Regulation: So what would I do?

This post is a very slightly scrubbed up comment on Paul Frijters’ comment on my recent column on regulation review and DIY super.

I have no silver bullets, but I think the whole area is dominated by a kind of category mistake. It has been assumed – by the reg review crowd and by the BCA and by regulation consultants and many commentators – that the problem we have is ‘over regulation’ and thus that the solution is the imposition of constraints on regulation.

The thinking is that if we erect barriers to poor regulation, the result will be better regulation. In a sense this is tautologically true – if you think that reg analysis will leave only cost effective regulation, what’s there not to like? Still regulation is one of the few major activities of government. Why is our scrutiny of regulation only a scrutiny of over-regulation. Why are we not focused not just on lowering its costs but on optimising its benefits?

I call this the Michelangelo theory of regulation after Michelangelo’s suggestion that sculpture involved take a block of marble and removing all the marble that wasn’t supposed to be in the sculpture you’re carving. Voila.

Beyond this problem, and even in the terms RIA is cast, the real questions are
1) if there are incentive issues producing the problems in the first place, does RIA solve them? I’ve argued no.
2) are RIAs a cognitively efficient way of working out how to regulate better?

On this second question there’s a presumption in all this that one can design systems which surveil regulation making from the top of some command structure. This is flattering to those at the top and those who like to pontificate about policy as if nutting it out from the top enables one to impose the right policy and then things jolly well sort themselves out. When the BCA produces work on regulation it hires some consultants and they produce very high level reports on, for instance which states have the ‘best’ reg review systems. Indeed, they produce a ‘scorecard?‘ (pdf). Everyone loves a scorecard.  Pity that to produce a good one you’d have to know more than any consultant or any organisation could ever know.

What if it’s not really like that? If you honestly do an RIA and think about it, you rapidly come to realise that they’re completely unsuited to the job they’re supposed to be doing. For instance, Lateral Economics did an RIS of pharmacy regulations. It was a pretty Mickey Mouse affair with about three real questions. How long should the ‘preceptorship’ – internship after graduation – be? Should there be a special private area in pharmacies and what would be the best way to provide for it? What equipment should be mandated? How would you handle those in an RIS? We had no idea. No-one had any idea. The literature had virtually nothing to say on the questions. The ‘answer’ is, I think that the regulatory system should itself operate so as to continually generate data and reflect on those issues so they can be optimised. That’s what we proposed – to the howling indifference of everyone who had been through a year of reg design and consultation and wanted their RIS ticked off. But some mug economist sitting in an office running his ruler over the activities of the regulators like a philosopher king is absurd (or was in this case).

Further, the analysis we actually did on those three questions ran to 60 odd pages. Imagine if you really were doing an analysis of all aspects of a substantial piece of regulation. In addition to being relatively clueless ‘in principal’ advice, the RIS would run to thousands of pages examining each regulatory option chosen. Go read some RIS’s if you think this is drawing a long bow. For instance here’s the Stronger Super RIS. It’s 83 pages long (rtf). It’s got umpteen sections each supposedly focusing on a major aspect of the relevant legislation/regulation. But the way all the complexity is handled – is to boil all the decisions down to a choice between (almost invariably) three different options – as called for in the RIS handbook. Very rarely is that a sensible or reasoned way to come to a decision. Often one or even two of the three options are silly or not really contenders. And guess which option that leaves? Usually it’s a silly way to reason one’s way towards decisions.

I think the metaphor of regulation should be a different one and have written about some of this in this Lateral Economics paper on Regulation and Innovation (pdf). I think we should be thinking of regulation as a complex system and one that requires high quality maintenance and governance right down to the level of the micro-detail. We have some examples of how this is done in business. It’s not done by getting consultants in or by command and control systems in which the managers and the engineers work it all out and then pass it down to the proles to implement.

