who bears the cost
of monitoring and reducing emissions. The extent to which firms can
pass on some of the costs to consumers in the form of higher product
prices depends on the degree of competition and the price elasticities
of supply and demand for goods in the markets affected by the
emissions constraint. In some cases, granting free permits to
participants in the permit market could go beyond compensating them
for their cost share of emissions reductions, leaving them better off
than before the permit system was introduced.

Lessons from the Sulfur Dioxide Program

Practical experience in designing and implementing trading programs
for pollution emissions permits is still limited. The highly acclaimed
sulfur dioxide (SO2) program--also called the acid rain
program--administered by the Environmental Protection Agency (EPA)
relies on, among other things, a system of tradable permits to reduce
emissions of SO2 from electric utilities. Trading of emissions permits
began in 1992, and to date the program is the only emissions permit
trading program that is national in scope. The SO2 program is being
implemented in two phases. The first phase covers the 110 most heavily
polluting electric generating plants. Phase II, beginning in 2000,
will impose a more stringent emissions cap and include a total of more
than 2,000 units. The program has been successful in several ways: a
large number of utilities engage in trading, SO2 emissions and ambient
concentrations have fallen, and the costs of reducing emissions have
been considerably lower than originally forecast.

Why the early cost estimates were higher than the costs actually
realized is a matter of considerable discussion. One contributing
factor was a greater-than-expected decline in rail freight rates,
which made low-sulfur coal from the Powder River Basin of Wyoming more
competitive with locally mined, high-sulfur coal in Midwestern
markets. Use of low-sulfur coal proved a less costly means of reducing
SO2 emissions than the smokestack scrubbers that utilities had
anticipated using. A second factor was lower-than-predicted costs of
using scrubbers, in part because of unexpectedly high utilization
rates. The average cost of reducing SO2 emissions using retrofitted
smokestack scrubbers was about $270 per ton in 1995, far below early
estimates of around $450 to $500 per ton.

One measure of the decline in cost relative to expectations is the
trend in emission permit prices (Chart 5-1). Currently, at
approximately $100 per ton of SO2, permit prices are well below
earlier estimates of around $250 to $400 per ton. These prices reflect
the short-run marginal cost of reducing SO2. Prices are low partly
because firms, believing that permit prices would be much higher,
overinvested in scrubbers. Average total control costs are likely to
be higher than these short-run marginal costs.

The permit trading program also allows firms to bank unused emissions
permits for future use, for example when emissions limits become more
stringent in phase II. By banking, utilities can lower costs by timing
their reductions according to their projections of emissions control
costs and permit prices. If firms expect permit prices or control
costs to go up, or if they want to take advantage of newly available
control technology, they can adopt measures to reduce emissions sooner
than they otherwise might.



Trading programs may not always bring cost savings as large as those
achieved by the SO2 program, nor will they always lead to the
discovery of much cheaper control strategies. Programs that involve
multiple pollutants or international cooperation will necessarily be
more complex. However, the SO2 experience does demonstrate how such
programs offer market incentives to find cheaper ways of reducing
emissions, and the flexibility to take advantage of them. Had
regulators simply required all utilities to install scrubbers,
utilities would not have been able to take advantage of the new
availability of cheap, low-sulfur coal, and the costs of pollution
abatement would have been much higher.

Another important lesson from the SO2 program is that efforts to
minimize transaction costs help ensure the successful operation of
markets for pollution permits. But even so, it takes time to develop
the institutions needed to facilitate trading and instill confidence
in the value of credits so that markets run smoothly. The volume of
trade in the market for SO2 permits, a measure of the potential gains
from such trade, started out quite small but has grown rapidly as
utilities gained experience with the program. In addition, increased
trading volume and the annual public permit auctions tightened the
range of market prices for permits. In the program's fifth year about
7.9 million allowances were traded, up from 900,000 allowances in the
second year (Chart 5-2).

We now turn to three other areas where the Administration is seeking
to improve the environment in a cost-effective manner:



attainment of the new air quality standards, policies to address global
climate change, and programs to reduce water pollution from agriculture.

AIR QUALITY STANDARDS

Air pollution has been linked to a variety of health problems ranging
from decreased lung function to increased mortality risk. These
adverse health effects are a classic externality: the emitter does not
bear the full cost of its actions. Under the Clean Air Act, the EPA
must periodically review, and may revise as appropriate, national air
quality standards for pollutants. State agencies are largely
responsible for developing programs (subject to EPA approval) to meet
these standards. In July 1997 the EPA issued a more stringent standard
for ground-level ozone and a new standard for fine airborne
particulate matter. Under the act, these standards must be set so as
to protect public health, with an adequate margin of safety. Courts
have confirmed the EPA's interpretation of this to mean that
consideration of costs or feasibility is excluded in setting the
standard. However, under the President's policy the EPA is to
implement these health-based standards cost-effectively.

Efforts to meet air quality standards have traditionally focused on
controlling emissions within ``nonattainment areas''--mostly urban areas
where concentrations of pollutants exceed the standard. Although some
States--California, for example--have set up trading programs or used
other market mechanisms to reduce the costs of compliance with air
quality standards, most rely on traditional prescriptive approaches to
controlling pollution. The Administration's plan for achieving the new
air quality standards departs from these traditional approaches by
designing regional strategies to complement local efforts, and by
encouraging the development of nitrogen oxides (NOx) trading programs
among sources in different States.

Regional Strategies and Market-Based Approaches

Studies of air quality have found that high ground-level ozone
concentrations are not just a local problem: under certain weather
conditions, ozone and NOx can travel hundreds of miles and contribute
to nonattainment of standards in downwind areas. Under traditional
regulatory approaches, nonattainment areas would have to make costly
emissions reductions within their borders even if upwind reductions
that would have similar environmental impact were available at lower
cost. To address this problem, the plan for implementing the new
standards will expand the geographic scope of the program. Under the
Clean Air Act the EPA has the authority to require emissions
reductions in any State that significantly contributes to
nonattainment outside its borders. In November 1997 the EPA proposed a
regional strategy that would require 22 Eastern States and the
District of Columbia to reduce NOx emissions by an average of 35
percent during May through September (when ozone levels are highest)
by 2007. Reductions in NOx emissions, apart from reducing ground-level
ozone, may also reduce excess nutrients in waterways and the formation
of airborne particles linked to adverse health effects. The design of
a cost-effective regional strategy that contributes to attaining and
maintaining the new standards will require careful attention to the
effects of emissions on air quality. Later this year the EPA will also
propose a rule to facilitate trading of NOx emissions reductions among
the States covered by the regional program.

Designing a Trading Program for Nitrogen Oxides

In designing a trading program for NOx, the EPA faces a number of
challenges. These include ensuring adequate scope for the trading
program, ensuring that trading does not adversely affect the
environment, and providing for necessary accountability and
compliance.

As discussed above, the scope of trading programs like the NOx program
is an important determinant of their cost-effectiveness. As more
emissions sources are included in the program, the increased
opportunity to trade emissions permits tends to lower the cost of
achieving a given level of emissions reduction. Utilities currently
account for only about 30 percent of NOx emissions, compared with
about 65 percent of SO2 emissions (Chart 5-3). Transportation accounts
for 49 percent and nonutility combustion for 18 percent of NOx
emissions.



Thus, extending NOx trading to nonutility sources could
reduce costs. However, the scope of the program may be limited by the
need to ensure accountability. For example, some smaller sources have
considerably lower control costs than electric utilities, but their
claimed emissions reductions may be more costly to monitor.

Including more sources from different sectors in the trading program
may also have desirable distributional effects. Utilities are likely
to pass the cost of compliance on to consumers in the form of higher
electricity prices, and low-income households spend a higher share of
their income on electricity bills than do households near the median
income. Moreover, broader scope can decrease the average cost of
pollution abatement, reducing the burden on all parties, including the
poor.

