[Economic Report of the President (2009)]
[Administration of Barack H. Obama]
[Online through the Government Printing Office, www.gpo.gov]

 
CHAPTER 9

Economic Regulation

The United States relies on the private sector to organize most
economic activity. Through price signals and competition, markets
allocate scarce resources to their highest-value uses, encourage
businesses to avoid waste, and create incentives to invest in new
technologies. Government plays a vital role in a market system by
guaranteeing property rights and enforcing contracts, meaning that
businesses and individuals can invest and trade with confidence that
their agreements will be honored and free from fraud. A private
enterprise system supported by consistent enforcement of laws
protecting property and contracts has been at the heart of the
American economy's tremendous prosperity and growth.
Although free markets produce the most efficient outcome in most
cases, there are markets in which government intervention can increase
economic efficiency. A market failure is an instance in which
unregulated markets yield an outcome that is inefficient from
society's point of view. As discussed in Chapter 2, regulation
is important in financial markets because of imperfect information;
for example, investors often have far less information about the firms
they invest in than the managers who control those firms. Chapter 3
discusses the role of regulation when production of a good creates a
negative externality, such as environmental harm, that does not
represent a cost from the producer's perspective but imposes a
cost on society. Regulation can mitigate the costs of negative
externalities by ensuring that consumers and producers bear the full
cost of their activities. Regulation can also reduce harm from natural
monopoly, which occurs when a single seller can produce a good or
service more cheaply than a competitive industry. In the presence of
natural monopoly, an unregulated market will yield output levels that
are too low and prices that are too high from society's
perspective. In cases like these, where there is a specific market
failure that can be effectively addressed by the government,
regulation may be able to improve economic outcomes.
When unregulated markets produce inefficiencies, however, government
is not always effective in eliminating or reducing the inefficiencies.
There are several reasons that government is often inefficient in
carrying out regulation. First, competitive market prices, which
efficiently coordinate decisions in competitive markets, are
unavailable where market failures have caused inefficiencies. The lack
of reliable price information makes it difficult for government to
design effective regulation. Second, government does not face market
incentives to keep costs low and to use resources in the most
efficient way possible. Third, government decision making reflects the
results of a political process in which decision makers may be
motivated by narrow interests rather than the broader goals of
society. Market participants may spend resources on attempts to
influence the political process, when other uses of resources would
produce greater public benefit. These factors mean that government
intervention can have significant costs, which must be weighed against
the potential benefits of addressing market failures.
One way government can mitigate these problems is by designing
regulations that take advantage of markets or market mechanisms
whenever possible. ``Command and control'' regulation, which
replaces decentralized market choices with centralized decision making
by government officials, exacerbates the three problems identified
above. Regulation that relies on market mechanisms, however, can take
advantage of individuals' information about costs and benefits,
give individuals the incentive to make socially efficient decisions,
and reduce the ways that narrow interests can influence policy
choices.
This chapter reviews several areas in which markets have been affected
by government policy in the past 8 years. The Administration has
pursued market-oriented policies that favor individual choice over
government decision making and has supported new rules when needed to
address identified market failures. The Administration has also
considered the effectiveness of the overall regulatory structure for
financial markets in particular, a summary of which is provided in
Chapter 2. The key points of this chapter are:
 Regulation is appropriate when, and only when, there is an
important market failure that can be effectively addressed
by the government. For example, the Administration has taken
steps to reduce restrictive regulation of broadband markets,
preserving an environment conducive to innovation and new
investment. Conversely, the Administration supported new
rules for financial reporting when it became clear that
existing laws did not adequately reduce information
asymmetries between investors and management.
 When the government intervenes to address market failures,
it should attempt to take advantage of market-based
incentives whenever possible. The Administration has helped
ensure that scarce spectrum licenses are allocated more
efficiently by increasing the amount of bandwidth allocated
through auctions rather than through arbitrary allotments.
In transportation, the Administration has supported market-
based approaches to financing infrastructure such as roads
and the air traffic control system.
 The Administration has endeavored to ensure that, when the
government does intervene in markets, it does so in a way
that supports the operation of competitive markets. When the
market for terrorism insurance was disrupted following the
attacks of 9/11, the Administration supported a temporary
program of Federal support for terrorism insurance, and the
Administration has insisted that subsidies be phased out as
private insurers adapt and return to the market. By
supporting tort reform, the Administration has helped reduce
the scope for class action lawsuits that create costs that
outweigh their social benefits.

Telecommunications and Broadband

Digital technologies and the Internet are rapidly changing the market
for telecommunications. Much of our system for regulating
telecommunications, however, is designed to address local monopolies
in telephone service. Regulation that was well suited to markets based
on prior technologies should be revisited as markets change.
Particularly when innovation is transforming an industry, outdated
regulations can hamper investment and prevent new products and
services from developing in the way that best serves consumers.
Governments regulate local telephone service because it has long been
considered a natural monopoly. It is expensive to build and maintain a
network of lines to homes and businesses, but once the lines are in
place, the extra cost of providing each call is small. This means new
entrants would find it very hard to challenge an incumbent phone
company. A potential competitor would need to invest large amounts to
duplicate an incumbent phone company's network of lines, and
resulting competition would make it hard for either firm to charge
rates high enough to pay for the investment. To prevent incumbent
phone companies from charging monopoly prices, government regulates
rates for local phone service. In addition, the Federal Government
attempts to encourage competition in local service by requiring
incumbent phone companies to make their lines available to competitors
and by regulating the price for access to their lines.

