Center for Business and Public Policy
at the University of Illinois, Urbana-Champaign

Illinois pensions are in the news yet again.  Last month, the Pew Center on the States reported that Illinois was once again the poster child for everything wrong with the funding of state pensions, noting that we had the worst funding ratio of any state in the country.

Last week, Illinois House Speaker Michael Madigan decided – finally – to take some action.  He secured a House vote to change pension benefits for future Illinois state workers.  Specifically, this proposal would raise the full benefit age to 67, cap the maximum pension income at a bit over $100,000, limit cost-of-living increases, and so on.  In short, the package amounts to benefit reductions for not-yet-hired future state workers.  

Why this option?  To put it simply, there are only two options for fixing the funding problem. 

Option one is increase revenue to the system.  In other words, make additional contributions.  But this would require that Illinois lawmakers raise taxes or cut other state spending, neither of which is politically popular.  

Option two is to reduce the liabilities.  But as I have written before, the impairment clause in the state constitution prohibits benefit reductions to existing retirees and existing employees.  So the only way to reduce liabilities is to cut benefits for future workers – those that have not yet joined the system.  And that is precisely what Madigan pushed through the House.

[By the way, the only “option three” is to, in the words of Alan Greenspan when discussing Social Security, is to “repeal the laws of arithmetic.”  I am pretty sure that most state governments would choose this option if they could!]    

As a fiscal conservative, I have no real objection to the decision to reduce future liabilities in the way that the House has chosen to do.  But two issues that have come up in the debate that I think are worth a bit of analytical clarity.  

First, estimates of future savings are almost surely inflated.  There are two reasons for this.  One is that some of the estimates appear to have simply looked at undiscounted dollar flows, which implicitly assumes a dollar saved in 2050 is the same as a dollar saved in 2020.  This is obviously not the case, since a dollar saved earlier has a much higher present value.  A second reasons is that – as I have written before – pensions are part of the overall compensation package.  If we reduce future retirement benefits, our ability to attract top faculty members, for example, will be reduced unless we increase compensation in some other way.  None of the cost savings estimates account for this.    

Second, there is clear confusion about the source of the funding problem.  Much of the rhetoric around this legislation focused on the level of benefits.  The Champaign News-Gazette is a typical example, stating:

“A big part of Illinois’ horrendous budget problems can be traced to the high costs for the lavish pensions many public employees enjoy. They are far more generous than those available to workers in the private sector, and that’s a big reason why state public pensions are underfunded to the tune of an estimated $80 billion.”

This is wrong for several reasons.

First, the real source of the funding problem is not level of benefits.  It is the fact the Illinois legislature has consistently failed to make the annual contributions that are called for under standard funding formulas.  My colleague Fred Giertz has done some calculations suggesting that if the legislature had made its required contributions every year, the Illinois system would be slightly over-funded, not under-funded.  In short, don’t blame the pensioners for the lack of fiscal discipline on the part of our politicians.

Second, the comparison of public pensions to private pensions is misleading.  One reason is that the public pension replaces both Social Security and a private pension.  Social Security costs roughly 12% of payroll today.  Private employers who offer pensions typically contribute several percent more.  On that basis, Illinois public pensions are not “lavish.”  A second reason is that – yes, I am repeating myself – this is part of an overall compensation package.  So any comparison needs to account for the value of all salary and benefits, not just a single piece of it.

Nobody likes new taxes.   When policy wonks like me talk about addressing the problem of global warming by introducing a carbon tax, nobody listens (even though all of the tax revenue could be returned by cutting OTHER distorting taxes on labor or on investment!).  Instead, policymakers like to use the Manhattan Project analogy, essentially saying that we can solve the whole global warming problem just by research and development (R&D), innovation and diffusion of new technology.  We’ll just throw money at the scientists, and they will solve the problem for us.  Policymakers want to subsidize or require wind power, solar power, and other low-carbon technologies.