Another challenge in designing a trading program for NOx within the
context of the regional ozone reduction strategy is to maintain broad
geographic scope while ensuring that trading does not result in
significant adverse environmental effects. The goal of this strategy
is to improve air quality in nonattainment areas cost-effectively. In
its simplest form, the problem of pollution transport can be thought
of in terms of a single downwind nonattainment area that is affected
by a number of upwind pollution sources located at varying distances
from it along a line indicating wind direction. In this case, sources
that are farther upwind will have less impact on the air quality of
the area than sources that are closer, all other things being equal,
and such differences may be as large as 10 to 1. It might then appear
that emissions trading could undercut the effectiveness of pollution
controls if it resulted in shifting emission reductions farther
upwind. Trading ratios that weight the reductions made at different
sources according to their distance from the downwind nonattainment
area might be considered to address this problem.  In reality,
however, there are a large number of nonattainment areas spread out
over the region, and several different weather patterns and wind
conditions characterize the ozone pollution episodes that the program
is trying to remedy. Sources affect multiple nonattainment areas in a
variety of directions from them, and it affects any single
nonattainment area differently under different weather conditions. The
polycentric nature of this problem complicates the identification of a
unique and stable set of trading ratios that would work for all
relevant cases. Thus, striking the proper balance between achieving
the cost savings from larger geographic scope and limiting the
potentially significant adverse environmental effects of trading is an
ongoing challenge.

Like most air pollution control programs, NOx trading programs would
require an estimate of emissions from each regulated source in order
to ensure compliance. The estimation method can have significant
implications for cost-effectiveness, both directly, through the cost
of performing the estimate, and indirectly. One indirect implication
is that more costly requirements may limit the number of sources that
could meet the estimation requirements and participate in trading, and
thereby raise costs. On the other hand, a more reliable estimation
method may offer regulators and sources greater confidence in the
permits, and thereby increase the willingness of sources to buy them
or offer them for sale. For example, the SO2 program requires
continuous emissions monitoring to provide precise information on
emissions. Such monitoring is expensive and impractical for many
smaller sources and thus may effectively exclude such sources from
participating. But such precise monitoring may not always be
necessary. Methods for estimating emissions that provide unbiased,
although less precise, estimates of emissions may be accurate enough
to ensure accountability.

CLIMATE CHANGE

Climate change is a global environmental externality: warming of the
earth's surface results from the accumulation of greenhouse gases from
myriad sources worldwide, none of which presently pay the cost to
others of warming's ill effects. The Intergovernmental Panel on
Climate Change, jointly established by the World Meteorological
Organization and the United Nations Environment Programme, concluded
in 1995 that ``the balance of evidence suggests that there is a
discernible human influence on global climate.'' Current concentrations
of carbon dioxide (SO2), methane, nitrous oxide (N2O), and other
so-called greenhouse gases have reached levels well above those of
preindustrial times. Of these, CO2 is the most important: net
cumulative CO2 emissions resulting from the burning of fossil fuels
and deforestation account for about two-thirds of potential warming
from changes in greenhouse gas concentrations related to human
activity. If growth in global emissions continues unabated, the
atmospheric concentration of CO2 will likely double, relative to its
preindustrial level, midway through the next century.

The accumulation of greenhouse gases poses significant risks to the
world's climate and to human well-being. Potential impacts include a
rise in sea levels, greater frequency of severe weather events, shifts
in agricultural growing conditions from changing weather patterns,
threats to human health from increased range and incidence of
diseases, changes in availability of freshwater supplies, and damage
to ecosystems and biodiversity.

Climate change is a complex, long-term problem requiring global
cooperation and a long-term solution. No single country has an
incentive to reduce emissions sufficiently to protect the global
environment against climate change. Even if the United States sharply
reduced its emissions unilaterally, greenhouse gas emissions from all
other countries would continue to grow, and the risks posed by climate
change would not be significantly abated. Since many of these gases
remain in the atmosphere for a century or more, the climatic effects
of actions taken today will primarily benefit future generations. But
delaying action to reduce greenhouse gas emissions until the
disruptive effects of climate change become widespread will
considerably reduce the options for remedial or preventive measures.

The Framework Convention on Climate Change

The threat of disruptive climate change has led to coordinated
international efforts to reduce the risks of global warming by
reducing emissions of greenhouse gases. The first international
agreement to address global warming was the Framework Convention on
Climate Change signed during the Earth Summit in Rio de Janeiro in
1992. This convention established a long-term objective of limiting
greenhouse gas concentrations and encouraged the established
industrial countries to return their emissions to 1990 levels by 2000.
Since then it has become clear that the United States and many other
participating countries will not meet this goal.

To address the lack of progress among many industrial countries toward
meeting this first target, the United States and approximately 159
other nations, in negotiations held in Kyoto, Japan, last December,
agreed to take substantial steps to stabilize atmospheric
concentrations of greenhouse gases. The Kyoto agreement, which
requires the advice and consent of the Senate, would place binding
limits on industrial countries' emissions of the six principal
categories of greenhouse gases: CO2, methane, N2O, sulfur
hexafluoride, perfluorocarbons, and hydrofluorocarbons. Each
industrial country's ``1990 baseline'' is actually based on its 1990
emissions of CO2, methane, and N2O and its choice of 1990 or 1995
levels of the other three categories of gases. The United States
agreed to a target of 7 percent below 1990 levels over 2008-2012. To
meet that target, net U.S. emissions of greenhouse gases--all emissions
minus removals of CO2 by certain forest activities such as planting
trees--must average no more than 1,484 million metric tons of carbon
equivalent per year during that period (Chart 5-4). The targets for
the European Union and Japan are 8 percent and 6 percent below 1990
levels, respectively. Australia, New Zealand, Norway, Russia, and
Ukraine all have less stringent limits. In sum, over the period from
2008 to 2012, the industrial countries are



expected to reduce their average emissions of greenhouse gases to about
5 percent below their 1990 levels.

The Kyoto agreement provides opportunities for the industrial
countries to trade rights to emit greenhouse gases with each other.
They may also invest in ``clean development'' projects in the developing
world and use these projects' certified emissions reductions toward
meeting their targets. Both of these mechanisms allow for emissions
reductions to occur where they are least expensive. Many of the
details of these provisions will be worked out in subsequent
negotiations.

Emissions Permit Trading for Greenhouse Gases

One component of the Administration's climate change proposal,
announced last October by the President, is a domestic emissions
permit trading program for greenhouse gases starting in 2008. As in
the similar program for SO2, permit trading would allow emissions
targets to be met at a lower cost than under a traditional regulatory
approach that sets fixed limits on individual firms' emissions.

As previously discussed, one consideration in designing an emissions
permit trading program for greenhouse gases is how initially to
distribute permits. The method of initial allocation would not
generally affect the efficiency with which emissions reductions are
achieved, but would have significant distributional implications.
Another issue is where, in the marketing chain of products responsible
for greenhouse gas emissions, permits would be required. One approach,
called the permit-to-market approach, would impose the emissions
limits at the point of first sale of the commodities responsible for
greenhouse gases. In the case of SO2 emissions, permits would be
required for the sale of fossil fuels and specified in terms of the
amount of SO2 released in their combustion. The requirement would be
imposed at the wellhead or the refinery (in the case of oil or natural
gas), at the mine (in the case of coal), or at the port of entry (in
the case of imported fossil fuels). Alternatively, a permit-to-emit
approach would issue permits to consume these fuels or to sell
products, such as automobiles, that do so. A hybrid of the two
approaches may also be possible.

The design of an effective greenhouse gas permit system needs to take
several other issues into account. First, a sufficient number of
participants must be included in the domestic permit market to ensure
that the market is competitive and efficient.

Second, the system should include a monitoring mechanism that assesses
compliance in the most cost-effective manner possible. In the case of
a permit-to-market system, since the amount of SO2 emitted per barrel
of oil or ton of coal consumed is relatively fixed, the task of
measuring SO2 emissions is straightforward. Moreover, for accounting
purposes firms already collect information and keep records about
their fuel transactions. Under the permit-to-emit approach, monitoring
would likely involve a more complex combination of emissions
calculation and measurement for all regulated greenhouse gas emitters.

Third, a permit system that would allow trades across all sectors of
the economy would minimize total cost. If, for example, the
incremental cost of reducing emissions is much lower in electric power
generation than in transportation, one could reduce the cost of
meeting the reduction target by allowing permit trading between the
two sectors. The permit-to-market approach would generally allow
trades across sectors. The permit-to-emit approach could also yield
the same result, depending on how it is implemented.

Timing Flexibility in Meeting Emissions Reductions

Flexibility about when emissions reductions take place can further
lower the cost of reducing greenhouse gas emissions. A system that
allows participants to borrow emissions permits from the future or to
save unused permits for future use would take advantage of differences
in cost abatement opportunities across time.

