12 January 2009
Perverse Incentives Distort Public Policy
Motivating managers, in finance, energy--across industry lines-- commonly involves incentives that must at once be meaningful to them personally and consistent with the goals of their organizations. When those organizations are private sector corporations, another set of incentives enters the picture: those that motivate shareholders to invest in them.
The usual ways to reconcile the potentially competing interests of shareholders and managers include tying executive compensation to the company’s P& L performance or to changes in its market capitalization. However, these gauges can be contradictory (cf. the Internet Bubble). They can also overlook the community’s long-term goals, like reduced carbon emissions or stable sources of mortgage and consumer credit.
Perverse incentives often result from relying on convenient shortcuts to measure success, such as using the calculation of short-term VaR (Value at Risk) to measure long-term investment quality (cf. Joe Nocera’s article in the January 4, 2009, New York Times Magazine, “Risk Mismanagement”), or a company’s stock market value to measure its worth to the community. A liberal democracy or an enlightened autocrat may decide to enforce a community goal, such as reduced carbon emissions, through tax policy or maybe a “cap-and-trade” system. However, the irresistible temptation would always exist to game any government regulation imposed to achieve a policy goal, just as happened to financial institutions with VaR, according to Mr. Nocera.
The market is a terrible tool for pursuing long-term community objectives. It is the ultimate short-term assessor. Public policy cannot be made there, liberal democracies should not model themselves on the marketplace, and our leaders and executives will not serve the community’s long-term interests if their reward for professional accomplishment depends on daily trading results.
So, how can we correct these incongruous incentives? First, payments to a liberal democratic government, taxes, ought to be made equivalent to dividends; i.e. the community must be treated like other shareholders in the corporation. One component of this approach would be to reduce the importance of tax avoidance in commercial practice. This ritual is enshrined in the definition of business cash flow as EBITDA (earnings before interest, taxes, depreciation and amortization), which makes taxes one of the principle costs of doing business that corporations are expected to minimize. Change in this behavior would result, formally, in reduced net corporate revenues. However, making the almost religious commitment to share a portion of business income with the community at large will institutionalize corporate citizenship.
In reality, overall profits from business enterprise will not change. Here’s why: During the 2008 financial crisis, the U.S. government has been forced to take an ownership position in several large private corporations in order to stabilize international markets. As a result, the community shares an equity interest with stockholders in the recovery and profitability of those enterprises. It is not much of a stretch to include taxes in the ROI of all private companies. This accounting rule change would bring shareholder dividends and corporate tax payments to the society as a whole into equivalence. If the political process achieves fair and progressive government fiscal policy, shareholders would also benefit paripassu from those tax payments. Moreover, shareholders should receive a proportional credit for corporate tax payments against their personal income taxes. This tax credit would help to reconcile the amassing of commercial fortune with civic responsibility.
A second reform strategy is for the community to enlist private industry to be the motive force behind the tide of globalization instead of being its flotsam. The privatization of many erstwhile functions of government not only takes advantage of individuals’ creative impulses, but also offers entrepreneurs the incentive to profit from managing what has traditionally been considered to be overhead in running the country. These tasks include, for example, national defense, policing the streets, educating the young, regulating the design and construction of living spaces, and moderating the destructive effects of using energy.
The information technology revolution has made it conceivable that private enterprise can carry out public policy initiatives without government. Just as IT has enabled the creation of virtual corporations, it is tempting to think that the national community can self-regulate through interactive communications. Whether or not that “virtual government” serves the community’s long-term best interests, including sustainable energy use, depends on how compelling a case is made that the success, if not the survival, of each individual or enterprise is unbreakably linked to that of the entire global community.
There is no simple resolution of the conflict between personal and community goals. The fundamental question is whether the cyclical swings between satisfaction of one set of goals and the other will ultimately be sustainable, or whether each swing brings us closer to self-destruction. Specifically, will the private exploitation of the planet’s energy resources harm the welfare of the community at large? Rewarding long-term foresight in the immediate present has always been a challenge; but the consequences of not doing so are potentially more threatening to the health and wealth of the planet than ever before.
It is the function of government to anticipate a danger to public security and enforce measures to deal with it. This is not a function that the market does well, if at all. Nor will incentives tied primarily to the market motivate business leaders to act in the long-term interests of the community. The free-enterprise ideal, in the end, will not be preserved without violating its dominion through authoritative and enlightened political action.