It’s done by optimising the micro-detail. And that requires that those in the chain of command buy into the mission and have the authority and the tools and the incentives (usually these are social, reputational and promotional rather than financial incentives) to optimise their own effectiveness. The Toyota Production System is emblematic of this kind of thing. Now it would be tautologically true to say that every change in the production line in a Toyota factory should be cost effective. But of course they don’t run cost benefit analyses on every change, or even any of them. They try to measure what they do and create the scope for those on the line to understand what they’re doing and together to optimise it.

Is this kind of thing a pipe-dream in regulation? Well perhaps doing it really well is, but it’s at least an appropriate model of what would be a system that worked. If regulation is important and if the volume of regulation is considerable – which it is in most areas – then minimising unnecessary regulation might be worthwhile, but optimising what’s there (for instance quickly enabling new approaches to emerge where they are worth trying and actually regulating to try to generate results – like safer, higher return superannuation funds, better informed markets etc) should be at least equally important though my guess would be that it would be a whole lot more important. And anyway, even if one were trying to achieve ‘minimum effective regulation’ we know that the current dysfunctional – or perhaps it would be fairer to just say ‘non-functional’ – system doesn’t come close to delivering it. So there’s not a lot to lose.

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derrida derider
derrida derider
8 years ago

As you probably know from previous comments I’ve always thought compulsory super is bad in principle, being founded on a series of economic fallacies. But in addition to my in principle objections, it was always plain from the start that the politics of it meant it was going to be a complete dog in its actual implementation.

Now this dog that was just an annoyance when the rate was 3%, but is doing serious damage to the welfare of large numbers of Australians at 12%. But then we always understood that one of the problems of introducing compulsory super was that we’d create a superbly funded lobby for assorted rent seekers to get their hands ever deeper into average Aussie’s pockets, so the rate was always going to rise.

In retrospect, it really would have been better if we’d opted for special bank deposits rather than giving “flexibility” in specially created funds, which is what the banks in fact lobbied for (they too were slavering over the future rents). The banks are efficient intermediaries who would hide investment complexity from the punters and would bear most of the risk too. The huge pot of money would have brought many new (mostly foreign) entrants into the banking sector, with welcome competitive effect on the rest of our banking sector. And for all the events of 2007 its still a helluva lot easier to regulate (and if necessary rescue) a few dozen banks than half a million super funds.

john r walker
john r walker(@annesanders)
8 years ago
Reply to  Nicholas Gruen

Nicholas
Just how many SMSFs end up down the gurgler?- given the rather poor performance of the managed sector I would not be surprised if SMSFs taken as a whole out performed the managed sector.

john r walker
john r walker(@annesanders)
8 years ago
Reply to  Nicholas Gruen

Nicholas
I overall agree , but I do wonder as a percentage of total numbers, just how many SMSFs have seen large negative growth in the past few years (or have disappeared down a ponzie event horizon)… is it a significant number?

I.e is the ‘need’ for regulation to protect or is it need for ‘regulation’.

john r walker
john r walker(@annesanders)
8 years ago
Reply to  Nicholas Gruen

PS just how big is the SMFS sector relative to the group managed sector and how has the mix changed over the past 5 years?
Despite being self employed we currently have our super in industry fund- it was less hassle- however we will be moving to SMSF simply because of the amount of money that is being lost- and bugger the hassle . Personally I think the problem is more about the uncompetitive unatractive nature of the management of large compulsory super funds than anything else.

Paul Frijters
Paul Frijters
8 years ago

Nick,

thanks for this. I certainly buy the argument that regulation is part of an evolving complex system. And sure, in many cases it would be better to have a networking-type organisation (dare i say based on team-spirit?) where the lower-downs are trusted to make decisions that are not too harmful and that, if there is some discretion everywhere in the system, that most problems get sorted out by others close to the coal face.

I would simply call this ‘decentralisation’: you are really talking about a change in the power structure of organisations, and then particularly ministries. What you envisage is more or less what is already normal in Scandinavian countries. More openness, more power lower-down, more self-reliance, less rents skimmed off at the top.