Three features of the Kyoto agreement contribute to timing
flexibility. First, the target for emissions reductions is based on a
5-year commitment period. For example, the target set for the United
States of a 7-percent reduction in emissions below 1990 levels is
specified as an annual average over 2008-2012. By averaging over 5
years instead of requiring the United States to meet the 7-percent
target each year, the agreement provides flexibility in the timing of
reductions that can lower costs, especially given an uncertain future.
Averaging can smooth out the effects of short-term events such as
fluctuations in the business cycle and energy demand.  It can also
lessen the impact of a year with a hard winter, when energy demand,
and thus emissions, would increase. Further, if firms anticipate that
a new technology will soon be available that lowers the cost of
reducing emissions, they could emit more greenhouse gases in the early
years of the period and less after the technology becomes available.
Another advantage of this approach is that it may avoid forcing a
costly rapid turnover of capital stock for electricity generation.

The Kyoto agreement allows countries to bank unused emissions rights
from one commitment period for use in the next. Should investments in
research and development yield some pleasant surprises in the form of
cleaner and more efficient technologies, banking will encourage the
early adoption of these technologies in order to save unused emissions
permits for future periods when the costs of emissions abatement may
be higher.

In addition to banking across commitment periods, countries may bank
certified emissions reductions obtained through the ``clean development
mechanism'' discussed below. Countries may use emissions reductions
achieved through this mechanism over the 2000-2007 period to assist in
complying with their targets in the first commitment period. This
provides an incentive for firms in industrial countries to begin
investing in energy-efficient technologies in developing countries
before 2008.

International Trading in Greenhouse Gas Emissions

Building on the benefits of the domestic trading program just
described, the Administration proposed in Kyoto an international
trading program for greenhouse gas emissions permits. The Kyoto
agreement established the right of countries assigned emissions
targets to meet their commitments by trading among themselves. This
establishment of the right to trade provides the foundation for a
trading regime among industrial countries, but leaves the details to
be agreed upon later. Since it is easier to reduce emissions in some
countries than others, and given that greenhouse gas emissions have
equivalent climate effects regardless of their location, allowing
global trading would achieve climate change objectives at lower cost.
Such a global approach would ideally allow trading among all sources
of greenhouse gases in participating countries and could incorporate
opportunities to remove greenhouse gases from the atmosphere, for
example by issuing emissions credits (which could then be sold to
other firms) for reforestation projects.

International trading could take place among firms that have been
allocated permits through domestic trading programs. For countries
that have no domestically tradable permits because they have opted for
a command-and-control or a tax approach to controlling emissions, it
may still be possible instead to arrange exchanges on a
government-to-firm or government-to-government basis.

The setting of binding targets among all countries, together with
international trade in permits, could in principle result in a global
market price for permits for greenhouse gas emissions. For example,
the permit price could be expressed in terms of dollars per ton of
carbon equivalent emitted. Firms in all countries would reduce their
emissions until the cost of further reductions exceeded this price, at
which point they would buy additional permits. Large differences in
both the patterns of energy use and the efficiency of energy
technologies among countries imply that the cost savings from
international permit trading would be large compared with a system
without international trading. Put differently, even in comparison
with a system with full domestic trading of emissions permits,
international trading could substantially lower costs. Some models
predict that the incremental cost of reducing CO2 emissions may be as
little as one-seventh of the cost of reductions from domestic trading
alone. The gains from international trade in permits would be
particularly large if developing countries were to participate.

The Importance of Developing-Country Participation

Negotiations leading up to the Kyoto agreement sought binding limits
on greenhouse gas emissions among industrial nations. Developing
countries have resisted committing themselves to binding limits on
their emissions because of concern that to do so would severely
constrain their economic growth, and because by far the greater part
of accumulated greenhouse gases in the atmosphere is the result of
past economic activity in the industrial countries (Chart 5-5).
However, current forecasts project that greenhouse gas emissions from
developing countries will surpass those from industrial countries
around 2030, and even sooner if industrial countries are successful in
limiting their emissions (Chart 5-6). Thus, eventual curbs on
emissions from developing countries are essential in order to





stabilize the amount of greenhouse gases in the atmosphere. Moreover,
some of the least cost opportunities for reducing greenhouse gas
emissions are in developing countries, because those countries now use
energy relatively inefficiently. Moreover, those that are
industrializing rapidly have greater scope to build their industry
around cleaner and more efficient energy technologies and fuels than
do mature economies whose capital stock is already in place.

Failure to involve developing countries in an international agreement
limiting greenhouse gas emissions could lead to a more rapid rate of
increase in emissions in those countries than would occur without any
agreement at all. This ``leakage'' effect of emissions reductions could
come about in any of several ways. As industrial countries reduce
their use of fossil fuels in response to emissions controls, future
world oil and coal prices are likely to be lower than they would be
otherwise. This is likely to increase energy consumption in countries
not bound to limit their emissions. U.S. industries are also concerned
about their international competitiveness if some countries remain
outside an international agreement, since factories in those countries
will face lower costs for producing goods that take relatively large
amounts of energy to manufacture. Some may be concerned that
energy-intensive industries might choose to relocate to countries not
subject to emissions constraints, although there is little evidence to
suggest that this would pose a significant problem in most industries.
For example, energy costs for manufacturing industries average just
2.2 percent of total costs.

Given the projected growth of developing countries' emissions, the
Administration's position is to seek meaningful participation by key
developing countries in the reduction of greenhouse gas emissions as a
condition for the United States taking on binding emissions
reductions. The President has indicated he will not submit the Kyoto
agreement for Senate ratification until there is meaningful
participation by key developing countries.

Joint Implementation and the Clean Development Mechanism

To encourage participation by developing countries in the climate
change initiative even before they formally sign on for binding
emissions limits, the President has proposed a program known as joint
implementation. This program would provide incentives to developing
countries to reduce their emissions of CO2 and other greenhouse gases.
The Kyoto agreement embraces the President's proposal in its
designation of a ``clean development mechanism'' (CDM): U.S. companies
that undertake projects that reduce greenhouse gas emissions in
developing countries could count those reductions to meet their
commitments. Institutionalizing key elements of joint implementation
through this mechanism would encourage firms in the United States to
transfer a larger volume of cleaner and more energy-efficient
technology to developing countries, especially in the electric power
generating industry, while providing substantial cost savings to U.S.
firms. It would also provide incentives to expand forests, which
absorb CO2. In addition to the CDM, the agreement allows industrial
countries to undertake joint implementation projects with each other.

A key issue is how to ensure that credits are awarded for actual,
additional emissions reductions, and not simply for projects that
would have been carried out anyway. The Kyoto agreement requires that
emissions reductions occurring through the CDM be certified to provide
real, measurable, and long-term benefits related to the mitigation of
climate change, and that the emissions reductions achieved are
additional to any that would occur in the absence of these projects.
Future negotiations will focus on developing the rules for certifying
and enforcing projects undertaken through the CDM.

Promoting Clean and Efficient Energy Technology

The President's plan to reduce greenhouse gases commits new resources
to energy research and programs to promote the wider use of cleaner
and more energy-efficient technologies in the U.S economy. The
emissions permit trading system for greenhouse gases is also likely to
encourage more private research and innovation, as companies seek to
lower the cost of meeting environmental targets.

Government support for science and technology in general addresses an
important market failure. Promising new technologies often fail to
attract sufficient private sector interest if their technical risk is
high and if they create economic and social benefits beyond what the
investing firms can capture for themselves. Economic studies have
shown that private firms, despite intellectual property protection,
are able to appropriate only about half of the total economic benefits
from their own research. This gap between social and private returns
may be particularly large for research on cleaner and more efficient
energy technology, when the environmental externalities associated
with energy use have not been fully addressed by environmental and
other regulatory policies.

The appropriability problem is not limited to basic research but
frequently extends to precommercial research as well. Precommercial
research is research that is close to yielding new products or
processes, but still far enough away from commercialization that
further development poses a substantial financial risk. New renewable
energy industries (wind power, solar energy, and biomass energy, for
example) may face particularly formidable constraints to
commercialization. First-of-a-kind products often have high unit
costs. High-volume production provides economies of scale, generates
experience in manufacturing and operation, and opens new opportunities
for incremental technological improvements--all of which may lead to
lower costs.

The President's commitment to increase Federal support for new energy
technology seeks to reverse a trend of declining national investment
in energy research (Chart 5-7). One reason investment in energy
research has declined since the late 1970s is falling or stagnant
energy prices, which reduced the economic incentive to develop new
sources of energy and improve efficiency. In the 1990s it is primarily
private sector energy research that has declined. Increasing
government investment in energy research is likely to be complemented
by more private research: public research on longer term, basic
scientific studies can open up new, profitable opportunities for
applied research and commercial development by the private sector. An
increase in support for research that raises the rate of progress in
developing cleaner and more efficient technologies would lower the
costs of reducing greenhouse gas emissions.