Here is why that idea will not work, for reasons based on some new research in a book called “Accelerating Innovation in Energy: Insights from Multiple Sectors”, edited by Rebecca Henderson and Richard G. Newell.     To see what might work for energy, they look at technology innovation in all the other sectors where R&D has been successful (the internet, chemicals, agriculture, and semiconductors).  They find that three elements were key in ALL of those success stories: “(1) the substantial, differentiated, end-user demand that enables private firms commercializing the technology to anticipate healthy returns; (2) the sustained funding and effective management of fundamental research; and (3) the development of an institutional environment that includes robust mechanisms to promote the widespread diffusion of both knowledge and technology and that favors vigorous private-sector competition.”

My point is all about #1: there has to be demand in the market for the technology.  No matter how much money Congress throws at the problem of research into new energy technologies, the program will not be successful unless people want to USE those new technologies.  And people will not particularly want to use those new low-carbon technologies, unless they face a carbon tax!  The researchers and developers of new low-carbon technologies might have great ideas, but those ideas will not come to fruition unless people are chomping at the bit to get those new technologies and use them to increase their profits or reduce their carbon tax burden.

My own thinking about this problem relates to the fundamental reasoning for any government policy intervention: the private market works fine unless you can point to a fundamental market failure.  One market failure is the pollution externality from carbon emissions, and that can be addressed by a carbon tax.  A different market failure is that any private firm might not have sufficient incentive to undertake R&D if they don’t capture all the benefits from it.  Patents only last for 17 years, not all ideas can be patented, other firms can see those ideas, and other firms can get similar patents for similar technologies.  These “knowledge spillovers” are a possible justification for government intervention to subsidize basic research, the kind of research that private firms would not undertake sufficiently.

But we still have two different market failures!  Two different market failures require two different policies to address them.  Subsidies for research might help address the knowledge spillover problem, but we still need a carbon tax to get people to want to use those technologies.

That is why we can’t solve the global warming problem by just throwing money into research.

There is an interesting piece in today’s Wall Street Journal by Fred Barnes entitled “The Health-Care Wars Are Only Beginning.”  Here’s a good paragraph:

“America will be in a constant health-care war if ObamaCare is enacted. Passage wouldn’t end the health-care debate. Rather, it would perpetuate ObamaCare as the dominant issue for decades to come, reshape politics, create an annual funding crisis in Congress, and generate a spate of angry lawsuits. Yet few in Washington seem aware of what lies ahead.”

While I agree with Barnes’s basic factual prediction – that we’re going to be fighting battles in this war for decades to come – I disagree on the interpretation.  We’re not fighting a battle over ObamaCare.  We’re fighting a battle over health care.  ObamaCare is the first salvo in a battle against our country’s unsustainable increase in health care costs.  But whether or not Obama and the Democrats had tried to enact this particular set of reforms this year, we are still destined to be in a health care war that will last decades.  We could have removed all regulation from health care and let free markets rule, or we could have enacted a single-payer system and put the government in complete control of the system.  Either way, we’d still be headed toward a constant health-care war.

As I’ve written in the past, the primary challenge facing our health care system (and to a certain extent, our overall economic system) is that growth in health care spending is increasing at a faster rate than the overall economy.  The bulk of this gap appears to be due to rising incomes and increases in medical technology.  Some spending on new technology is probably excessive (other technologies may be under-developed), but to a certain extent we’re spending more and we’re getting more.  [For another interesting take on why health care costs rise faster than the economy as a whole, see this article on the “Baumol Effect.”]

Some people liken high health care spending to an unsightly mole.  All we have to do is find the way to cut out the problem – either through deregulation or nationalizing health care or a several-thousand-page reform bill – and the problem will be fixed.  This oversimplifies the point, and perhaps contributes to the disappointment that the current health reform bills aren’t going to solve the problem.  High health care spending (and more importantly, high health care spending growth) is more like a serious, chronic disease.  It is going to be with us as long as there is an us (U.S.?) for it to be with.  As annual health care spending heads toward one fifth of U.S. GDP and threatens to keep growing, it probably should become a central preoccupation of policymakers.