Motivating managers, in finance, energy--across industry lines-- commonly involves incentives that must at once be meaningful to them personally and consistent with the goals of their organizations. When those organizations are private sector corporations, another set of incentives enters the picture: those that motivate shareholders to invest in them.
The usual ways to reconcile the potentially competing interests of shareholders and managers include tying executive compensation to the company’s P& L performance or to changes in its market capitalization. However, these gauges can be contradictory (cf. the Internet Bubble). They can also overlook the community’s long-term goals, like reduced carbon emissions or stable sources of mortgage and consumer credit.
Perverse incentives often result from relying on convenient shortcuts to measure success, such as using the calculation of short-term VaR (Value at Risk) to measure long-term investment quality (cf. Joe Nocera’s article in the January 4, 2009, New York Times Magazine, “Risk Mismanagement”), or a company’s stock market value to measure its worth to the community. A liberal democracy or an enlightened autocrat may decide to enforce a community goal, such as reduced carbon emissions, through tax policy or maybe a “cap-and-trade” system. However, the irresistible temptation would always exist to game any government regulation imposed to achieve a policy goal, just as happened to financial institutions with VaR, according to Mr. Nocera.
The market is a terrible tool for pursuing long-term community objectives. It is the ultimate short-term assessor. Public policy cannot be made there, liberal democracies should not model themselves on the marketplace, and our leaders and executives will not serve the community’s long-term interests if their reward for professional accomplishment depends on daily trading results.
So, how can we correct these incongruous incentives? First, payments to a liberal democratic government, taxes, ought to be made equivalent to dividends; i.e. the community must be treated like other shareholders in the corporation. One component of this approach would be to reduce the importance of tax avoidance in commercial practice. This ritual is enshrined in the definition of business cash flow as EBITDA (earnings before interest, taxes, depreciation and amortization), which makes taxes one of the principle costs of doing business that corporations are expected to minimize. Change in this behavior would result, formally, in reduced net corporate revenues. However, making the almost religious commitment to share a portion of business income with the community at large will institutionalize corporate citizenship.
In reality, overall profits from business enterprise will not change. Here’s why: During the 2008 financial crisis, the U.S. government has been forced to take an ownership position in several large private corporations in order to stabilize international markets. As a result, the community shares an equity interest with stockholders in the recovery and profitability of those enterprises. It is not much of a stretch to include taxes in the ROI of all private companies. This accounting rule change would bring shareholder dividends and corporate tax payments to the society as a whole into equivalence. If the political process achieves fair and progressive government fiscal policy, shareholders would also benefit paripassu from those tax payments. Moreover, shareholders should receive a proportional credit for corporate tax payments against their personal income taxes. This tax credit would help to reconcile the amassing of commercial fortune with civic responsibility.
A second reform strategy is for the community to enlist private industry to be the motive force behind the tide of globalization instead of being its flotsam. The privatization of many erstwhile functions of government not only takes advantage of individuals’ creative impulses, but also offers entrepreneurs the incentive to profit from managing what has traditionally been considered to be overhead in running the country. These tasks include, for example, national defense, policing the streets, educating the young, regulating the design and construction of living spaces, and moderating the destructive effects of using energy.
The information technology revolution has made it conceivable that private enterprise can carry out public policy initiatives without government. Just as IT has enabled the creation of virtual corporations, it is tempting to think that the national community can self-regulate through interactive communications. Whether or not that “virtual government” serves the community’s long-term best interests, including sustainable energy use, depends on how compelling a case is made that the success, if not the survival, of each individual or enterprise is unbreakably linked to that of the entire global community.
There is no simple resolution of the conflict between personal and community goals. The fundamental question is whether the cyclical swings between satisfaction of one set of goals and the other will ultimately be sustainable, or whether each swing brings us closer to self-destruction. Specifically, will the private exploitation of the planet’s energy resources harm the welfare of the community at large? Rewarding long-term foresight in the immediate present has always been a challenge; but the consequences of not doing so are potentially more threatening to the health and wealth of the planet than ever before.
It is the function of government to anticipate a danger to public security and enforce measures to deal with it. This is not a function that the market does well, if at all. Nor will incentives tied primarily to the market motivate business leaders to act in the long-term interests of the community. The free-enterprise ideal, in the end, will not be preserved without violating its dominion through authoritative and enlightened political action.
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