The President's proposal also includes programs and tax incentives to
encourage the wider adoption of existing technologies that can
decrease greenhouse gas emissions. Of particular importance are
technologies that reduce consumption of fossil fuels. In addition to
encouraging clean and renewable energy sources, these programs will
provide economic incentives and other forms of assistance (such as
better information) for improving energy efficiency in industry,
transportation, and homes. The President's plan to use Federal
procurement policy to reduce greenhouse gas emissions is another way
to increase market penetration of these technologies.

Until an emissions cap and trading system are in place, however, the
economic incentive to use these technologies may be low, because at
present the price of energy does not reflect the environmental cost of
CO2 emissions. This environmental externality results in a market
failure to make the most efficient use of new technologies that lower
emissions. Many of these technologies are expected to be more
profitable once a CO2 emissions cap is in place and the environmental
costs associated with energy use are more fully reflected in energy
prices.

There is also evidence that many households and businesses fail to
invest in some home and building improvements that appear profitable
even at today's energy prices. More efficient home refrigerators and
air conditioners, fluorescent lighting, and ``low-E'' glass for windows,
for example, are available on the market and, by some accounts, offer
potentially large energy and cost savings. By spending money now on
these more efficient technologies, proponents argue, many consumers
could quickly recoup their investments in the form of lower energy
bills. But if such investments are in consumers' own economic
interest, why don't they invest in them on their own? Insufficient
knowledge and information may be a key factor: consumers may not be
aware of new technologies that could reduce CO2 emissions and save
them money on energy bills, or may not be convinced of the economic
benefits that could be realized from adopting them. Lack of up-to-date
information on recent technological developments may also lead people
to overestimate technical risks--they may doubt whether a new
technology is as reliable as current methods, particularly if the new
technology is not yet widely used.

On the other hand, even if a new technology is beneficial for many
users, it may not be so for everyone. People differ in their
willingness and ability to make investments today in order to realize
savings in the future, especially if the initial expense is relatively
large. In addition, some consumers may value a product for attributes
other than its energy efficiency--for example, its convenience, size,
or design. And not all consumers may achieve all of the promised
energy savings, depending on the climate of the region where they
live. These considerations reflect the great diversity of needs and
preferences among businesses and households and help explain why new
technologies may diffuse slowly over time.

Better information about the potential cost savings from improving
energy efficiency may increase the use of technologies that already
meet the market test--that is, that meet consumer standards for quality
and dependability and offer real economic benefits. The Federal
Government is working with the private sector to promote wider use of
such technologies. For example, through the Green Lights program, the
EPA provides technical information to private companies on the
economic and environmental benefits of switching to new, fluorescent
lighting systems. Energy Star is another EPA program, in which
innovative products that use significantly less energy than older
generation products are allowed to bear a special, readily
identifiable label. More rapid diffusion of new emissions-saving
technologies would make an important contribution toward meeting the
goals of the Kyoto agreement.

NON-POINT SOURCE WATER POLLUTION

Protecting the quality of the Nation's water resources has been a
major component of U.S. environmental policy since passage of the
Clean Water Act in 1972. The act regulates water pollution from point
sources--discrete, concentrated sources such as the discharge from
factories and municipal sewage treatment plants--but not from non-point
sources. Non-point source water pollution is the entry of pollutants
into a body of water from a broad area, such as a cultivated field or
the streets and lawns of a city. In recent years attention has
increasingly turned to pollution from these non-point sources,
especially runoff from agricultural operations. Since environmental
regulation has already led to extensive control of point sources of
water pollution, further improvements in water quality are likely to
be less expensive if they address non-point sources. Recently, the
Administration has given renewed emphasis to non-point source water
pollution (Box 5-1).

Agriculture is one of the principal sources of non-point source
pollution. The environmental problems caused by agriculture stem

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Box 5-1.--The Clean Water Initiative

On the 25th anniversary of the passage of the Clean Water Act, in
October 1997, the Vice President called for a new set of initiatives
to further improve the quality of the Nation's water resources. These
initiatives will address the principal remaining challenges,
especially public health protection, polluted runoff, and
community-based watershed management. Agencies will emphasize
innovative approaches to control pollution, including the use of
incentives and market-based mechanisms. The EPA and NOAA are directed
to expedite the full implementation of the Coastal Zone
Reauthorization Act Amendments. The Administration also challenged the
Congress to help strengthen the Clean Water Act, especially for the
control of non-point sources of water pollution.
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mainly from the runoff of soil, agricultural chemicals, and livestock
waste into lakes, rivers, and estuaries. These pollutants may cause
undesirable algal blooms, impair recreation and fishing, and adversely
affect wildlife. Pesticides and nutrients can also leach into
groundwater, threatening drinking water supplies. Soil erosion from
U.S. farmland raises the cost of municipal and industrial water use,
shortens the life span of dams and hydroelectric projects, damages
aquatic habitat, and can contribute to flooding. These off-farm
damages from soil erosion have been estimated at $7 billion to $25
billion per year. In 1994 the EPA estimated that at least 6 percent of
all U.S. river miles and 21 percent of lake surface areas were
water-quality impaired (that is, unsuitable for their designated
uses). The same study identified agriculture as a major contributor to
impairment in about 60 percent of those river miles and 50 percent of
those lakes and reservoirs.

Since these environmental effects are largely imposed on other users
of the water resources, and not on the farms that caused them,
agricultural non-point source water pollution is another example of an
environmental externality that market forces alone are unlikely to
solve. In a world of perfect and costless information, the efficient
policy response would be to monitor the erosion and runoff from each
farm and reduce it to the point at which the incremental cost of
further reduction equals the incremental benefit to the environment.
This textbook approach, however, is often unworkable because the cost
of assessing the pollution caused by each farm can be prohibitive.
Instead, public policies to address non-point source pollution from
agriculture tend to focus on farmers' choice of farming practices,
which is much more easily observed.

Non-point source pollution from agriculture, like many other
environmental problems, raises the policy question of whether and how
to encourage the adoption of environmentally friendly technologies.
Examples of such practices include conservation tillage, integrated
pest and nutrient management, precision farming, and buffer zones
along waterways. These practices may actually be profitable for some
farmers to adopt. As discussed above in the context of energy
technology, direct subsidies for the adoption of existing technology
improve ecomonic efficiency when the benefits to society at least
equal the costs, including the social cost of subsidies. This section
examines three policy approaches that have been used to encourage the
adoption of farming practices that reduce non-point source pollution:
incentive programs, regulations, and emissions trading programs.

Incentive Programs

The U.S. Government has implemented several programs that provide
incentives to farmers and ranchers to limit their impacts on the
environment. These include support for State programs through Section
319 of the Clean Water Act and several important components of the
1996 Federal Agriculture Improvement and Reform (FAIR) Act. Three
programs account for the bulk of Federal spending on environmental
incentive programs for agriculture: the Conservation Reserve Program
(CRP), begun in 1985; the Wetland Reserve Program (WRP), initiated in
1990; and the Environmental Quality Incentives Program (EQIP),
established by the FAIR act. The CRP and the WRP (both of which were
reauthorized by the FAIR act) establish voluntary contracts with
producers in which they agree to adopt certain practices on their
land, including establishing long-term conservation easements and
taking it out of production for a period of years. In return, the
government provides incentive payments, subsidies for the cost of the
practices, and technical assistance as needed. EQIP provides
assistance for environmental and conservation improvements on the
farm. The FAIR act requires new acres enrolled in the CRP to meet
higher environmental and conservation criteria than land enrolled
under earlier versions of the program, and funds for EQIP are intended
to maximize the environmental benefits per dollar expended and help
farmers and ranchers meet national, State, and local environmental
standards. Other program provisions, such as Conservation Compliance,
require farmers who cultivate highly erodible land to adopt
conservation practices or else forgo benefits from other agricultural
programs. All these programs differ significantly from traditional
regulation in that they are voluntary: no requirements apply to
producers who do not wish to participate.

Efforts to remove environmentally sensitive land from agricultural
production and encourage the adoption of resource-conserving farming
practices have met with much success in reducing soil erosion from
cropland. Between 1982 and 1992, erosion from cropland is estimated to
have declined by about one-third.