New Technologies Permit Greater Competition in Telecommunications

New technologies are changing the telecommunications market. A new
market has developed in broadband Internet connections that can
transmit data at high speeds. Broadband data can be delivered along
the same physical lines that carry telephone signals, but can also be
delivered via cable, via fiber optic connections, wirelessly via
``third-generation'' networks or satellites, or via newer
technologies such as broadband over power lines. Because digital
signals can be delivered in a variety of ways, the broadband market is
more open to competition than the traditional phone system, which
required copper wires connected to every home.
Unlike local phone service, for which Americans traditionally had only
one provider available, the large majority of Americans can now choose
among competing broadband providers. As of June 2007, 99 percent of
U.S. ZIP codes had access to two or more high-speed Internet service
providers, and more than three-quarters of ZIP codes were served by
five or more providers. The price of broadband service has fallen in
real terms even as the average broadband connection has become more
advanced. Chart 9-1 shows that the total number of subscribers has
grown dramatically, with an increasing variety of technologies used.
These same digital technologies, combined with large investments in
wireless telephone networks, mean that consumers have new choices for
local telephone service, a market situation that undermines the
traditional arguments for regulation in local telephone markets.
Between 2002 and 2006, the number of households that use a wireline
for their primary phone connection fell from 102 million to under 90
million, and the number of ``wireless-only'' households
increased from 2 million to 19 million. That new competitors are
challenging the longstanding monopoly position of local telephone
providers raises questions about the best approach to regulating local
telephone service going forward.



Telecommunications Regulation in an Evolving Market

The Administration's approach to broadband regulation has
recognized that a dynamic and competitive broadband market should not
be governed by rules designed for monopoly telephone services. That
does not mean that no rules are appropriate. Broadband companies
should disclose the policies they use in managing their networks; if
consumers know what they are getting, competitive pressures will offer
the most effective means of providing consumers with low prices and
high-quality service. However, prescriptive regulation of a growing,
dynamic market carries two risks. First, because the market continues
to evolve, a regulation aimed at temporary or hypothetical problems
may cause permanent harm by preventing new and innovative ways of
delivering service. Second, regulations that make it harder for
broadband providers to price or manage their networks effectively may
lower the incentives to invest in new capacity, ultimately harming
consumers.
Following the principles outlined in the previous paragraph, the
Administration has supported policies that avoid unwarranted
regulation of the broadband market and encourage private sector
investments in the market. In a series of decisions, the Federal
Communications Commission (FCC) determined that broadband service
providers would not be regulated as a local phone service; in
particular, they are not required to make their high-speed lines
available to competitors at a regulated price. While govern-ment-
mandated access can facilitate competition between a large incumbent
provider and potential competitors, applying it to an emerging
industry that features competing technologies would have risked
undermining incentives to invest in new capacity. In fact, the private
sector has invested more each year in building broadband networks, in
real terms, than the Federal Government invested annually in the
Interstate Highway System in the 1950s. These investments in turn have
meant more options for consumers, and ultimately more competition in
the broadband market.
There is certainly a role for telecommunications regulations that
target specific failures in the telecommunications market. For
example, 911 services provide external benefits by making it more
likely that emergencies are promptly reported to emergency services.
The Administration supported the FCC's efforts to ensure that
911 services are available for subscribers of Voice over Internet
Protocol telephone providers. When there is a role for regulation, the
rules should facilitate competition and consumer choice whenever
possible. In implementing the ``Do Not Call'' list, for
example, the Federal Trade Commission did not dictate a market outcome
but created a way for people to decide whether they wanted to receive
certain telemarketing calls (see Box 9-1).

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Box 9-1: The Do Not Call List

Telemarketing can be an effective way to inform people about products
and services, but it generates a negative externality by wasting the
time of those who are not interested in the product being sold.
Although the harm from each call may be small, many consumers have
found the aggregate externality to be quite large. The policy behind
the Do Not Call list is to permit consumers to decide for themselves
whether the benefits of telemarketing calls outweigh the costs.
Individuals who do not want to receive calls simply add their phone
numbers to a central registry, and telemarketers must delete any
numbers listed in the registry from those they plan to call. The
program has proved quite popular: as of 2007, according to one survey,
72 percent of Americans had registered on the list, and 77 percent of
those say that it made a large difference in the number of
telemarketing calls that they receive (another 14 percent report a
small reduction in calls). Another survey, conducted less than a year
after the Do Not Call list was implemented, found that people who
registered for the list saw a reduction in telemarketing calls from an
average of 30 calls per month to an average of 6 per month.
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Spectrum Policy

