Paying Attention to Incentives

The key to successful government reform is getting the incentives right. True privatization makes formerly government services responsive to market signals, which are usually helpful. But incentives can be tricky.

People often apply the term “privatization” to programs that aren’t true privatization. Sometimes opponents of privatization use the term to describe failed semi-privatization efforts, such as the reform of British Rail, in order to discredit the idea of real privatization. And sometimes advocates of half-measures use the term to gain support from backers of real privatization.

During the 1980s, the government of New Zealand decided to privatize its ocean fisheries by giving every fishing boat an annual allocation, in pounds of fish, based on their historic fishing rates. After doing so, the government realized it got the incentives wrong, since every boat then had an incentive to fish its allocation whether it was sustainable or not.

So the government bought back the allocations and then gave them out again in terms of percentages of annual harvest. This gave the fishermen incentives not to overharvest, since overfishing would deplete the fishery and reduce the value of their allocations. The result is that New Zealand today has one of the few healthy ocean fisheries in the world.

British Rail’s privatization separated the infrastructure from the trains. One company, called Railtrack, was to operate and maintain the infrastructure and collect fees from other train operating companies for using the rails. This separation proved a disaster, as Railtrack neglected maintenance in order to earn as much as possible in fees from the operating companies. After several fatal accidents, the government took back the infrastructure and now operates and maintains it itself.

Meanwhile, the operating companies bid to provide passenger service on various routes. Since most passenger trains lose money, most of the bids are negative and the government ends up paying the operating companies to run the trains. Buses would be more efficient and probably wouldn’t require subsidies on many routes, but some people insist on the government providing trains. The result is high costs to taxpayers for a system that really isn’t privatized.

In the United States, many transit agencies have similarly contracted out transit service, paying private companies to operate transit buses or trains on selected routes. Denver’s Regional Transit District (RTD), for example, contracts out half of its bus routes. The operators of the half that are contracted out must pay taxes on fuel and property (which RTD is exempt from paying) and pay wages comparable to RTD (one of them is even unionized). Yet the buses that are contracted out cost half as much to operate, per vehicle mile, as buses that RTD runs itself.

Unfortunately, this savings did not translate into reduced costs to taxpayers. Instead, RTD used the savings to start building an expensive light-rail network. The anticipated costs of constructing the full, 140-mile network are about $10 billion, and after beginning construction with the savings from buses RTD convinced voters to raise taxes to complete it.

As this suggests, one problem with contracting out is that the money saved usually ends up being spent on some other, often frivolous, projects. Another problem is that it still relies on central planners to, in this case, determine the routes and frequencies of bus service, which makes it costly for taxpayers who must foot the bill for routes that can’t be supported by the market.

Most American cities forbid private companies from offering transit service, but a few do not. In Atlanta and Miami, private bus owners compete directly with the public transit agencies, often charging a little lower fare, yet managing to make a profit. This suggests that many cities could completely privatize their transit systems and no longer rely on tax subsidies that currently are used to extend service into suburban neighborhoods, whose residents rarely use transit anyway.

Atlantic City, NJ, has no public buses. Instead, the transit system consists of privately owned “jitneys” that offer 24-hour service on a variety of routes. Some routes are free because they are subsidized by local hotels. Other routes cost $2.25 a ride, with discounts for frequent riders and seniors.

A completely privatized system would schedule bus service on heavily used routes and offer non-scheduled, door-to-door shared-ride service in areas where scheduled service could not earn a profit. Such shared rides, such as SuperShuttle, are available in most cities for getting to and from airports, but most operators are not allowed to take people to other destinations.

San Juan, Puerto Rico has a private, non-scheduled bus system called públicos that competes directly with the public bus and train system. Without any subsidies, the públicos carry more people more miles each year than the subsidized buses and trains combined. All of these examples suggest that transit could be privatized.

Few countries in the world have contemplated complete privatization of roads. But many countries offer franchises to private companies to build roads and toll them for 40 or so years, after which time the road reverts to public ownership. At least one highway in the United States, the Dulles Greenway in Virginia, is completely private, and with electronic tolling, there is no technical obstacle to complete privatization of our road network.

Air traffic control is another candidate for privatization. Canada privatized its air traffic control in 1996, putting in the hands of a non-profit company whose primary goal is safety and which installed the latest air traffic control technologies. In 2010, the company won its second award from the International Air Transport Association, recognizing it as one of the world’s leading air traffic control systems. Meanwhile, the United States still uses antiquated air traffic control systems that depend on federal appropriations to continue.

If it is done wrong, as in the initial New Zealand fishery and British Rail programs, privatization can fail to solve resource problems and even make them worse. But if it is done correctly, full privatization can offer many benefits and save taxpayers money that is now being wasted supporting government bureaucracy and inefficiency.

Also from this issue

Lead Essay

  • In a sweeping essay, Sheldon Richman explains why private property and free competition are superior to state-provided goods and services. He warns against granting “private” corporate monopolies, which are not true privatizations, but act as arms of the state. He adds that for many state activities, the best way to privatize is not to provide the service at all — as in the case of punishing victimless crimes, which no one should do. For legitimate services, he recommends a “homesteading” approach, in which stakeholders in a public service, such as a school, would receive shares in a new, independent corporation.

Response Essays

  • Leonard Gilroy argues for the benefits of incremental privatization. The general public, he writes, must still be convinced that private entities can perform many of the services that have for a long time been provided by monopoly government entities. To win them over, demonstrations will be necessary, and these should be incremental in nature. Gilroy cites several such attempts and argues that they have successfully built support for the idea of privatization.

  • Professor Stevenson agrees that much so-called privatization does not deserve the name. It both fails to shrink the government and also creates new constituencies for government spending–the private firms who win lucrative contracts. That said, we must think very carefully about what a more privatized world would look like, and whether we would really prefer it in all cases. Are we comfortable, for example, with the largely religious education system that would likely replace state-run schools?

  • Randal O’Toole argues that the difference between success and failure in privatization is primarily a matter of incentives. He cites examples of failed incentive structures, like British Rail and New Zealand’s fishing quota system, as well as some successes: Denver’s Regional Transit District has contracted bus service that runs for half the cost of its government-operated lines, and Atlantic City has an entirely private bus fleet.