A couple of news stories this morning, both coincidentally having to do with Massachusetts governor Mitt Romney, got me thinking about perverse incentives. Because incentives are at the heart of capitalist/free-market economic theory, and often of my disagreement with laissez-faire dogma, perverse incentives are something I think about often. In fact, I just noticed that two of my drafts here have to do with different variants of the same topic. I’ll get to those below; first, here are the two items about Romney.
The first news item is that Romney wants to reduce the state income tax, in accordance with a 2000 referendum. At many levels it’s The Right Thing To Do. However, it made me think about the general politics of tax cuts and increases. One of the most effective moves a politician (usually an executive) can make is to push for a tax cut that they know cannot be made permanent. They get credit for lowering taxes and their opponents (usually in the legislature) get blame for raising them subsequently, which is a major win even though the practical net effect of the whole process is nil. The same approach can be applied to any other issue where one can create a perception of pushing for a particular outcome even if there’s no actual hope of it being achieved. The perverse incentive here is to waste everyone’s time going back and forth on an issue, coming back to the same point with no change except the political.
The other news item is Romney’s education-reform plan, which includes substantial “merit pay” for teachers whose students do well on standardized tests. Unfortunately, many implementations of teacher merit pay account only for output and not input, creating a perverse incentive for teachers to seek assignments with the best students. The more difficult students, who one could argue need the most help, are not profitable, and so they’re practically abandoned – similarly to what already happens under Bush’s No Profitable Child Left Behind act, but more so. If merit pay is based only on outcomes, and not on outcomes relative to incoming student ability, then it tends to have no or negative effect on overall student performance. Teachers need an incentive to tackle hard problems, not rewards for sticking to the easy ones.
The first old example of perverse incentives has to do with health insurance. Everybody wants lower premiums, creating fierce competition among insurers on that basis. So far, so good. However, this competition creates not only good incentives (e.g. to reduce waste or help subscribers prevent illness) but also perverse ones (e.g. to deny legitimate claims or to exploit their own employees). Nobody switches insurers because of how they treat their employees. This is related to the collapse of public health that Laurie Garrett details in Betrayal of Trust. Late-stage medical intervention is not more cost-effective than preventive care, but it’s more profitable. In fact, profit tracks cost, so there’s actually an incentive in the system to favor the highest-cost approaches to health care instead of the lowest-cost. This is why the US has by far the highest health-care costs in the world, in return for outcomes that are significantly worse than several other nations. As usual with perverse incentives, the solution is to provide a different incentive – in this case by making prevention profitable.
The second old example has to do with privacy. This is an area where the market cannot be trusted to regulate itself, because those who possess and abuse a resource (your personal information) have absolutely no incentive to do so. Their customers are the people who buy such information, who – by definition – have an incentive favoring such abuse. The information brokers profit because they shift the cost (negative effects to you) onto others.
What both of these old examples have in common is the nature of the solution. That solution is not to have the government take over a function (public health) or engage in fiat regulation (privacy). Markets work. Let’s use them, but use them to promote the common good instead of undermine it. What the government can do in both cases is change the incentives. If the government were to make prevention profitable, instead of subsidizing the larger cost of facilities used for treatment later, the market would respond well instead of badly and we might actually have a functioning health-care system. If privacy were treated as a commodity, and information brokers required to reimburse individuals for consuming or degrading that commodity, they market would respond and companies would lose interest in invading privacy. A similar “change the incentives” principle might apply to teacher merit pay.
The main point here is that part of evaluating a government policy should always be to consider what incentives it creates for whom, and whether those incentives actually promote the policy’s stated goals. Unfortunately, anyone who looks at contemporary US politics through such a lens will find that such a match rarely occurs. Most bills, particularly at the federal level, are riddled with perverse incentives. As if by coincidence (but it’s not) these incentives almost always lead to benefits for the same people and groups, regardless of who the politicians say will benefit. These are all examples of the political problem I mentioned first, of politicians doing things that are popular but wrong, because that’s where their own incentive lies. The solution to that particular problem is to change their incentives by becoming more educated and insisting on sound policy instead of gamesmanship.
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