Since the 1920s, the U.S. Government has required a license of anyone
who transmits radio signals on most frequencies. Radio communication
works by transmitting a signal on a specific frequency of the
electromagnetic spectrum. Mandatory licensing prevents interference:
when multiple signals are broadcast on the same frequency, it is
difficult to receive any of those signals clearly. Interference is an
example of an externality, because when one person decides to
broadcast a signal, he or she does not take into account the harm this
causes to people who are attempting to send or receive other signals
on the same frequency.
While licensing addresses the externality problem, it puts the
government in the position of allocating a scarce and valuable
resource. Given spectrum's value, it is important to allocate it
efficiently. Radio waves can be used in many different ways: for two-
way communication, to broadcast radio or television programs, and for
radar, among other uses. The more spectrum is set aside for broadcast
television stations, for example, the less spectrum is available for
wireless phones. The challenge of spectrum licensing is to ensure that
spectrum is divided among competing uses in the way that creates the
greatest benefits to society.
Ordinarily, markets allocate scarce resources using prices, ensuring
that resources are dedicated to their highest-value uses. For many
decades, however, the U.S. Government awarded spectrum licenses
through an administrative process, deciding both how spectrum would be
used and who would be allowed to use it. Prospective users submitted
applications to the FCC, and the FCC attempted to identify the
applicant who would offer the greatest public benefit.
The optimal allocation of spectrum, however, depends on information
not easily available to government, from technical information about
how much spectrum is needed to effectively carry out different
activities and how that is likely to change in the future, to
questions about the value to consumers of the various services that
require spectrum. Administrative assignment of licenses also gives
firms no incentive to find ways to use spectrum more efficiently,
because they cannot change their method of transmission and cannot
sell or lease unused capacity to others who would use spectrum in a
different way.
The United States began using a more market-oriented approach to
allocating spectrum rights in 1994 with the first auctions of radio
spectrum for use in wireless phones. In the auctions, the FCC
announces the portion of the spectrum for which licenses will be made
available, and all interested parties are invited to submit bids. By
2008, the FCC had held more than 70 auctions that raised tens of
billions of dollars for the Federal Government. More important than
the revenue, however, is that auctions ensure that spectrum will go to
those who are able to use it in the most efficient way. When one
company outbids others, it generally means that the winner believes it
can produce more value using that spectrum, by using it more
effectively or in a more innovative way than its competitors. Instead
of a government evaluation of which applicant is best able to use
spectrum to serve the public, the bidding process allocates licenses
based on what companies reveal about the benefits they can actually
produce.
The Administration has worked to increase the role of auctions in
allocating spectrum. Most spectrum remains under licenses granted long
ago; as of 2001, less than 7 percent of the most valuable spectrum was
available for allocation through market mechanisms. One obstacle to
reallocating spectrum is that incumbent license holders have a strong
incentive to retain spectrum they use, even if others might be able to
use it more efficiently. One way the Administration has tried to
overcome this obstacle is by making it easier for incumbents to
transfer their spectrum to others. In October 2003, the FCC
established new procedures for holders of existing licenses to more
easily sublicense their spectrum to third parties, helping to foster
secondary spectrum markets. More broadly, the Administration has
supported policies under which incumbents are compensated as part of a
process that reduces the total amount of spectrum they use. Two major
spectrum auctions using this general approach since 2001 have freed up
significant bands of spectrum, nearly doubling the amount of spectrum
allocated through auctions for wireless use.
In early 2008, the FCC held an auction to allocate spectrum that will
be vacated when the United States makes the transition to digital
television broadcasting, pursuant to the Digital Television Transition
and Public Safety Act of 2005. Digital signals allow broadcasters to
transmit television programming more efficiently, so that the spectrum
that was used to broadcast a single analog television channel is now
able to carry multiple digital channels. One result of the transition
is that spectrum that was previously used for channels 52 to 69
(between 698 and 806 megahertz (MHz)) will become vacant. Television
stations using other frequencies will be able to transmit using
digital signals. Much of the newly vacated spectrum was auctioned for
wireless communications use.
In December 2004, the President signed the Commercial Spectrum
Enhancement Act, which created a mechanism for transferring spectrum
from government use into the private sector. Government users of these
frequencies were given the opportunity to switch to other parts of the
spectrum, with the transition costs (including new equipment) paid for
using a portion of the auction proceeds. Under the Act, the
reallocation of spectrum was not to take place unless the auction
raised sufficient funds to compensate the affected agencies. In fact,
auction revenues were several times what the agencies had reported was
necessary to compensate them for the switch. The large difference
between the market value of spectrum and the costs of the transition
demonstrate the large efficiency gains available from reallocation of
spectrum. Together with the transition to digital television, the
Commercial Spectrum Enhancement Act has freed up 152 MHz of spectrum
to be auctioned for wireless communications use, and all but 10 MHz
had been auctioned by 2008. This represents an increase of 80 percent
over spectrum available for mobile telephones at the beginning of this
Administration.
The President's Spectrum Policy Initiative for the 21st Century,
which was announced in 2003, requires a studied look at the current
spectrum management policies and practices in the United States. As
part of this program, the Commerce Department's National
Telecommunications and Information Administration has worked to
establish or expand incentives for promoting efficient spectrum use by
the private sector as well as Federal agencies, using market-based
approaches wherever appropriate. Areas of particular interest have
included revising the traditional ``command and control''
management of Federal spectrum, developing user fees that reflect
market worth, and creating property rights that would permit spectrum
trading.

