Regulation. It is all about incentives

  • John Luxton
International Trade

James Cook Centra, Wellington

It is all about incentives. As people who are leaders in your respective organisations, you know that to change behaviour, you need to change incentives.

Since the mid 1980's, Labour and National Governments have embarked on a reform programme that has changed the incentives for New Zealanders on a range of economic policy fronts. The result has been a changed economy that is better able to compete in a global marketplace, and that gives more choice and opportunity to its participants. A key to the reforms was that government focused on incentives to get desired outcomes. Process followed.

We now face a similar challenge, but on a different front. If we are to succeed as a democratic nation as we move into the new millennium we need to address the incentives within our government institutions to intervene and regulate.

Today, I would like to explore with you how we might surf the next wave of major reform in New Zealand: regulatory reform and the incentives that drive government institutions. I will not try to provide all the answers today, but I hope to stimulate thinking and debate on this critical issue.

I want to say up front that this is not just about smaller government in a philosophical sense. It is not about the level of intervention per se, but about the practical search for optimum, not minimum, government intervention. Government regulation is required and is often positive. But it is like money or alcohol. It isn't bad in itself, but the excessive use of it can have undesirable consequences. One might suggest that currently we have overindulged in excessive government intervention and are suffering from a regulatory hangover.

The problem and its costs
The reality of the global economy means that people, knowledge, technology, and capital, are not restrained by national boundaries and other barriers. Change is a constant reality. The nature of commerce and social interaction has to adapt to keep up. Government has a role to play in this transformation.

While Government has introduced privatisation and limited contracting out, it is not making the same institutional changes that are being forced on the rest of society. In fact, rather than reduce the government tax burden, we are currently close to a 100 year high. Rather than simplify or reduce government interventions, in the last 10 years we have introduced 1600 pieces of new and ammended legislation and 3600 pieces of new and ammended regulation.

In addition, new instruments and numerous interventions have grown at the secondary and tertiary level. Local Government and now even Government departments are able to make rules and regulations unchecked.

As a result of this energetic activity to grow interventions, a government's ability to facilitate progress in the face of rapid social change is stunted. The costs are both economic and social.

The direct costs of compliance have been estimated to be possibly as high as 10 % of GDP. However the incentive costs in terms of frustrated creativity, lost opportunity and reduced investment are hard to measure, but I believe are much higher. As a result, economic growth has lagged below potential and employment and standards of living are lower than would otherwise be the case. Our ability to pay for social and environmental goals, where appropriate, is reduced.

Individuals and businesses have become more cycnical of government and there is a perception of a decline in many social indicators.

As some say, "more regulation makes government less relevant". Or, as a recent report on the "Reinventing Government" project of the Netherlands Antilles says: "More Government may lead to chaos. As governments become bigger, they tend to dysfunction: the service to the community becomes ineffective, inefficient, unfriendly and costly. Big Government tends to become a self-serving organisation that loses its contact with the very public it is supposed to serve."

This expansion of government has taken place not only in New Zealand, but across the world, regardless of local differences in political practice or constitutional structure. Moreover, attempts to address the issue have not often met with success. As Michael J Trebilcock, a New Zealand born professor at the University of Toronto says in a recent article:

"As government regulation and spending loom larger in the lives of citizens in all developed democracies, and as the costs of those activities rise apace, the need for more efficient government has become acute.... Despite widespread support for the principle of restructured and refocussed government, however, successes have been few and generally balanced by setbacks."

Causes of the problem
A key cause of excessive intervention is the current incentives on government and its institutions. Governments intervene to:

protect the consumer;
create property rights;
prevent specific activities (e.g., crime, cloning and driving on the right);
provide or fund services (e.g., defence, law and order, education and health); and
redistribute wealth.
In each of these areas, there are a number of options for intervention, including doing nothing, contracting out, providing guidelines, educating the public, developing codes of practice and creating or amending Acts and regulations.

The track record tells us that there is an inherent bias within Government towards solving more and more problems by legal rules and fewer through voluntary accommodation. This is for two reasons.