Regulatory Control of Agricultural Pollution

The Coastal Zone Act Reauthorization Amendments (CZARA) authorized the
first federally mandated program requiring specific measures to
address agricultural runoff as well as four other major non-point
sources of water pollution. The EPA and the Department of Commerce's
National Oceanic and Atmospheric Administration (NOAA) issued Federal
guidelines for implementing CZARA in 1993. The guidelines set out
certain requirements that State coastal non-point source pollution
control programs must meet, but they allow States to tailor their
programs to their own environmental concerns, geographic conditions,
site characteristics, and farmer preferences. These programs,
currently in the approval process, identify the set of management
measures that may be required of individual farms in the State. This
process is designed to provide enough flexibility to allow farmers and
technical assistance providers to select the practices appropriate for
a given farming operation, and to help keep farm compliance costs low.
Existing sources of pollution, such as most agricultural sources, will
have 3 to 8 years to comply from the time their State program is
approved, adding further flexibility and cost-saving opportunities in
the timing of implementation.

Trading Water Pollution Credits

To achieve water quality standards cost-effectively, several State and
local governments have experimented with programs that are similar in
principle to the air pollution trading programs discussed earlier, but
do not involve marketed permits as such. Much like the joint
implementation projects discussed in the context of climate change
above, these programs allow point sources of pollution to meet
environmental standards by paying non-point sources (such as farms) to
adopt practices to reduce pollution. As already noted, it may be
considerably less expensive to attain the same environmental outcome
by reducing pollution from non-point sources than from point sources.
But because verifying pollution reduction from farms is prohibitively
expensive, the agencies administering these programs rely on verifying
that farmers have adopted land management practices that are linked
with pollution reduction, assessing credits based on the estimated
amount of pollution reduced, and certifying the ``trades.'' Most of
these programs focus on fertilizer and animal waste pollution,
including nitrogen and phosphorus compounds.

Cost savings from such exchanges, if fully implemented, could reach
several billion dollars annually. But few trades have occurred to
date. For example, the Dillon Reservoir program in Colorado provides
opportunities for trading between point and non-point sources. Early
estimates expected significant cost savings from trading for the four
municipal sewage treatment facilities, but few trades between a point
source and a non-point source have occurred since 1984.

The Tar-Pamlico Basin program, implemented in North Carolina in 1989,
is not strictly a trading program. Rather, it allows an association of
14 point sources to average all of the members' nutrient discharges
under one cap. Then, if total discharges exceed the cap, the
association must contribute to a State program that subsidizes
management practices on farmland to reduce non-point source pollution.
To date, the association has not exceeded its cap, so no contributions
to the non-point program have been required.

Trading has been limited both because the scope of trading
opportunities has been constrained and because transaction costs have
been high. To ensure that all sections of water bodies meet
environmental standards, trading is often restricted to a local
watershed or certain stretches of a river. Other policy constraints on
trades may further limit the potential gains from discharge credit
trading. For example, point sources are often required to adopt
specific pollution control technologies before they may consider
trading. This may limit the discharge reductions that they buy from
other sources and reduce the potential gains from trading. In the
Tar-Pamlico program, point sources receive only one unit of pollution
credit for every two units of pollution reduction they buy from
non-point sources. By explicitly requiring nonequivalent emissions to
be traded, the program increases the cost of participation. Moreover,
these point sources must pay a 10-percent administrative surcharge for
every pollution credit they purchase. Finally, programs have often
failed to provide assurances that the credits will continue to be
honored in the future. This reduces the economic value of the credits
and is another impediment to trading.

Although economic theory indicates that the costs of complying with
environmental regulation can be significantly reduced through a
trading system, the limited experience with water pollution credit
trading has not yet provided substantial cost savings. So far the
small size of the markets for trades, both geographically and in the
number of potential traders, and the regulatory constraints on trades
have generated extra costs that make trading less attractive.

IMPROVING HEALTH CARE AND HEALTH INSURANCE MARKETS

Without regulation, health insurance markets do not function well. A
variety of policies have been implemented or proposed to address these
shortcomings. This section discusses policy initiatives that this
Administration has promoted to help improve the functioning of these
markets. The Health Insurance Portability and Accountability Act
(HIPAA) of 1996 helps workers maintain continuous insurance coverage
by limiting exclusions of preexisting conditions, whereby insurers do
not cover previously diagnosed conditions for some period, and by
expanding guaranteed issue and renewability requirements, which
prohibit insurers from denying coverage or renewal on the basis of
health status or claims experience. The President's 1999 budget
includes policies that improve access to affordable health insurance
for people aged 55-65 and for small businesses. In addition, the
Administration and the Congress are considering legislation to help
ensure that consumers have enough information about health insurance
plans and prescription drugs to make informed decisions. Finally, new
initiatives to discourage teenage use of tobacco products are aimed at
protecting those who may lack the maturity to make decisions about
risky behaviors like smoking.

IMPROVING ACCESS AND PORTABILITY

Adverse Selection in Health Insurance Markets

A variety of concerns about health insurance markets relate to the
problem of adverse selection, the danger that only those persons most
likely to need insurance will purchase it. Adverse selection in
insurance markets can arise because of asymmetric information:
would-be customers typically know more about their likelihood of
incurring high medical costs than do insurers. If insurance is priced
to reflect the average risk of a particular population (a practice
called community rating), some healthier people may choose to go
without. The average risk (or expected medical costs) of the insured
pool will then be higher than that for the whole population, and the
insurer will lose money. Insurers will, therefore, seek ways to ensure
that they do not attract a group that is particularly unhealthy. For
example, they may avoid offering comprehensive coverage (by limiting
access to specialists or not covering chronic conditions, for
example). They may also engage in targeted marketing or change their
health plans to appeal to healthier persons and discourage sicker ones
from enrolling, by adding benefits, such as health club discounts or
coverage for well-baby care, that are more attractive to persons in
good health. In addition, in an unregulated market insurers may
explicitly exclude higher risk individuals through exclusions of
preexisting conditions or by simply denying coverage. Thus, adverse
selection in health insurance markets can result in underinsurance
among both younger, healthier individuals and the very sick.

Adverse selection is reduced when insurers can insure large groups of
people whose purpose in associating is unrelated to their preferences
for health insurance. Insurers can be reasonably sure that the members
of such groups are not exceptionally unhealthy on average, and healthy
people are not likely to leave the insured pool. Employee groups,
particularly those of larger organizations, are a natural pool for
spreading risk, and this, in part, explains why employer-based
insurance is widespread. The lower premiums offered to such groups,
the tax-preferred treatment of employer-provided insurance, employer
subsidies, and the difficulty of obtaining coverage on the individual
market all encourage healthy workers to purchase insurance through
their employers, making adverse selection a much less serious problem.

Small firms might like to pool together to offer insurers larger risk
pools and reduce administrative costs, but these pools may fall apart,
as firms with healthier employees are likely to want to leave the pool
to seek lower premiums on their own. The prevalence of employer-based
insurance may also discourage self-employment or employment in smaller
firms, where obtaining affordable insurance is more difficult.

Even if one could correct the problem of asymmetric information
directly, by giving insurers the same information that their customers
have, this may not lead to a better outcome, for two reasons. First,
there may be a ``missing market'' for longer term contracts for health
insurance. Most health insurance contracts are for 1 year, but
purchasers might prefer to buy long-term insurance to avoid the
possibility of high premiums or cancellation should they become sick.
In addition, the government cares not only about efficiency and market
failures in health insurance markets, but also about improving access
to care. If insurers had more information, they could choose not to
cover some individuals or could charge higher premiums, which is
likely to reduce insurance coverage and access to care.

Employer-Based Insurance and ``Job Lock''

Health insurance coverage in the United States is closely tied to
employment: about 90 percent of the privately insured have
employment-related coverage. Thus, changing jobs often means changing
health plans. Before HIPAA, workers starting a new job often had to
wait to qualify for coverage of preexisting conditions. In some cases,
new hires faced waiting periods for any health insurance. However, one
important drawback of employer-based insurance is reduced mobility
between jobs, or ``job lock.'' Waiting periods or preexisting condition
exclusions make it difficult to ensure continuity of insurance
coverage when changing jobs. This can be a barrier to job mobility,
particularly for those with chronic conditions. Evidence on the extent
of job lock is mixed: some studies find little or no effect, but one
study estimates that employer-based health insurance can decrease job
turnover rates by up to 25 percent. When a person obtains coverage
through a new employer, he or she may be subject to preexisting
conditions exclusions or waiting periods under the new plan. In
addition to creating costs for individuals, who may stay with a
particular employer in order to keep health insurance, job lock may
also impose costs on the economy by preventing workers from moving to
those jobs where they are most productive. Policies like HIPAA and the
proposed Medicare buy-in may help improve mobility between jobs.