If ObamaCare passes, we’ll certainly make changes – some in a more free-market direction and others in a more nationalized one – in the years to come.  If it doesn’t pass, we’re going to have to confront these issues soon anyway.  In this sense, whether you favor the current attempt at reform or not, if its passage means that citizens and policymakers will begin to think seriously about the kinds of trade-offs between spending and health care that we want to be making and that we’ll begin to confront these issues instead of kicking them down the road, this should be counted as one of the benefits of the effort.

Last month the Departments of Labor and Treasury issued a Request for Information in order to solicit public comment on ideas related to converting 401(k) account balances into annuities or other guaranteed retirement income streams.  This is a topic about which I have given a lot of thought – indeed, I even wrote a paper recommending that annuities become the “default option” for distributing from 401(k) plans.  (Click HERE to see the paper).

 As I see it, there is a good case to be made for thinking about guaranteed lifelong income as the default distribution option.  My primary motivation is to ensure that individuals have the private sector financial tools available to optimally manage their retirement portfolios in the presence of uncertainty about how long they will live.  Annuities solve this problem by allow one to trade a lump sum of wealth for an income stream that will last as long as you (and possibly a spouse) live.  There are mountains of academic research suggesting that annuities can make people better off by offering a higher level of sustainable consumption, insuring against longevity risk, and so on.

Enter stage right, Newt Gingrich and Peter Ferrara.  In a piece on Investor Business Daily’s website (read it here), they wrote an article entitled “Class Warfare’s Next Target: 401(k) Saving.”  In it, they essentially argue that treating annuities as the default distribution option is somehow a left-wing conspiracy to tax your retirement, force people to buy government bonds, and do other evil things in the name of “class warfare.”  (You can also find it on the AEI webpage and a related post on the conservative blog watch.)

I am extremely puzzled by their hostility towards the general idea.  But before I point out what I do not like, let me point out some valid points they raise:

First, they correctly point out one longer-term risk of a government program that starts out as optional – which is that they can, through the political process, end up paving the way toward a mandate.  There is no question that mandated annuitization would be a bad thing on many levels – it would interfere with individual liberty and choice, it would effectively redistribute resources from the poor (who don’t live as long) to the rich (who tend to live longer), and so on.  So they are right to be concerned about where an optional program will ultimately lead in a political environment – a point that academic economists too often overlook when thinking about optimal policy designs.

 Second, I completely agree with their general dislike of the Ghilarducci proposal to invest in a guaranteed retirement account administered by the Social Security Administration.  Indeed, I could write 20 blogs on all the things I dislike about this proposal, whether it be the absurdly high return that Ghilarducci proposes to guarantee at taxpayer expense (without appropriately accounting for the true economic cost) or the very idea that the under-resourced, overly-bureaucratic Social Security Administration should be expanded into an area that the private sector can run perfectly fine.  

 Third, I certainly cannot quibble with their general ideological distaste for policies that keep “punishing responsibility and rewarding failure.”  As readers of this blog can probably tell, I am an advocate of free market capitalism, and I generally distrust over-reaching government regulation.  

Given all of this, why do I support annuities as a default option?  And why do I disagree with the Gingrich/Ferrara critique?  Here are a few reasons.  I will keep it short so this post does not grow monstrous in size, but perhaps I will return later:

Part of the goal here is to do what conservatives like me generally like – to provide people with more choice, not less.  The idea is to get more plan sponsors to offer annuities as a distribution option from their 401(k) and other DC plans.  Right now, few do so, and so individual participants who want annuity income are forced into the individual market where they don’t get as good of a deal (due to concerns about adverse selection, etc.)