The first is the public sector, which has every interest to maintain and grow its position, and little incentive to ensure an optimal outcome from interventions. Its driver is to maximise, not optimise, regulatory interventions. Whilst the public sector has been downsized in personnel terms and restructured in organisational terms, the size of Government in tax and regulatory terms to has never been bigger. The structural bias that creates a regulating culture has remained.

The second is the politicians, wanting to create a perception that they have done something to solve a problem and the expectation that they can cure the "ill". The "we legislated for that didn't we" syndrome. Expectations are created that regulation is the tangible solution.

Recent "light handed regulation" has demonstrated the political paradox. While this framework has delivered a better outcome for consumers than the more heavy-handed frameworks of other countries, there is ongoing pressure to change it. I am still a strong advocate of the light-handed approach and always look to the reasons behind advocates of a more interventionist approach.

As President Bill Clinton has said on Government: "We can no longer afford to pay more for - and get less from - our government. The answer for every problem cannot always be another program or more money."

Having been involved in the budget process, I can say that it is the same in New Zealand.

He goes on: "It is time to radically change the way the government operates - to shift from top-down bureaucracy to entrepreneurial government that empowers citizens and communities to change our country from the bottom up. We must reward the people and ideas that work and get rid of those who don't".

Technology and brains in the end will always outflank heavy handed regulation. Regulation changes are too often introduced in hindsight and are too late anyway. We often regulate for the 5% problem and penalise the remaining 95%.

The Solution
Currently around the world there are many people putting their minds to solving this problem. There are a range of possibilities.

At the end of last year, I announced a "Six Pack" of measures as a starting point of regulatory reform. This package includes:

a code of good regulatory practice;
a generic policy development process;
a requirement for regulatory impact statements;
a number of reviews currently underway of the impact of specific Acts on business;
a proposal to establish a taskforce to examine existing regulation; and
a Regulatory Responsibility Act.
These measures provide an important first step in improving Government intervention and in changing attitudes and behaviours within the system. They focus primarily on process, putting more quality checks and disciplines into the system to help reduce the compliance burden of the law. By introducing greater transparency and a new accountability framework into policy development, they will go some way to alter the all too often overriding paradigm: "if in doubt, regulate".

Code of Good Regulatory Practice
The Code contains a set of regulatory design principles. It will be based on the principles of effectiveness, efficiency, equity, transparency and clarity; implementation details, such as ways to entranch the code into the current systems, to be reported back by officials by 1 May 1998;

Because they apply broadly across the full range of regulatory activities, these principles establish common quality standards for regulatory management. In that sense, they regulate the regulators, and are designed to establish best practice across all departments. Currently many departments are doing a high quality job, so it might be said that the introduction of the code may not make much difference. However for those departments who currently do not measure up to best practice, the code will provide them with an opportunity.

These principles also act as avenues of communication between political levels, the regulators, and the public. They provide explicit policy statements on how government should, or should not exert its regulatory powers.

Generic Policy Development Process
The proposed Generic Policy Development Process also looks to identify a set quality standards, but specifically in relation to good processes in developing regulatory proposals.

Again, these are based on generally accepted best-practices and centre around notions of effective consultation, early and on-going consideration of the legal and international implications of proposed policy, and the consideration of alternatives to regulation

The other aspect of the generic process looks at developing strategies to ensure effective planning and co-ordination at the beginning of the policy development process.

It deals with questions of how to encourage earlier, explicit consideration of key policy elements and trade-offs? How do you effectively provide for substantial external input into the policy formulation process? What is the best way of clarifying the responsibilities and accountabilities in the process?

These issues become more important when there is more than one agency responsible for a particular regulatory regime. Where there are significant trade-offs between competing policy objectives. Where legislative change is likely to be an on-going process. Where the subject matter is highly technical and requires significant external input from specialists.