The Health Insurance Portability and Accountability Act

HIPAA contains a number of reforms designed to improve the operation
of individual and group health insurance markets. It helps ease the
transition between jobs and into self-employment and improves access
to insurance for those who lack access to employment-based insurance
and for small firms.

Guaranteed issue and renewability. HIPAA prohibits insurers from
declining to cover individuals who were previously covered by a group
plan and who have elected and exhausted their eligibility for extended
coverage under COBRA (the Consolidated Omnibus Budget Reconciliation
Act of 1985), which allows workers to buy into their former employer's
plan for up to 18 months. HIPAA also prohibits insurers from refusing
to renew coverage on the basis of health status, claims experience,
genetic information, or other related factors. These provisions can
help improve access to health insurance for small firms and
individuals. However, HIPAA imposes no restrictions on the premiums
that insurers may charge, so some individuals or firms may still be
effectively excluded by prohibitively high premiums. In addition,
insurers may try to find other ways to avoid selling insurance
policies to high-cost individuals, through more targeted marketing or
plan design as described above, for example. Newspaper accounts report
that some insurers may even be instructing their agents in how to
avoid enrolling higher risk applicants.

Limiting preexisting condition exclusions. HIPAA generally limits
exclusion periods for preexisting conditions to 12 months. Some
exclusions for preexisting conditions are appropriate, because
otherwise people would have little incentive to purchase insurance
when they are healthy, knowing that they could simply sign up after
they get sick. Thus, it is important to design policies that increase
accessibility without exacerbating this free-rider problem. HIPAA
addresses this problem by requiring that individuals have continuous
coverage in order to take full advantage of the limits on preexisting
conditions exclusions. If a person was covered for a particular
condition at one job and then changes jobs or elects to purchase
individual insurance, he or she can ``credit'' the time covered under
the previous plan against the preexisting condition period in the new
plan. For example, someone who had 8 months of coverage could be
required to wait no more than 4 months for coverage at a new job
(assuming the employer offers insurance). In addition, those seeking
insurance on the individual market must have 18 months of creditable
coverage and must have exhausted coverage under COBRA (if eligible).
Insurers offering coverage to these persons may not impose preexisting
condition exclusions.

Proposals to Improve Access to Health Insurance for 55- to
64-Year-Olds

Americans aged 55-64 are one of the more difficult-to-insure
populations: they have less access to and great risk of losing
employer-based health insurance, and they are twice as likely as
younger people to have health problems. Many lose their coverage when
they lose their jobs as a result of company downsizing or plant
closings. Still others lose insurance when their retiree health
coverage is dropped unexpectedly.

To address these problems, the Administration has proposed three
policies as part of its proposed 1999 budget. First, persons aged
62-64 who lack access to employer-provided insurance would be allowed
to buy into Medicare. The premiums, which would be paid in two
parts--one contemporaneously, the second after turning 65--would cover
the full cost of participation, making the policy self-financing in
the long run. Second, displaced workers aged 55 and older who have
lost their employer-based insurance as a result of job loss could also
buy into Medicare. Third, retirees aged 55 and older whose employer
drops their retiree health coverage would be eligible to buy into
their former employer's health insurance through COBRA. Retirees would
pay a higher premium than do other COBRA participants, to reflect
their higher costs. Each of these options provides a competitive
alternative to individual insurance for people in this age group.

Voluntary Purchasing Cooperatives for Small Businesses

As described earlier, small businesses are at a disadvantage in
purchasing health insurance. To address this problem the
Administration has proposed giving States grants to establish
voluntary purchasing cooperatives for small businesses. Small firms
could then pool together to negotiate insurance rates that are more
affordable than those offered to them individually. This policy could
help the large numbers of individuals working for small firms who are
presently uninsured.

CONSUMER PROTECTION AND QUALITY IN THE HEALTH CARE INDUSTRY

Health insurance plans are of two general types: fee-for-service plans
pay providers for each service they perform, whereas managed care
plans (such as health maintenance organizations) usually shift some
financial risk to providers. Between 1980 and 1996, the share of
workers enrolled in fee-for-service plans fell from 92 percent to 25
percent, primarily in response to rising health insurance costs. The
expansion of managed care has helped slow the rate of growth in health
insurance premiums by giving providers a greater incentive to control
costs. But perceptions that the quality of care has suffered in
managed care plans have made managed care the subject of criticism
from consumer groups, the press, and the public. The last few years
have seen a flurry of activity by the Congress and State legislatures,
regulatory agencies, health plans, consumer advocates, and others to
define a new set of consumer rights, protections, and responsibilities
in response to consumers' concerns about the changing health care
system. Although managed care has focused new attention on these
issues, many of the concerns raised by these groups--and the actions
they propose to address them--are equally important for traditional
insurance plans.

The President's Commission on Consumer Protection and Quality in the
Health Care Industry was established to advise the President on
changes occurring in the health care system and, where appropriate, to
make recommendations on how best to promote and ensure consumer
protection and the quality of health care. The commission submitted a
report, including a Consumer Bill of Rights and Responsibilities, to
the President in November 1997. In addition, the Health Care Financing
Administration (HCFA) has promulgated rules designed to protect
Medicare and Medicaid managed care participants.

How Managed Care Works

Managed care organizations typically contract with a group of
hospitals and doctors to care for their enrollees. Enrollees generally
must seek care from providers in the plan's network, although
point-of-service plans, which allow enrollees to see providers outside
the network, with higher cost sharing, are growing in popularity.
(``Cost sharing'' refers to out-of-pocket payments, such as deductibles
and copayments, required of insured individuals who receive care.)
Whereas traditional fee-for-service plans control utilization mainly
through cost sharing, managed care organizations rely on a number of
``supply-side'' utilization controls. For example, they may require
enrollees to see a primary care physician, or ``gatekeeper,'' before
they can go to a specialist, or may limit the types of treatments that
providers can offer. Another important feature of managed care plans
is that providers often bear some of the financial risk. For example,
managed care plans may pay providers a fixed (``capitated'') payment for
each member or use other mechanisms that give providers financial
incentives to limit care.

Promises and Pitfalls in Consumer Protection Legislation

Managed care highlights a new challenge to policymakers, namely, how
to protect consumers and promote their informed choice among health
plans without undermining managed care's ability to control costs.
More employers now offer their employees a choice of health
plans--including managed care plans--and many of these ask employees to
pay more for more expensive coverage. This can encourage plans to
operate more efficiently, control costs, and provide higher quality
care, but consumers need sufficient information to make good decisions
about what features they want in a health plan--and how much they are
willing to pay for them. Many of the activities of the President's
commission have focused on addressing the need for more user-friendly
information about health plan features and quality, and for
strengthening consumer confidence in the health care system. In
addition, government attempts to micromanage the practice of
medicine--whether in the name of cost containment or in the name of
consumer protection--are an unwise use of regulatory authority and
would either waste valuable resources or run counter to the goal of a
quality-focused system.

The commission includes consumers, health care providers, health
insurers, health care purchasers, representatives of State and local
governments, and experts in health care quality, financing, and
administration. In drafting its Consumer Bill of Rights and
Responsibilities, the commission was guided by four principles:

 All consumers are created equal. The rights and responsibilities
outlined by the commission should apply to all participants in the
health care system, including beneficiaries of public programs,
government employees, persons with individual policies, and those with
employer-based coverage, including self-funded coverage. In addition,
to the extent possible, these rights should be accorded to those who
have no health insurance but make use of the health care system.

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Box 5-2.--Quality Data Collection for Medicare Managed Care

The Health Care Financing Administration has promulgated rules
that will enable the agency to collect data on quality of care in and
beneficiary satisfaction with Medicare managed care plans. The
National Committee for Quality Assurance, in conjunction with HCFA,
industry representatives, other purchasers, and beneficiary advocates,
has developed 40 quality measures related to the Medicare population.
These measures build on the Health Plan Employer Data and Information
Set (HEDIS) developed by the National Committee for Quality Assurance
for the under-65 population. HCFA will publish summary data to help
beneficiaries choose among plans. Quality indicators will also allow
HCFA to ensure that Medicare beneficiaries receive appropriate care
from managed care providers, and will help identify areas for quality
improvement.
Currently, managed care plans contracting with Medicare may have
no more than 50 percent of their enrollment from Medicare.  This
provision was designed to help ensure that plans contracting with
Medicare offer service of similar quality to that provided in the
private sector. The Balanced Budget Act of 1997 eliminated this
requirement, and new rules will allow HCFA to use actual quality data,
rather than the 50-percent rule, in deciding which managed care
organizations are eligible to contract with Medicare. This effort will
improve HCFA's ability to ensure high-quality care and help
beneficiaries make informed health plan decisions. In addition, more
information about these plans could improve confidence in Medicare
managed care, encouraging more beneficiaries to enroll in these plans.
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 Quality first. In considering each proposal, the commission asked
whether it would improve the quality of care and of the system that
delivers that care.