Tort Reform

Even when businesses are not regulated directly by the government,
they face the possibility of being sued under the tort system.
``Tort'' refers to the body of law that permits individuals
to sue others, seeking compensation when they have been accidentally
or deliberately injured. Many tort suits arise from harms involving
strangers, such as automobile accidents, but an important class of
torts arises when buyers of a good or service sue the seller in
response to harm related to the purchase of the good or service.
Tort law can be a response to the market failure of imperfect
information. Buyers often cannot tell ahead of time whether a product
is safe or a service provider is qualified. By providing buyers with
redress when a product or service they buy causes harm, tort law can
encourage sellers to exercise appropriate care and to make sure buyers
are getting what they expect when they enter into a transaction.
Like more direct forms of government regulation, tort law establishes
rules that firms must follow to avoid being penalized. Tort law can
increase sellers' incentives to provide safe, high-quality
products and services. It also compensates victims of some accidents,
providing a form of insurance when an accident is caused by
another's negligence. However, the tort system is an expensive
form of regulation, and tort law can be abused in ways that make its
costs to society greater than its benefits. One study found that out
of each dollar of costs in the tort system, only 46 cents goes to
compensating plaintiffs for their losses. This makes the tort system
much more expensive to administer than other systems that compensate
victims for unexpected losses, such as worker's compensation.
Total tort costs represent a significant part of U.S. economic
activity. Tort costs in 2007 totaled $252 billion, or 1.83 percent of
gross domestic product (GDP), including damages paid to compensate
plaintiffs, costs of defense, and administrative costs. As shown in
Chart 9-2, more than half of tort costs come from lawsuits against
businesses (including doctors) as compared with personal lawsuits such
as automobile accidents.
The Administration has worked to reduce the scope of lawsuits in
areas where costs often outweigh benefits. A type of lawsuit that may
be especially susceptible to abuse is the class action suit, in which a
single suit is filed on behalf of a large number of plaintiffs with
the claim that everyone in the class has been harmed by the defendant.
Class actions can be efficient in some cases in which a large number
of people have suffered a similar type of harm, because they eliminate
the redundancy of multiple courts exploring similar sets of facts, and
because absent a class action, each individual may have little
incentive to bear the costs of a lawsuit. A potential problem with
class action lawsuits, however, is that plaintiffs' lawyers may
have incentives that are not



aligned with those of their clients. Because individual plaintiffs may
not have a large stake in the outcome, they may not effectively monitor
their attorneys, and plaintiffs' attorneys may negotiate a
settlement with the defendant that works well for the attorneys but
does not represent meaningful redress for the people actually harmed.
In 2005, the President signed the Class Action Fairness Act, which
contained provisions aimed at reducing the number of abusive class
action lawsuits. An important set of reforms addressed ``coupon
settlements,'' one arrangement that may often serve the interests
of defendants and plaintiffs' lawyers at the expense of
plaintiffs themselves. In a coupon settlement, members of the affected
class receive coupons that can be redeemed for discounts on the
defendant's product, but attorneys receive what may be a very
large cash payment based on the nominal value of the coupons. For
example, in one case, plaintiffs alleged that a video rental company
had failed to disclose its late-fee policy. Members of the class
received coupons worth $1 off a future rental, while the
plaintiffs' attorneys received a fee of $9.25 million. Experts
estimated that at most 20 percent of the coupons would be redeemed.
Moreover, it is plausible that the coupons were more effective as a
marketing effort by the defendant than as a deterrent to poor
disclosure policies. The Act reduced possible abuse of settlements
through a number of reforms, including instructing courts to
scrutinize settlement agreements more carefully and a requirement that
attorney fees be based on the value of coupons actually redeemed,
rather than coupons issued.
The Act also took steps to curtail ``forum
shopping''--that is, efforts by plaintiffs to choose a
jurisdiction that they expect will be friendly to their case. Lawsuits
are generally tried in a jurisdiction that has some connection to the
parties, but because class actions often include a large number of
plaintiffs nationwide, attorneys had the opportunity to initiate a
lawsuit in a location where they felt either the court or the local
jury pool would be most favorable to their case. The Class Action
Fairness Act addresses this issue by making it easier for defendants
to have their case heard in Federal court, reducing opportunities for
plaintiffs to shop around for a jurisdiction in which they are likely
to have an advantage.