1. We already have a default distribution option from 401(k) plans – in most cases it is to take a lump-sum distribution.  The question is about what type of default option makes the most sense for the most people.  I think the research is pretty clear that most individuals do not have adequate sources of guaranteed retirement income, and that a product that provides guaranteed lifetime income would make them better off.  A lump-sum strikes me as precisely the wrong default option for a retirement plan.
2. What I favor is an optional program.  As I have outlined in my proposal, people would have plenty of opportunity to take an alternative distribution if they want it.  Those who (like me) place a high premium on individual liberty should take comfort in the fact that my proposal would place no restrictions on an individual’s ability to opt out of the annuity if they want.
3. There is nothing in my proposal that forces people to hold treasury bonds or subject themselves to inflation risk, as implied by Gingrich and Ferrara.  Indeed, I am a big advocate of inflation-indexed annuities and/or variable payout life annuities in which the lifetime payouts are linked to an underlying portfolio like those offered by TIAA CREF (disclosure: I am a Trustee for TIAA.)  Plus, an annuity provides what some call a “mortality premium,” which is an extra rate of return in exchange for making the benefits life-contingent.
4. Under my proposal – and under most of the serious proposals I have heard so far – the government (whether it be Social Security Administration or some other agency) would NOT be the administrator of this program.  Rather, plan sponsors could contract with private sector annuity providers – and there is a nice, active, competitive market for such products.

Yes, I am a big fan of free markets.  But only a fool would think that the existing 401(k) system looks like it does because of pure free market forces.  The complicated system we have in place today is as much a creature of government regulation as any program we have.  Indeed, the name “401(k)” itself refers to a section in the Internal Revenue Code! 

As long as we are operating in a world in which government rules largely drive plan sponsor decisions about what kind of retirement plan to offer – and as long as plan design influences participant behavior – and as long as participant behavior drives how well off these participants will be when they retire – then does it not at least make sense to ensure that the basic set of rules be ones that make people’s retirement more secure rather than less?  Especially if we can do it in a way that preserves individual choice?

I respect Gingrich/Ferrara’s healthy skepticism of government.  But sometimes ideology can get in the way of a good idea.  

I just ran across an idea by one of my favorite policy economists, Gene Steuerle of the Urban Institute, in a piece he wrote entitled A New April 15: Make It a Day of Giving (Efficiently).  In a nutshell, he calls for treating charitable contributions in the same manner that we treat IRA contributions - by allowing tax deductibility to extend through the April 15 tax filing deadline.  This is one of those incredibly simple ideas that ought to be implemented tomorrow. 

As background, charitable contributions typically have to be made by December 31 to qualify for deductibility from that year’s taxes.  However, December 31 comes at a time of year in which a lot of people are focused on major holidays rather than taxes.  We allow people to make deductible 2009 IRA contributions as late as April 15, 2010, thus allowing people to make their IRA contribution decision simultaneously with figuring out their 2009 taxes.  This timing is much more salient and allows people to optimize more effectively.  Why not do the same for charitable contributions?  After all, we have done so after major disasters, including the 2005 Tsunami and the 2010 Haiti disaster.  Why not allow it for all contributions every year?

Clearly, this would be a better approach than favoring certain types of deductions over others by extending deductibility on a case-by-base basis, a point made by Howard Gleckman in January recent blog post.  The basic point he makes is that, yes, Haiti needs relief.  But so do hundreds of other incredibly good causes, be it starving children in Somalia or the American Red Cross response to a localized disaster.

As part of my teaching duties, I include a couple of lectures on macroeconomics in my financial economics course.  Now, many of the choices I’ve made in my life can be traced back to a desire to avoid studying macroeconomics.  But, my brief foray into the area this fall taught me an important lesson that is applicable to many areas, including the quest to reduce the cost of health care.