 Preserve what works. Some elements of managed care and of
fee-for-service plans must be changed to protect the rights of
consumers. But each delivery system can also point to elements that
have improved quality and expanded access.

 Costs matter. The need for stronger consumer rights must be
balanced against the need to keep coverage affordable. Ultimately
costs are borne by consumers and their families through higher health
insurance premiums, higher prices, lower wages, fewer benefits, or
less coverage.

Some reforms proposed by States and consumer groups would make managed
care plans look more like traditional plans--for example, by requiring
health maintenance organizations to accept all providers or limiting
the use of financial incentives that may encourage physicians to limit
treatment. To the extent that these regulations would prohibit
practices that have helped managed care plans control utilization and
spending, they could undermine the ability of health plans to control
costs, and could ultimately reduce accessibility and affordability.
However, to the extent that such policies improve the delivery of
high-quality, efficacious care, they could improve health outcomes and
may help offset cost increases.

Among the rights laid out by the commission is the right of consumers
to ``fully participate in decisions related to their medical care.'' In
order for consumers to participate in decisions affecting their health
care, both when choosing a health plan and when considering treatment,
they need information. The commission recommended that plans should
disclose all factors--for example, the method of provider compensation
and the plan's ownership of or financial interest in health care
facilities--that could influence providers' advice or treatment
decisions. In addition, ``gag clauses'' and penalties on health care
professionals who advocate on behalf of their patients should be
eliminated, so that providers can freely discuss all treatment options
with their patients, and so that patients can make decisions based on
informed consent.

New Rules for Plans Serving Medicare and Medicaid

In 1996, HCFA adopted regulations limiting the use of some financial
arrangements for health plans serving the Medicare and Medicaid
populations. These rules prohibited plans from making payments to
providers to limit necessary care, required plans to institute
``stop-loss'' provisions--which protect providers from very large
financial losses--if the compensation method used places physicians or
groups of physicians at substantial financial risk, and required
disclosure of information about arrangements that transfer substantial
financial risk to the health care provider. HCFA also banned the use
of ``gag clauses'' for Medicare plans beginning in 1996 and Medicaid
plans beginning in 1997. In addition, HCFA has sought new ways to
ensure that Medicare managed care plans provide high-quality care by
collecting data on quality and satisfaction in those plans (Box 5-2).

FOOD AND DRUG ADMINISTRATION REFORM

The Food and Drug Administration Modernization Act of 1997 is designed
to ensure the timely availability of safe and effective new products
that will benefit the public health. The act, which codifies a number
of initiatives taken by the Administration as part of its reinventing
government effort, includes important provisions that will establish a
clearly defined, balanced mission statement for the Food and Drug
Administration (FDA), improve access to certain experimental drugs
prior to their final approval, establish a fast-track approval process
for drugs to treat life-threatening or serious diseases, and
reauthorize the Prescription Drug Users Fee Act (PDUFA) of 1992,
increasing the resources available for the drug approval process.

Why Drug Regulation Is Needed

Even without regulation, drug manufacturers would have some incentive
to distribute honest and accurate information about their products. If
a manufacturer repeatedly releases drugs that turn out to be
ineffective or unsafe, its reputation will suffer, and it may have
more difficulty selling new products in the future. The threat of
litigation or a public relations crisis can further discourage drug
companies from marketing unsafe products. However, drug companies are
not likely to produce enough information about their products' safety
and efficacy without regulation. The legal system may not provide
adequate consumer protection, and regulation through litigation may
come with high transaction costs. For example, companies could set up
corporate subsidiaries to issue new drugs and shield the parent
company from loss of reputation. Government regulation is then needed
to remedy this underprovision of information by evaluating and
approving drugs before they may be marketed.

Setting the Standard of Proof

Setting the standard of proof for new drug approvals entails balancing
two risks. On the one hand, approval of unsafe drugs may cause injury
or death, and approval of ineffective drugs may crowd out alternative
treatments or increase wasteful medical spending. On the other hand,
denials or delays in approval may prevent sick people from getting
more effective treatment.

The FDA has historically focused primarily on minimizing the first
type of risk (Box 5-3). In the late 1980s, however, the focus began to
shift with respect to drugs for life-threatening illnesses,
particularly AIDS. The FDA instituted a fast-track approval process
for these drugs, and more patients were offered early access to these
drugs before final approval. These policies recognize that the risk
that a drug will prove unsafe or ineffective must be weighed against
the risks of the disease itself. The FDA Modernization Act codifies
and expands upon these reforms and establishes a mission for the FDA
that explicitly emphasizes not only protecting the public health, by
ensuring that products approved by the FDA meet high standards for
safety and efficacy, but also designing a review process that does not
unduly limit innovation or product availability.

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Box 5-3.--History of Food and Drug Administration Regulation of Drugs

In 1937 an elixir of sulfanilamide, an antibiotic, killed 107 people,
most of them children. This tragedy hastened the enactment, the
following year, of food and drug legislation already pending: the
Federal Food, Drug, and Cosmetic Act gave the FDA authority to
regulate cosmetics, prescription drugs, and therapeutic devices. The
act required that products be shown to be safe before they are
marketed. During the 1940s and 1950s the Congress subjected a number
of other products, including food additives and pesticides, to FDA
approval and enacted other requirements.
In 1962 the sleeping pill thalidomide was linked to serious birth
defects in Europe. Although concerns with thalidomide related to
safety, not efficacy, and the drug had not been approved in the United
States, the scare generated support for extending the FDA's mandate to
determining the efficacy of new drugs. These events culminated in the
passage of the 1962 Drug Amendments, which required drug manufacturers
to show that drugs were not only safe but also effective. The
effectiveness requirement was associated with a rapid increase in
total drug development time (Chart 5-8).
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Box 5-4.--The Prescription Drug Users Fee Act of 1992

Between 1980 and 1991 the Congress enacted 34 laws that placed
additional demands on the FDA. Yet the agency's budget resources have
not always kept pace with growth in the number of products it reviews.
The Prescription Drug Users Fee Act (PDUFA) of 1992 helped address
this problem by allowing the FDA to assess fees on manufacturers
seeking approval for drugs. PDUFA also set ambitious performance goals
for reducing approval time for new drug applications and required that
the fees not offset current funding.
Although faster NDA approval is important, it represents only a
fraction of the total time necessary to develop and approve new drugs.
Nor do shorter NDA approval times necessarily translate month for
month into shorter total drug development times. The standard of proof
for approval determines how many trials and how much analysis must be
completed and is an important determinant of the time it takes a drug
to travel from the laboratory to the medicine cabinet. In addition,
total drug development time may rise or fall in response to a variety
of other factors, from the efficiency of laboratory analysis to the
chemical complexity of the drug.
Growth in total development time appears to have slowed nevertheless,
and PDUFA is widely viewed as a success. The FDA has hired more than
600 new reviewers, and NDA approval times have fallen to record lows.
As a result, PDUFA and its recent reauthorization have garnered broad
industry support. In fiscal 1995 the FDA reported that 100 percent of
the application backlog had been eliminated. In addition, the agency
has met and exceeded PDUFA's performance goals for action on NDAs.
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Improving Efficiency in the Drug Approval Process

Whatever the standard of proof for approval, rapid processing of new
drug applications (NDAs) reduces the health costs associated with
delay. Over the last several years the FDA has endeavored to
streamline the NDA approval process and reduce unnecessary delays, and
NDA approval times have declined significantly, especially for
``priority'' medications expected to have important therapeutic value.
For example, seven drugs for AIDS and other life-threatening illnesses
were approved in under 6 months in 1995. After rising since the early
1960s, the growth in total drug development time seems to have
stabilized in the 1990s (Chart 5-8).

The FDA Modernization Act builds on the success of these initiatives
to further streamline the approval process and reduce costly delays in
drug application reviews. The act reauthorizes the Prescription Drug
Users Fee Act of 1992, ensuring that the FDA has the resources to
review drug applications quickly and efficiently (Box 5-4).