Corporate Governance Reform

For small businesses, a firm's owner is likely to be its
manager. But large corporations may be owned by thousands of
shareholders at once, and such a large, dispersed group must delegate
management to a smaller group of people. This separation of ownership
and control makes it possible to maintain central control over a
firm's operations while raising the large amounts of capital
needed for many corporate investments. But it also introduces the
problem of ensuring that managers make decisions that are in the best
interests of the shareholders. Corporate governance refers to the
systems through which shareholders are able to control the choices of
those who manage the firm on their behalf.
Regulation of corporate governance arises from the fact that managers
know more about the corporation's situation than the
shareholders on whose behalf they are making decisions. Most
shareholders would like the corpora-tion's managers to make
decisions that maximize profits. To encourage this, corporate boards
attempt to design incentives that reward managers when their actions
increase profits. For these incentive systems to work, however, they
must be based on accurate financial reports that are generated in a
transparent way.
A corporation will be better off if it can ensure accurate financial
reporting, because if investors doubt the information they receive,
they will be less willing to invest. But it is difficult for
shareholders to observe the mechanisms that a corporation uses to
improve accuracy and to prevent management from making misleading
reports. Furthermore, shareholders are a large, dispersed group, so
that an individual shareholder will not receive the full benefit of
costly efforts to monitor management. In the face of these challenges
to private monitoring of financial reporting, the U.S. Government
attempts to ensure the accuracy of financial reporting through the
securities laws enforced by the Securities and Exchange Commission
(SEC).
Beginning in the late 1990s, an increase in earnings restatements and
some large accounting scandals at major companies led to concerns that
corporations had been misleading investors about the extent of their
profits. In March of 2002, the President proposed a plan to improve
corporate governance, centered on three principles: accuracy and
accessibility of information, management accountability, and auditor
independence. Congress later passed the Sarbanes-Oxley Act of 2002,
which incorporated these three principles by introducing a number of
changes to U.S. securities laws. Some of the key reforms are described
in the following paragraphs.
To promote greater accuracy and accessibility of information,
Sarbanes-Oxley requires corporations to disclose more information
about internal control structures and the members of their audit
committees. It also significantly increases the penalties for criminal
fraud, increasing the maximum term for securities fraud to 25 years in
prison and permitting terms of up to 20 years for destroying
documents.
To promote greater management accountability, Sarbanes-Oxley requires
chief executive officers and chief financial officers to certify the
accuracy and completeness of financial reports that they file with the
SEC and makes it a criminal offense to knowingly certify a false
report. In addition, executives must forfeit any bonuses or other
incentive compensation to which they would have been entitled during
the year after a false report is issued.
To increase auditor independence, the Act creates the Public Company
Accounting Oversight Board, which oversees the firms that audit
corporations' financial reports. The Board conducts regular
reviews of accounting firms' activities, and if it discovers
problems it can impose sanctions and can bar a firm from providing
audit services to corporations listed on U.S. securities exchanges. In
addition, the Act creates new requirements to ensure that accounting
firms are more independent of a corporation's management.
Accounting firms are no longer permitted to sell certain non-audit
services to their corporate audit clients, and a company's
accountants must be chosen by a committee of directors who have no
ties to management.
Since passage of the Sarbanes-Oxley Act, many have expressed concern
about the cost of compliance with its requirements. There is evidence
that some firms, especially smaller firms and foreign firms, have
chosen to cease or to avoid trading on U.S. public markets because of
the expense of complying with Sarbanes-Oxley, although there is no
definitive evidence on how large this effect has been. While some
increase in costs is the inevitable result of stricter reporting
standards, it is important to ensure that the increased costs are
justified by greater accuracy and transparency. Many of the specifics
of Sarbanes-Oxley depend on rules and standards under the control of
the SEC and the Public Company Accounting Oversight Board. As
regulators and corporations become more familiar with the
implementation of the Act, and as reporting companies adapt their
practices and regulators adjust rules to eliminate inefficient
requirements, the costs should fall.