One of the first diagrams presented to macro students is the so-called “circular flow diagram” that depicts how money and goods and services flows up and back between households and firms.  On the output side, firms send goods and services to households and households send money back to the firms in exchange.  If this were all there were, firms would quickly end up with all the money, and the economy would grind to a halt.  However, there is also another side to the diagram.  In order to produce goods and services, firms need inputs like capital and labor, and these are supplied by households.  So, households supply capital and labor to firms, and in exchange firms send money back to households in the form of wages, interest, dividends, profits, etc.  This last is a critical and often overlooked point.  Firms don’t enjoy profits – their owners do.  So, if you think that health insurers are earning excessive profits, what you’re really saying is that the returns to people who own health insurance stocks are too high.  Anyway, the point of the circular flow diagram is that, in equilibrium, these flows are all the same.  In particular, the total expenditure on goods and services must equal the total income to households.

 There’s the rub.  Applied to the context of health care, the circular flow diagram says that total expenditure on health care – including payments to insurers, doctors and hospitals, etc. – must equal total income from health care related activities – including total wages paid to health care workers, profits to health care firms, etc.  Thus, if you are concerned about reducing the rate of expenditure on health care, this is the same as saying that you are concerned with reducing the rate of income from health care.  In other words, reducing either wages of health care workers or profit to health care companies.  And, while many people would like nothing better than to stick it to the big corporations, the ones who really bear the brunt are the owners of these corporations.  And, the populist call for windfall profit taxes on health insurers sound quite different when you realize that it is simultaneously a call for a tax people’s 401k returns!

 So, the lesson from Macroeconomics 101 for health reform (or any other reform for that matter) is that expenditure is just another way of expressing income.  So, reducing expenditure necessarily means reducing somebody’s income.  Seen in that light, it is not so surprising how difficult it has been, and will be, to reduce the rate of expenditure growth in health care.

Jim Berkovec was a colleague and co-author of mine when I was at the University of Virginia.  He then became an economist at the Federal Reserve Board, and later moved to Freddie Mac.  Just a couple of months ago, I got some very bad news that Jim had died in a bicycle accident.  At the young age of 50, he was out for some exercise near his home in the Washington DC area.  He was going too fast down a hill and around a curve, and hit a slippery patch.

So in honor of my friend Jim, I want to tell you about our joint research project, a 1992 paper in the Journal of Political Economy, called “A General Equilibrium Model of Housing, Taxes, and Portfolio Choice.”

This research starts with the observation that a wise diversification strategy would include not only U.S. stocks and bonds, but also real estate (and even assets in other countries).  You don’t want all your eggs in one basket.  And for real estate, diversification would mean spreading your investments across properties in many different locations.  That kind of diversification might be possible for rental real estate, but for two reasons it is not possible for your owner-occupied house. 

First of all, you can’t live in all those diversified locations.  The fact that you own the house where you live means that you must have all your eggs in one basket.  And the federal government encourages people to own their own homes, through tax advantages for homeownership, so the government is discouraging diversification.  When a bad event occurs, the homeowner loses the whole basket.

A second reason the homeowner cannot diversify properly is that the amount of the housing investment must be tied to the amount of housing one wants to consume.  You can’t pick the house size that is best for your investment portfolio, if you have to choose the house size that fits your family or other life style choices.  Some people like to spend their money on vacations or electronics, while others like to live in a great house.  Choosing based on those preferences means not balancing your investment portfolio. 

Having an unbalanced portfolio means taking extra risks, and it makes us worse off.  If you invest in one stock or one asset, you get the normal expected rate of return and a large variance (large risk).  If you invest in a diversified portfolio, you still get the same normal expected rate of return, and low variance (low risk).

That might all seem like an unavoidable fact of life, if folks are to own their own homes.  But government policy can make it better or worse.  Just compare the following alternatives.   If government were to take away some housing incentives by disallowing property tax deductions or mortgage interest deductions, then you would still own your whole house.  Those measures do not help share this risk.  But suppose that government were to treat housing just like any other asset.  That is, suppose you had to treat yourself as a renter in your own home: (1) calculate the amount your house would rent for, if it were rented to someone else, (2) include that imputed rent as income on your income taxes, and (3) continue to deduct mortgage interest paid and property taxes paid, just as a landlord would do.  You could also (4) take additional deductions for maintenance and insurance, as a landlord would do.