REDUCING TEENAGE SMOKING

The mere fact that people engage in hazardous behavior is not by
itself evidence of market failure. But an externality exists if their
behavior imposes costs on others, and an information market failure
exists if they are not aware of the full costs to themselves of the
activity. Smoking, especially by teenagers, arguably illustrates both
types of market failure. In addition, because the cigarette
manufacturing industry is highly concentrated, with just four firms
accounting for the bulk of sales, market power is also a
concern--although the higher prices that might result discourage
smoking and ameliorate the other possible market failures. This
section reviews important tobacco policy developments in 1997 and
assesses them with respect to the rationale for government action
based on market failure.

Last year marked a historic turning point in the long-running battle
between tobacco companies and public health advocates over the harmful
effects of cigarettes. First, a landmark rule by the FDA to protect
children from the damage of tobacco products was upheld by a Federal
judge in North Carolina. Next, the 1997 Balanced Budget Act took a
first step toward reducing teen smoking by increasing the Federal
excise tax on cigarettes. Revenue from this tax increase will help
fund the State Children's Health Insurance Program. In addition, a
proposed national tobacco settlement was reached last June between the
major tobacco companies and a group of state attorneys general.
Following an Administration review of the proposed settlement, the
President challenged the Congress to pass sweeping tobacco legislation
to reduce teen smoking. Full congressional consideration of such
legislation was postponed until this year.

A major objective of both the FDA rule and the proposed settlement is
to reduce access to and use of tobacco products by minors. The FDA
rule prohibits the sale of nicotine-containing cigarettes and
smokeless tobacco to persons under age 18 and imposes a number of
restrictions on manufacturers, distributors, and retailers to limit
easy access to cigarettes and other tobacco products and to decrease
the amount of positive advertising imagery that makes these products
appealing to children and teenagers. The proposed settlement goes
beyond these prohibitions: it would increase the price of cigarettes
and impose penalties on the industry if specific targets for reducing
youth smoking are not met. Teens are more sensitive to the price of
cigarettes than adult smokers. Estimates suggest that for every
10-percent increase in the price of cigarettes, the number of teenage
smokers falls by 7 percent, versus about 4 percent for adults. The
President's call for legislative action sought a comprehensive plan to
reduce teen smoking, including even tougher penalties than under the
proposed settlement if targets are not met.

The Rationale for Regulating Smoking

Tobacco use is one of the most important preventable causes of illness
and premature death in the United States. Tobacco use is responsible
for over 400,000 deaths each year--about 20 percent of all deaths. The
average smoking-related death costs its victim up to 15 years of life.
These facts alone might justify an active antismoking effort on public
health grounds. But to make an economic case for discouraging smoking
based on market failure requires evidence that people are unaware of
the risks of smoking or that their smoking imposes costs on others.
This case is less obvious than the public health case. It is hard to
argue, for example, that people do not know that smoking is hazardous
to their health. Indeed, at least one study suggests that people
generally perceive the risks from smoking to be even greater than is
consistent with scientific evidence. Another study finds that light
and moderate smokers' assessments of the impact of their smoking on
life expectancy are realistic, whereas heavy smokers significantly
underestimate the risks. Similarly, it is widely recognized that
smoking is habit-forming and most likely addictive. Yet mature adults
are generally given the freedom to make choices that involve trading
off the best possible health for other pleasures (like playing
dangerous sports, overeating, overdrinking, or sitting on a couch
watching too much TV).

The economic case for discouraging smoking based on incomplete
information focuses therefore on the decision by teenagers to start
smoking. To the extent that young people have short time horizons and
are influenced by industry advertising, they may discount too heavily
the risks of smoking and the difficulty of quitting. The studies cited
above of people's perceptions of the risks associated with smoking did
not include teenagers. The finding that heavy smokers underestimate
the risks included only 50- to 62-year-olds; it is likely that
teenagers' assessments are even more unrealistic. Society may
legitimately wish to limit to adults the right to make such a risky
decision as whether or not to smoke.

Tobacco use also imposes externalities. To the extent that the costs
of treating smoking-related illnesses are not reflected in the
insurance premiums paid by smokers, or in their tax and premium
contributions to programs such as Medicare and Medicaid, smokers
impose uncompensated costs on the rest of society. One influential
study suggests that these costs are offset to some extent by the
social savings in reduced pension and Social Security payments due to
the premature death of smokers; it also suggests that existing excise
taxes cover the net external costs of smoking. However, this study
does not include the costs of all diseases in which smoking has been
implicated, nor does it consider such additional, potentially large
external effects as illness and death from second-hand smoke.

Thus, reasonable economic grounds exist for policies aimed at
regulating and discouraging smoking. Until last year, the tobacco
industry was able to mount a largely successful effort to limit such
efforts. It did, however, face the prospect of numerous lawsuits,
including several State-initiated class action suits, aimed at
recovering damages for smoking-related State Medicaid expenditures.
Although the industry had a good record of winning such lawsuits, the
ongoing litigation costs and the huge potential costs of an adverse
verdict apparently made it worthwhile to the tobacco companies to seek
a settlement.

Economics of the Proposed Settlement

The proposed tobacco settlement reached last June illustrates some of
the issues that will have to be addressed in any tobacco legislation.
The settlement would impose a one-time $10 billion charge on tobacco
firms plus an annual payment, which would be adjusted for inflation
and for the quantity of tobacco sold in the United States. In effect,
the annual payment would function like an excise tax. Although the
figure of $368.5 billion is often cited as the industry's total
payment, this number is misleading in several respects. First, $368.5
billion is the simple sum of the $10 billion initial payment and the
base value of the first 25 years of annual payments (in constant 1997
dollars). A more economically meaningful approach would calculate the
discounted present value of the stream of payments expected from the
settlement, recognizing that a dollar paid 25 years from now is worth
far less than a dollar paid today. For example, using a conservative
discount rate of 3 percent, the present value of the first 25 years of
payments described in the proposed settlement would be about $260
billion at current sales volumes. Second, the base payment does not
represent the amount that would actually be paid. Because the annual
payment functions like an excise tax, the quantity of cigarettes sold
will decline to the extent that the payment is passed on to consumers
through higher cigarette prices. The payment collected will fall
accordingly. (On the other hand, other features of the proposed
settlement, such as the surcharge for not meeting youth smoking
targets and an ``excess profits'' provision, could increase the
payment.) Third, because it is anticipated that the settlement payment
will be fully reflected in the price of cigarettes, the incidence of
the annual payment will fall primarily on continuing smokers, not on
the tobacco companies.

A Federal Trade Commission analysis of the proposed settlement raises
additional concerns about its antitrust implications. The tobacco
industry is highly concentrated, as noted above. Gross profit margins
are also high. But even in highly concentrated industries, where
prices may be higher than would prevail under perfect competition,
rivalry among firms and the illegality of explicit collusion tend to
keep prices below the level that would maximize industry profits.
Numerous economic studies have found an elasticity of demand for
cigarettes in the range of about 0.4 to 0.5 in the short run--meaning
that each 10-percent increase in the price of cigarettes leads to a 4-
to 5-percent decline in the number of packs sold. This implies that a
price increase would raise industry profits: not only would the
increase in price be more than enough to offset the decline in the
quantity sold, but total costs would also fall with the reduction in
quantity. Since demand is inelastic, if firms were free to collude
they would have an incentive to raise prices substantially. The
Federal Trade Commission's analysis points to certain aspects of the
settlement, most notably its broad antitrust exemption, that could
reduce rivalry and increase collusion. In general, the antitrust laws
forbid collusion to fix prices because higher prices increase industry
profits at the expense of consumer welfare and economic efficiency. In
the case of cigarettes, however, higher prices could further the
social policy goal of reducing smoking. Nevertheless, granting a broad
antitrust exemption is neither the most direct nor the most socially
desirable way of achieving higher cigarette prices.

This Administration believes that tobacco legislation must include
stiff penalties that give the tobacco industry the strongest possible
incentive to stop targeting young smokers. The proposed settlement
includes targets to cut teen smoking by 30 percent in 5 years, 50
percent in 7 years, and 60 percent in 10 years. Legislation should
further impose financial penalties that hold tobacco companies
accountable to meet those targets. The Administration supports
penalties that are non-tax-deductible, uncapped, and escalating--so
that the penalties get stiffer and the price increases greater the
more the companies miss their targets. Recognizing that one of the
surest ways to reduce youth smoking is to increase the price of
cigarettes, the President has called for a combination of industry
payments and penalties that could add up to $1.50 per pack to the
price of cigarettes over the next decade. The Administration also
supports a number of nonprice strategies for reducing youth smoking
through tobacco settlement legislation, including public education,
counteradvertising, stronger and more visible warning labels, and
expanded efforts to prevent youth access to tobacco products.