Insurance Against Terrorism and
Natural Disasters

When disasters occur, such as the terrorist attacks of September 11,
2001, or hurricanes such as katrina in 2005 or Ike in 2008, the
government plays an important role in providing emergency relief and
helping communities to recover. At the same time, insurance coverage
is vital in helping individuals and businesses recover from
catastrophic events. Most insurance is provided by the private sector,
regulated to make sure that insurers are able to repay claims if they
come due. But disaster relief acts as a form of public sector
insurance, and this means that the market for insurance against
catastrophic events is inevitably affected by government policy. To
preserve private insurers' important role in mitigating
disasters, government disaster relief should help the Nation recover
from major losses without discouraging the operation of private
insurance markets.
Insurance markets give individuals and businesses a way to reduce
risk. For example, anyone who owns a building faces a small risk of
losing property in a fire. Rather than accepting a small probability
of suffering a large financial loss, insurance allows one to
substantially reduce this risk by paying a regular fee, called a
premium, in exchange for compensation for some or all of the losses
sustained in the case of a fire. Because only a small fraction of the
population will suffer a fire in any given period, the premiums from
the overall pool of insured people provide funds to pay for the damage
suffered by those few who do suffer fires.
Insurance markets work most effectively if premiums are tailored to
risks that are observable or can be controlled by the insured
customer. If individuals with different risk profiles are grouped
together and charged the same premium, then those who in fact have low
risks are being charged premiums that are greater than the expected
value of their losses and may choose to go without insurance.
Differences in premiums can also lead individuals to make more
efficient choices about what risks to take and how best to mitigate
risks--for example, if driving a safer car means paying lower
insurance premiums, people will have an incentive to choose safer
vehicles. Similarly, it may be more expensive to live in some coastal
areas because a high risk of storm damage leads to higher insurance
premiums. This means that when home buyers decide whether to live in
those areas, they will take into account the extra cost associated
with potential storm losses.
For risks such as house fires or automobile accidents, the fraction of
the population that will suffer losses each year is relatively stable.
This means that insurers can feel reasonably confident about what
level of premiums will be sufficient to cover the year's losses.
Losses from major catastrophes are much more difficult to
predict--for example, flood losses in 2005 related to Hurricane
katrina were many times larger than the annual flood losses from
preceding years. This creates the risk that total losses in a year
will be greater than the funds available to the insurer to pay claims.
Insurance companies address this risk by purchasing reinsurance for
large losses: in exchange for premiums, reinsurers agree to bear a
fraction of insurer's losses if those losses exceed a certain
amount. Because reinsurers typically diversify their risks
internationally, they are in a position to pay claims arising from
catastrophic losses in a single country.
The 9/11 attacks seriously disrupted the market for terrorism
insurance. Prior to the 9/11 attacks, the risk of terrorist attacks
was covered by most commercial insurance policies. In the months
following the attacks, however, insurers were forced to reassess the
likelihood of potential terrorist attacks and the capital reserves
they would require, and many insurers began excluding terrorism risk
from commercial insurance policies. Congress passed the Terrorism Risk
Insurance Act (TRIA) to address this disruption in the market and to
help reassure businesses that they could obtain insurance against the
commercial risks associated with the threat of terrorism. Under TRIA,
the U.S. Government provides reinsurance for terrorism losses: in the
event of a claim for terrorism-related losses, an insurer would pay
the claim to the insured party and then be compensated by the
Government for a large share of the losses above certain limits.
Insurers do not pay premiums up front for this reinsurance. Instead,
TRIA specifies that assessments from insurers would be made after the
fact.
TRIA was intended to address a sharp temporary disruption in
insurance markets, not to be a long-term subsidy to insurers that
provide terrorism coverage. Providing insurance at subsidized rates
reduces the efficiency of the insurance market. First, it undermines
the incentive effects of premiums that reflect expected losses as
discussed above. This can encourage people to undertake risks that
they would otherwise not be willing to bear and discourages people
from taking actions that would mitigate risk. Second, government-
provided reinsurance undermines the private market for reinsurance,
discouraging innovation and efficient pricing of risk.
Because of these problems with government-subsidized insurance, the
Administration has insisted that TRIA should be a temporary program
and that subsidies should be reduced as markets adjust to the
post-9/11 environment. The subsidies provided by TRIA have gradually
been reduced. The insurer's deductible was initially 7 percent
of the insurance company's previous year's premiums, and
this fraction had been increased to 20 percent by 2007. In addition,
the Federal share of insured losses has been reduced from 90 percent
to 85 percent, and as of 2007, Federal payments will not be made
unless insured losses from a terrorist event exceed $100 million. The
program is scheduled to expire in December of 2014.
The market in terrorism insurance has grown since 2002, even as
subsidies for terrorism insurance have been reduced. As shown in Chart
9-3, the fraction of policyholders purchasing terrorism insurance
increased from 27 percent in 2003 to 59 percent in 2007, even as
deductibles for the Federal reinsurance program were increasing. As
the private market develops to accommodate the post-9/11 environment,
government assistance should be eliminated to allow the market to
operate efficiently.



Roads

The Nation's roads are built and maintained primarily by State
and local governments; the Federal Government's role has been to
help fund these activities. Like some other infrastructure projects,
roads are often natural monopolies: once a road is constructed, it is
usually less expensive to accommodate extra traffic on that road than
to construct a competing road. But rather than organizing roads under
a regulated, private sector monopolist, the government generally owns
and operates the roads itself--at least in part because of the
expense that would be involved in limiting access to roads to paying
drivers and collecting revenue from road users.
When government provides a service itself to an identifiable subset of
society, it is often most efficient to pay for the service through
user fees that reflect the marginal cost of providing it--that
is, the extra cost created by each user. This approach, when
practical, both ensures that the service will be used when its value
is greater than its costs and provides information about whether and
when capacity should be expanded. User fees that reflect marginal
costs will lead drivers to make efficient decisions, choosing to drive
when the benefits they receive are greater than the costs their trip
generates.
On an uncongested road, the marginal congestion imposed by each driver
is very small, and fees that reflect marginal cost may often be
insufficient to pay the fixed costs of building and operating the
road. In this case, the goal is to finance roads in a way that does as
little as possible to discourage efficient road use. When a road is
congested, however, each trip adds to the delays experienced by other
drivers, meaning that the marginal cost of each trip can be quite
large. As discussed below, efficient user fees will reflect these
congestion costs.
Broadly speaking, roads in the United States are financed in one of
three ways: through general revenues such as property or sales taxes,
through fuel taxes and other vehicle fees, and through tolls. Chart
9-4 shows that about a third of expenditure on roads is raised through
taxes unrelated to road use, largely at the State and local level.
About half is raised through fuel and vehicle taxes, and only about 5
percent through tolling (11 percent is funded through bond issues that
will be repaid from one of these three revenue sources). Almost all
Federal expenditure is funded by fuel and vehicle taxes, reflecting an
early decision that the Nation's Interstate Highway System
should be funded by the drivers who benefit from it.
One advantage of funding roads with fuel taxes rather than general
revenues is that they approximate a user fee: roads are paid for by
those who use them, and on average people who drive more contribute
more of the cost of providing the roads. However, fuel taxes do not do
a good job of capturing the marginal cost of using the road. One of
the most important