If homeowners were all in a 33% tax rate bracket, then the government would be taking one-third of all returns to all housing investments, and it could then return that money to everybody through some other tax reduction.  We would NOT be paying higher taxes, overall, but the net effect is that we each would “own” only 2/3 of our own home, and we would each – through our government – become part owner in one-third of everybody else’s home.

In other words, we all would be better diversified, effectively sharing in the returns to all real estate all around the country, with less of an investment in the one house we choose to live in.  According to the economic model in my research with Jim Berkovec, that policy would make us all unambiguously better off.

Jim was a pretty smart guy, and a great researcher and friend.  We’ll miss him.  Here is the official “abstract” of the more technical version of this research paper:

We describe a model in which rental and owner housing are risky assets, tenure choice is endogenous, and each household is constrained to consume the same amount of owner housing that it has in its investment portfolio. At each iteration in the search for an equilibrium, we determine the new taxable income for each of 3,578 households (from the Survey of Consumer Finances), and we use statutory schedules to find the marginal rate and tax paid. Equilibrium net rates of return are major determinants of the amount of owner housing, but a logit model indicates that demographic factors are the main determinants of ownership rates. In our simulation, taxes on owner housing would raise welfare not only by reallocating capital but also by the government’s taking part of the risk from individual properties and diversifying it away. Measures to disallow property tax or mortgage interest deductions do not help share this risk. Simulations of the 1986 tax reform indicate a small shift from rental to owner housing and welfare gains from reallocating risk.

In the last few weeks, the lousy funding status of state and local pension plans was back in the news, thanks primarily to a new study released by the Pew Center on the States (click here for a link to the study).

The news is not good.  The study reports that there is a $1 trillion gap “between the $3.35 trillion in pension, health care and other retirement benefits states have promised their current and retired workers as of fiscal year 2008 and the $2.35 trillion they have on hand to pay for them.”  In fact, the news is probably even worse because this study was conducted before the worst of the equity market decline in late 2008.  

For those readers here in Illinois, you probably already know that our state is among the worst.   According to the Pew Study, “Illinois was in the worst shape of any state, with a funding level of 54 percent and an unfunded liability of more than $54 billion.”  Not that any of us are surprised to learn that Illinois is a case study in bad governance …

I’ve written before (here) about why the pension funding hole may be even worse than the official statistics indicate, especially in those states that have constitutional guarantees of benefits.  What I thought I would do today is make a simple point about an important asymmetry in how funding levels affect pension obligations and what this implies about appropriate funding levels and portfolio allocations.

Let me be clear at the outset – I am usually an advocate of fully funding our pensions.  And I wish we lived in a world in which politicians could engage in rational policy-making based on good economics.  This would include providing responsible levels of pension benefits to public employees and properly funding them.  Unfortunately, we do not live in such a world.  So I thought it would be fun to speculate for a moment about what this political reality implies for pension funding.

I’ve read quite a bit about the history of state pension plans over the past few decades.  I believe the following is almost surely true:  in good economic times (rising state revenues, high equity values, more fully funded pension funds), state governments appear much more likely to increase the generosity of pensions.  But in bad economic times (falling revenues, low equity values, larger funding shortfalls), these same states are legally and/or politically unable to decrease the generosity of pensions.    

This assymetry (increasing benefits in good times, but not being able to cut them in bad times) creates a bit of a conundrum for those of us who normally advocate full funding of pensions.  The reason is that the asymmetric political response suggests that some level of under-funding might actually be optimal (at least in a “second best” sense) because it serves as a constraint on further benefit increases!  

In short, we may prefer that our politicians underfund the pension obligation in order to limit the size of the obligation that ultimately needs to be funded.  Rational economic policy would not have to resort to such tactics.  Real economic policy in a political world might need to do so.