That is a societal transformation, Nick. You really are a revolutionary in a suit!

derrida derider
derrida derider
8 years ago

John, you may be right that there are more SMSFs outperforming than underperforming the managed sector (especially after the opportunities an SMSF gives some people to tread along the fine line between tax avoidance and tax evasion). But the point is a large fund pooling many peoples’ money has both an insurance element and an information-economising element which is lost with SMSFs. The second is especially important – underperforming SMSFs are differentially likely to belong to those least equipped to get and mange information – ie the least well off. If you must have a compulsory savings scheme (and I won’t go into why I think that’s a bad idea here) all experience shows extreme simplicity is essential if you don’t want large numbers of people badly ripped off. There really are times when “choice” is a Bad Thing.

I was interested in Nicholas’ advocacy of tax-favoured savings schemes. Such schemes will usually reduce national savings by reducing government saving more than it increases net private saving, unless the lost revenue is made up by higher taxes elsewhere. If you make it up by higher income or wealth taxes then you’ve just offset your new savings incentive with a new disincentive. If you make it up by consumption taxes then you could achieve exactly the same effects (better incentives to save at the cost of reduced progressivity) much more simply and cheaply by merely raising consumption taxes to fund lower income taxes.

john r walker
john r walker(@annesanders)
8 years ago
Reply to  Nicholas Gruen

nicholas
super contributions are taxed at a much lower rate than the tax on income saved in a non super investment, are you opposed to supers “tax favored” status?

Pedro
Pedro
8 years ago
Reply to  john r walker

Of course tax concessions will generally go to the well-off, they pay the most tax. But surely:
1 tax concessions for savings could be capped;
2 invested savings may be more valuable to the less well off than the taxes;
3 another way to think about savings concessions is that you are redefining taxable income to exclude deferred consumption.

I always think tax-subsidy is a misleading term. How is a progressive system not a tax-subsidy from the rich to the poor?

john r walker
john r walker(@annesanders)
8 years ago
Reply to  Nicholas Gruen

Negative/zero growth (after costs) is not too hard to beat.

Pedro
Pedro
8 years ago

“In retrospect, it really would have been better if we’d opted for special bank deposits”

Hear hear!

“Rather there will be the occasional disaster and then it will be a case of ‘tough luck’ for the mugs who got suckered by the spivs”
And this is the case with all investment risk. The effectiveness of regulation to manage investment risk seems low.

More broadly on the topic. In my experience one of the issues with regulation is that govts appear to have limited time to fix the crap and so bad regulation will last years unless there is a sufficiently large interest group complaining about it. I think this would be a major barrier to continuous improvement, even though continuous improvement is obviously a sensible approach to a very complex issue.

Pedro
Pedro
8 years ago
Reply to  Nicholas Gruen

Yes, but then the regulators need the power to amend the rules they regulate, which they normally don’t have. It is true that Regulations, as compared to Acts, are easier to change, but in Qld, and I expect everywhere else, it still requires the Governor in Council. I completely agree with continuous improvement as an excellent approach, but it needs institutions rearrangements.

Richard Jamonts
8 years ago

Two thoughts: I wonder if the question of regulation, not only in super but more broadly, needs to shift from a focus on the drivers of activity (whether they be rules or principles) to definitions of boundaries; where we accept any pathway that leads to outcomes consistent with predefined conditions. In super this might mean demanding less be spent on compulsory auditing (an activity) at the same time proscribing an outcome where the income of brokers and fund managers is a set percentage of both profits and losses but where they are free to earn this through either some form of fixed payment or commission at their discretion. This would obviously have a dramatic impact on industry practises (perhaps it would lead to more conservative investment strategies and require them to provision for potential losses) and even the type of people who work in the industry (but given the track record of most fund managers over the last ten years we could do with more Warren Buffets and fewer Gordon Gekkos anyway). I would also frustrate holders of SMSFs chasing high risk-high return outcomes but who’s to say the fault for the GFC doesn’t in part lie with even greedy “mum and dad” investors? There would be less auditing (and fees for accountants) but maybe there’d also be less need for auditing given more conservative strategies being applied.