costs associated with road use is congestion: when a driver uses a
congested road, she or he increases the delays experienced by everyone
else. The increased delay is a negative externality, because each
driver does not take into account these costs when deciding when,
where, and whether to drive. The fuel tax fails to account for this
negative externality, because drivers pay the same amount whether
driving on an urban highway at rush hour or on an empty rural road.
Many economists point out that fuel taxes can be effective in
addressing some negative externalities directly related to fuel use,
such as environmental degradation and petroleum dependence. But this
does not imply that fuel taxes are the best way to finance roads. In
fact, as vehicles become more fuel efficient, they will produce less
revenue for each mile driven, so that the same amount of driving will
contribute less and less highway revenue.
The Administration has supported exploring ways to begin moving away
from fuel taxes toward forms of direct pricing, such as tolls, that
would be more effective at matching what drivers pay to the costs they
impose. Not only are tolls independent of a vehicle's fuel
efficiency, but they also have the flexibility to address congestion
externalities because they can be adjusted according to time and
place, so that drivers pay more to travel on busy routes or during
busy times. Such tolls encourage drivers to drive at times and places
where they will contribute less to the delay experienced by others on
the road. Furthermore, tolls that reflect how busy a road is can
provide information about how much drivers are willing to pay to use
each road. This information can help improve decisions about new
investments, by providing objective measures of how valuable roads are
to drivers.
By linking revenue to particular road projects, tolling can
facilitate private investment in building and maintaining roads. This
increases the likelihood that investments will be based on a careful
analysis of a project's benefits and costs. When funding is
controlled by the government, decisions about road investments are
likely to be influenced by a political process that takes place among
people with competing interests, and the process frequently does not
reflect an objective cost-benefit analysis. Tolling permits
revenues to be collected at the point of road consumption and directed
to those responsible for building and operating the road. Toll revenues
can give investors strong incentives to pursue only investments with
revenues that exceed their costs, so that they will not ignore
projects with a large revenue-to-cost ratio and will not spend money
on projects that do not have a positive return (see Box 9-2). However,
private infrastructure investments may not give weight to public
benefits of an investment that are not reflected in the
project's revenues, such as increased safety or reduced
pollution. For projects for which such benefits are substantial, it is
important to have a public partner that can contribute funding that
reflects the public benefits of the project.
To encourage development of more efficient forms of highway finance,
the Department of Transportation has entered into Urban Partnership
Agreements with several metropolitan areas that will undertake
programs that include congestion pricing or variable toll
demonstration projects. Calling for broader reform to highway finance,
the Secretary of Transportation proposed a plan in 2008 to reform
Federal highway policy by initiating a movement away from the fuel-
tax-based approach to funding highway investment to methods that link
fees more closely to use of the road system, such as congestion
pricing.  The Secretary also proposed expanding support for private
sector participation in road projects, including removing current
Federal statutory and regulatory barriers to tolling on Federally
supported highways.

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Box 9-2: The Role of Incentives in Road Investments

When private sector road operators rely on user fees for their
revenue, the potential for profit gives them incentives to invest in
projects that improve service to the public. Examples of such
investment can be seen on the Indiana Toll Road, which provides a key
route between Chicago and Ohio. In 2006, the State agreed to turn over
operations on the road to the Indiana Toll Road Concession Company
under a 75-year lease. Within the first year, the company installed
electronic tolling facilities, easing congestion and saving commuters
valuable time. The company also spent $250 million to add lanes to
highly trafficked areas of the road. Because the company's
profits depend on the toll revenues it generates, the operators have
an incentive to improve road conditions when the cost of doing so is
less than the extra revenue it gains from improving service to
drivers.
While some State and local governments use cost-benefit analyses
to guide their infrastructure investment decisions, many others fail
to make the investments that offer the greatest net benefits. Traffic
signal optimization is one area in which municipal governments have
frequently failed to invest resources despite very high expected
returns. Over time, pedestrian and vehicle traffic patterns change
substantially as cities grow and residential and commercial areas
develop. Retiming traffic signals to optimize traffic flow can reduce
vehicle stops, which in turn reduces delays, fuel use, and vehicle
emissions. Transportation engineers recommend retiming signals every 3
to 5 years, but a recent survey showed that only 60 percent of State
and local traffic agencies retime their signals at least every 5
years.
Signal optimization is relatively inexpensive, and recent projects
have seen benefits in time and fuel savings exceed their cost by more
than 40 to 1. Cities like Nashville, Austin, and Portland, Oregon,
have invested in signal optimization plans and seen improvements in
traffic delay and air quality, but State and local agencies often fail
to allocate resources to signal optimization programs. Many retime
their signals infrequently or conduct traffic assessments only in
response to citizen complaints. Local governments will better serve
drivers if they follow the private sector's lead and base their
investment decisions more heavily on cost-benefit analysis.
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Aviation