I do, of course, realize the irony here.  Namely that bad economic policy – our inability to have a rational, coherent approach to benefits for public sector workers – is serving as the basis for justifying more bad economic policy – underfunding our pensions.  But as the “theory of the second best” points out, in the presence of one distortion, sometimes society is better served by a second distortion that helps to offset the first.  

I spent a good chunk of last week working with US and Mexican colleagues, looking at data from a forest conservation program in Mexico. This “Payment for Environmental Services” (PES) program is in the highly threatened area where Monarch butterflies stay over winter. The program pays producers and communities not to log their forestland, as a means to halt the rapid deforestation that has threatened the area for years. While in many cases, PES programs have been placed in regions with little initial threat of logging, this region is at the opposite end of the spectrum. The program operates in an area with a very high threat of logging, and the real worry is that the most tempting lands left are those with the relatively pristine, dense forests – the ones in the core of the Monarch butterfly area.

At first glance, one might think the program looks like a great success. The land inside the program area is much more heavily forested than the land outside, so a quick comparison of average forest cover argues that the program is working. At a second glance, the program looks like an abject failure. Comparing deforestation rates, we see more logging inside the core region than outside, so clearly the payments aren’t working. The real problem of course is twofold: first, the core land was selected to be in the program because it was more forested. Second, as other lands are deforested, the core zone becomes increasingly attractive to loggers, and it becomes harder and harder to keep the illegal loggers out.

These PES programs, where villagers are paid for providing an environmental service, are notoriously hard to evaluate. First is the problem that many such programs are put in places where people would likely have never cut down the forest in the first place. So the program may be only paying people for doing something they would have already done anyway (“additionality”). To determine the true opportunity cost of preserving this land – i.e. to determine whether these communities would have kept their forests intact without the payment – it’s helpful to have a control group to compare them to. But finding true control groups is tricky. For example, in places where there is a lot of logging pressure, by taking some land out of production, other neighboring land becomes more valuable, and therefore subject to higher logging pressure (“spillover effect”).
If this second effect is in place, just comparing the land use of those receiving the payment to those who are not will give a biased result. Since the program is driving increased logging into the control group, it’s going to look like the program is working amazingly well, even though overall deforestation hasn’t changed.

After trying to explain the pressure for logging using physical characteristics of the land and transportation cost, I found that when one looks at the map of deforestation, deforestation follows community boundaries amazingly well. So, for all that one would expect the high-value forest to get cut first, or land close to roads to be particularly at risk, deforestation, at least in part, seems to come down to community governance. Some communities have not only ceased logging, they are patrolling their forest to keep their trees safe. Other communities are not being so diligent. In some cases the illegal logging is spilling over from neighboring logged regions. In other cases, the community itself is split, and the faction that didn’t agree with the decision to participate in the conservation program just went ahead and logged anyway. We also observe some communities who refused to take the money even though they were formally losing the right to log. Rumors are that leaders in these communities did not want to give up the opaque payments they receive from the forestry companies in exchange for the very transparent payments they would receive from the conservation fund. Besides, illegal logging is rarely prosecuted, so losing the right to log was not apparently as great a threat as one might hope.

Why do we care? One reason we might is that a number of countries are looking at imposing these PES programs to pay for carbon sequestration (often referred to as “reducing emissions from deforestation in developing countries, or REDD).   The point is that when we consider any form of payment for environmental service, we need to consider the community institutions needed for such a program to be successful. Now, the situation in this conservation program in Mexico is complicated by the fact that land is often managed communally, but even if one is relying on a group or institution to organize private property owners, one could see similar problems. Second, much land in developing countries, particularly land that might be the target of a carbon-based reforestation program, is owned collectively. If all we are interested in is preserving carbon, we may just want to target well governed communities, to ensure that PES actually produce what was purchased. If we want to deliver development goals, we may need for some thought to go into designing PES programs that not only pay communities, but also help them establish the institutional structure needed to deliver the services purchased.