My second point about regulation, in a broader context, is that we need to reconsider what i believe is an unspoken assumption: that it’s even possible to design a system where nobody loses. Whether it be in the super industry or in organisational design and management there are many who look for the magic pill that will ensure “it works perfectly all the time”. Tabloid media searches for and sensationalises a small number of genuinely sad stories about unfortunate people who lose their savings – politicians and regulators apply another round of rules or principles in response; they may as well look up at the windmills. This isn’t to say we should be unsympathetic to those who miss out – it’s just that efforts to protect everyone usually end up hurting someone else. Better i think to ensure that we anticipate and accept losses in any complex system and put our effort into doing all we can to give people the best chance of success whilst establishing supporting infrastructure (whatever that might be) to help those that miss out

john r walker
john r walker(@annesanders)
8 years ago
Reply to  Nicholas Gruen

” just what vehicles you do the saving in?” the tax concessions viewed the other way round are a large penalty against savings that are not put into super, and that is my beef with it.

john r walker
john r walker(@annesanders)
8 years ago
Reply to  john r walker

For the self employed running their own small biz the tax differential is/was provably the only reason why investment in Super as a particular way of saving/investment was effectively compulsory.

Anybody fully exposed to the ups and downs must be quick and adaptable. Super is a very inflexible investment- for example the money I have tied up in my current super cannot be accessed until I ahem “retire” I.e I can acess it posthumously . If super contributions were treated the same tax way as other income I would have never gone near it, it really is worse than useless.

I certainly cannot relocate my current super to investment in what I do for a living, learning new stuff, payments for new ‘plant and equipment’ and on and on, rather I must draw down on better performing investments and take a bigger line of credit.

When you say you favor compulsory super without the tax perks , how would you in practice make such an unattractive option effectively compulsory ?

PS
Nicholas
I have quickly read your paper on Regulation and Innovation,for what its worth, I think its good stuff. However the governments form over the five past years is not encouraging.
Our experience is that :
a) if its not regulated then that is sufficient reason/need for new regulation.
b) If the new regulations only harm things that are spread out and/or hard to see, the regulation is a success.
And
c) if the new regulations turn out to be a bit too obviously toxic- dead bat till the end of 2013 and leave it for the next government to sort out the mess (and get the blame for it).

john r walker
john r walker(@annesanders)
8 years ago
Reply to  john r walker

We have always been careful about money, only as good as my last show type stuff.

For the self employed how would you force me to invest in rigidly defined super, if not by effective tax penalties ? jail?

Pedro
Pedro
8 years ago
Reply to  Nicholas Gruen

NG, I was thinking about saving concessions for a world without compulsory super, and I suggested a cap. I’m an even more free market kinda guy obviously, so I’ll always prefer lower taxes, but I think there is good sense in removing compulsory super and bringing in voluntary tax advantaged-savings with a cap on the tax free capital amount.

Tim Macknay
Tim Macknay
8 years ago

I think RIA can work well if the participants treat it pragmatically as a problem-solving exercise. In my experience it’s been very useful in making the proponents of regulation think harder about why they are taking a particular regulatory approach, and about who the regulation will affect and how. I agree the process focuses on constraining regulation, but I surmise that the presumption is that government agencies are already sufficiently motivated to regulate. In my experience, this is the case.

Tim Macknay
Tim Macknay
8 years ago
Reply to  Nicholas Gruen

That’s quite true Nicholas. Once an agency has internalised the practice of thinking about costs and benefits, there shouldn’t be any further need for a formalised, externally administered RIA system. Then it becomes a pointless bureacratic exercise.

john r walker
john r walker(@annesanders)
8 years ago

Tax rates of about 25% to 40% and then a additional 12% of income compulsorily sequestered in some fund till you retire at 70+ … courageous .

Financial friends tell me that Super is a slow moving debacle. The big funds have very over invested in equities – unlikely to recover value for a long time. The funds investment research apparently resulted ind a spread that copied what everybody else was doing and they have also put a fair bit on bets on the market index = long term adjusted, after management costs, net loss.

The tax deductions are necessary to make the system look better less ugly, add in the forgone taxes and whilst great policy it equals bad reality.