Regulatory Impact Statement
This builds on the current requirement relating to Compliance Cost Statements in Cabinet papers be expanded to include information on the total regulatory impact and would include the following information;

a statement of the nature and magnitude of the problem to be addressed;
a statement of the public policy objective;
a statement of feasible options (regulatory and non regulatory);
statement of the net benefit of the proposal, including the total regulatory costs (administrative, compliance and economic costs) and benefits (including non-quantifiable benefits) of the proposal, and other feasible options; and
a statement of the consultative programme undertaken.
The Regulatory Impact Statement essentially provides summary information (in two or three pages) on the basis of proposals for regulatory action and aims to ensure that proposals are necessary, cost effective, and in the best interest of society.

It will increase the transparency of the regulation-making process. In particular, the scrutiny of regulatory proposals, which will sharpen the quality discipline on policy-makers as their advice is subject to scrutiny by a wider audience.

In this way, a degree of contestability in the provision of policy advice is introduced into the regulation-making process. This is important as it may, for example, halt any regulatory action for which the analysis does not clearly show positive net benefits to society, or lead to the identification of more costs-effective alternatives to regulation.

It can be seen that the effectiveness of the RIS is dependent on a high level of disclosure. It is therefore proposed that the RIS be attached to Bills going before the House and regulations referred to the Regulations Review Committee, and be made publicly available.

This disclosure will allow Cabinet, Select Committees, Parliament, and the public to efficiently evaluate the basis for, and impact of, regulatory proposals.

Regulatory Task Force
Equally important is a recognition that good regulation can become bad regulation overtime, as social, economic, and market conditions change and new approaches to regulatory problems evolve. This requires regulators to review, update, and eliminate unnecessary and harmful regulatory interventions.

My officials are still working on the concept of an independent Regulatory Task Force and will report back 1 July 1998. This task force would look at existing regulation and ways of improving it. It is likely to build on the reviews currently underway.

Review of specific acts
The intentions of the reviews are to ensure that costs imposed by the legislation are minimised, not to question the basic principles on which the legislation is based. The following legislation has been selected for review;

Building Act 1991,
Health and Safety in Employment Act 1992,
Privacy Act 1993,
Human Rights Act 1993,
Meat Act 1981, Dairy Industry Act 1952 and related legislation governing food safety,
A work program on the Resource Management Act 1991 between Commerce and the Ministry of the Environment is being drawn up
The Employment Contracts Act, ACC are being considered by the Ministries responsible.

Regulatory Responsibility Act
But maybe we need to do more to change the incentives generated by our institutional structures and cultures. With Cabinet agreeing in principle to a Regulatory Responsibility Act we have a further opportunity to build on this base to continuously improve government intervention.

An Experts Group which I set up to act as a sounding board in developing the Regulatory Responsibly Act has pointed to the need for an appropriate institutional framework to support the regulatory responsibility package. It is proposed that regulatory matters need to be exposed to the same institutional disciplines as is the case with fiscal matters.

Suggestions include a senior Minister in charge of a regulatory responsibility portfolio with powers necessary to review and comment on regulatory proposals put forward by other Ministers; annual reporting to Government on the exercise of regulatory responsibility; a Select Committee with a specific focus on matters of regulatory responsibility, consideration of the concepts such as Regulatory Budgets and what they might contain, and an annual debate in Parliament on regulatory responsibility.

These proposals are still being developed and considered by the Group. One of the key issues in assessing the content of the Act will continue to be incentives.

As Trebilcock says in his CD Howe Institute article 1994:

"... in evaluating choices among alternative policy instruments for realising policy objectives, an insistent focus must be trained on the incentive effects for all effected actors that are likely to be associated with particular institutional structures. The blunt fact is that incentives (pecuniary and non-pecuniary) are central determinants of human behaviour, and to ignore this reality in the choice of policy instruments entails a socially very costly form of romanticism.

If the goal is to change the outcomes produced by existing policy instruments, alternative policy instruments must embody a different set of incentive structures that are more congruent with the desired outcomes. Rhetorical exhortations to do better or to try harder will rarely be effective by themselves."

This quote is made in relation to policy problems in general, but is equally applicable when thinking about the incentives on the public service themselves.