Like roads, airports and air traffic control services are often
provided by the public sector. As with fees to finance roads, it would
be economically efficient to set aviation fees where a competitive
market would set them, at marginal cost. In fact, aviation fees bear
little relationship to marginal costs. Airport landing fees are
generally based on aircraft weight, and air traffic control operations
are funded largely by a ticket tax of 7.5 percent on each airline
ticket. Air traffic control operations are also funded by fuel taxes
and additional fees.
This approach to financing means that fees do not reflect marginal
costs in at least two important respects. The cost of air traffic
control services depends on the number of planes, not on the size of
those planes or the number of passengers each carries. Similarly, each
flight at a congested airport contributes approximately the same
amount to congestion, regardless of the plane's size. Because
fees are roughly proportional to the size of each plane and the value
of tickets sold, an airline that flies a single plane with 200
passengers might pay roughly the same fees as an airline that flies 10
planes with 20 passengers each. The second airline, however, generates
approximately 10 times as much congestion and requires about 10 times
as much air traffic controller time.
The result is that airlines do not take into account the external
cost they impose when they schedule a flight using a crowded airport.
Airlines schedule frequent flights with small aircraft rather than
fewer flights with larger aircraft. Overcrowded airports mean delayed
flights, and delays have been increasing in recent years, with
congestion at the Nation's busiest airports a significant
contributing factor. Delays were especially severe in New York City
airports in the summer of 2007; for example, at John F. kennedy
International Airport (JFk), only 56 percent of flights arrived on
time during the summer months.
One method the government can use to address overcrowding is to place
caps on the number of flights permitted to land at an airport, in
order to limit those flights to the capacity the airport can accept.
When the Federal Aviation Administration (FAA) establishes a cap at an
airport, each airline is assigned ``slots'' permitting its
aircraft to land or take off at particular times. Delays are thereby
reduced by excluding other airlines from the airport. In the past,
slots have been assigned through a negotiated process, and this
approach was used in 2008 at JFk and Newark Liberty International
airports after severe delays in the summer of 2007.
A problem with this approach is that the government must decide whose
planes can and cannot land at the airport. The need to obtain slots
from the government acts as a barrier to new entry at the airport, so
that passengers are denied the benefits of competition. Even if the
FAA makes wise decisions about which airlines should initially receive
slots when a cap is imposed at an airport, this allocation will become
inefficient over time. But the FAA will find it difficult to further
reallocate the slots regardless of how inefficient a given
distribution of slots becomes: given their scarcity, slots are very
valuable, so an incumbent authorized to use the slot will go to great
lengths to maintain its allocation.
Recognizing the inefficiency that results when the government decides
which airlines have access to an airport, the Administration has
sought to use market-based mechanisms to allocate scarce airport
capacity. One approach is to allow airports to charge landing fees in
a way that reflects the greater demand to operate at certain times of
the day. The Department of Transportation published guidance in 2008
clarifying that airports have the authority to charge congestion-based
prices that would help encourage planes to use the airport when it is
less busy, as long as the total charges imposed do not exceed the
eligible costs of operating the airport. Under such an approach,
airlines--and ultimately passengers--would decide whether it
was worth paying a premium to schedule a flight at the most popular
time.
Another approach with a similar result is to auction slots so that
each slot is used by the airline that values it most highly. As with
congestion-based landing fees, an auction would drive up the price of
slots at the busiest times, but it would be less expensive to schedule
a flight when the airport is less crowded. Auctions would permit new
entry by airlines if they believed they could serve consumers more
efficiently. In New York City, the Administration issued rules that
would implement this approach for a limited number of slots. Apart
from efficiently allocating the slots within the cap, an auction would
reveal the market value of the other slots held by the airlines. This
could help encourage airlines to trade slots among themselves if they
discover that particular slots would be worth more in the hands of a
different airline.

Conclusion

Government can play an important role in addressing the market
failures associated with natural monopoly, externalities, and
imperfect information. However, it would be naive to assume that
government can eliminate all inefficiency in a market. Government
lacks the information and incentives that make competitive markets
work efficiently. Before intervening in a market, policymakers should
first examine whether the inefficiencies of government involvement are
outweighed by the inefficiencies of an unregulated market.
Regulation will be most efficient if it takes advantage of market
mechanisms where possible. The Administration has taken an approach to
regulation that supports competitive markets and attempts to take
advantage of private sector incentives rather than working against
them. There are many opportunities to further improve the efficiency
of regulations, and this chapter has laid out a number of areas where
such improvements are possible.