As those of you who have introduced ISO 9000 standards know, while it is important to improve the process, incentives within the organisation must be correctly aligned in order to gain the maximum benefit. Employees will change their behaviour more easily if the incentives on them to produce quality are consistent with the requirement of the process. Just telling them that you are concerned about quality and want more of it, doesn't always work. And of course you will only implement such a programme if you have the incentive to do so.

I agree with President Clinton's sentiments when he says:

"Our goal is to make the entire federal government both less expensive and more efficient, and to change the culture of our national bureaucracy away from complacency and entitlement toward initiative and empowerment. We intend to redesign, to reinvent, to reinvigorate the entire national government"

To provide the right incentives, to empower and invigorate the public service, perhaps we need a more market-oriented approach. Globalisation is having a similar impact now on regulation that it has had on money. As Alfred C Aman Jnr says in a 1997 paper:

"Deregulation, cost benefit analysis, market-oriented regulatory approaches, declining regulatory budgets, devolution and the delegation of public tasks to the private sector are but some of the hall marks of what I have called the global era of administrative law. These regulatory trends are not limited to the United States. In various degrees, they typify new approaches to public law in various countries around the world. Almost all these reforms are market oriented; that is, they either substitute markets and the private sector for regulatory regimes or have public agencies use market approaches, structures and incentives to achieve their regulatory goals."

A paper entitled: "Reversing Regulatory Creep, Reclaiming the Relevance of Government in New Zealand " written by two of my office staff, suggests a simple market mechanism. That is "for every new regulation that is created, a number of existing regulations must be repealed." Regulation in this instance refers to Acts and regulations and could also include Local Government interventions. Such a mechanism would dramatically change incentives. I have some questions about its workability but have asked the Experts Group to consider its merits in their consideration of the content of the Regulatory Responsibility Act.

A recent Economist has an article on a market for regulation and a suggestion of Professor Roberta Romano, a specialist in corporate law at Yale. She notes the potential to move from the monopoly powers of American Securities and Exchange Commission (SEC) by allowing "several regulators trying different approaches" which would "reveal more about what leads to the most smoothly functioning securities markets". She notes that already in the US there is a market for corporate law as American firms can incorporate in any American state and that State's company law governs the firm throughout the US.

In New Zealand we have an element of this approach with the unlisted market, operating outside of the fully listed stock exchange. This provides an alternative for shares to be traded. Shareholders can trade their shares on this less regulated and cheaper market, while investors trade in the knowledge that the regulatory framework is less robust and very much buyer beware. This enables unlisted private companies an alternative to the more expensive and rigerous fully listed public option.

Likewise, the introduction of the Trans-Tasman Mutual Recognition Agreement shortly between New Zealand and the various states of Australia begins the process of creating a market for regulations within Australasia.

Growth of the Internets World Wide Web will increasingly impact on Governments ability to regulate and tax activity. Traditional areas of regulating in gambling, intellectual property, and censorship are under pressure. The ability to tax will also be eroded as internet transactions fall into cyberspace, and outside nations tax sphere. These are very challenging issues for Governments around the world, especially for those who promote bigger Government. Some in the European Union for example seek to impose ever increasing complex heavy handed regime.

So already we are seeing an erosion of the monopoly regulatory role of our sovereign state, just as occurred in the mid 1980's with the financial sector. The reality of a global marketplace for regulation is evolving.

Intervention by Governments around the world has to be changed to keep up with the changing world. It is all about incentives. Currently the Government has a package of measures which are a good start to attack the problem. The Experts Group, along with officials, is now currently examining the content of the RRA and what other measures may be useful for this next wave of reform. There are a range of options and possibilities.

I want you to think about what initiatives we could take. I hope we can build on our current package and come up with a reform which will have a major impact on incentives and outcomes for New Zealanders. This is not just a PR exercise. As we move into the next millennium, if we are to succeed as a country, both socially and economically, we need to address the challenges of regulatory reform and incentives on our government institutions. I believe the costs of not meeting this challenge would be high.

Conferences such as this help highlight the compliance costs of ever increasing regulation. I hope that this will stimulate those involved to challenge the status quo, to look for more innovative approaches and above all to get the incentives right.