Animal Testing: An Outdated Model

Posted by on Jun 29, 2012

Filed Under (Environmental Policy, Other Topics)

In 2010, U.S. researchers conducted experiments on 1,134,693 animals – including 71,317 nonhuman primates – according to U.S. Department of Agriculture data collected in compliance with the Animal Welfare Act (source).  Almost 100,000 of those animals were subjected to experiments in which researchers intentionally inflicted pain and did not administer pain relief.  These data exclude experiments conducted on birds, mice, and rats because they do not fall under the definition of “animal” used in the AWA (source), and thus the real number of animals under experimentation in the U.S. could be in the tens of millions per year.

What, if anything, does society gain from these experiments on animals?  The statistics say not much.

Many argue that animal experimentation is most useful in pharmaceutical research and vital to new drug development.  However, a Food and Drug Administration (FDA) study found that “92 out of every 100 drugs that successfully pass animal trials and go into human clinical testing fail during the human clinical trial phase (source/source).”   That is a lot of animal suffering for less than a 10% success rate on humans.

Question: What about the drugs that do not pass the animal testing and thus “save” humans from harm?  Answer: With such a dismal record of prediction in one direction (success on animals to success on humans), what makes us confident of our predictive powers in the other direction (failure on animals to failure on humans)?  Of course, we do not have statistics on this counterfactual and thus will never know.  Indeed, it is possible that the miracle cure for cancer in humans failed trials with mice and thus was not tested on humans.

It seems clear that pharmaceutical companies and the FDA are reluctant to drop animal testing for one important reason: liability.  They want to be able to say ‘look, we tried it on animals’ if something goes wrong in the human testing phase.  However, even after all that testing on animal, and then on humans, the FDA still has to recall from market hundreds and sometimes thousands of drugs per year (source).  Stop experimenting on animals now, it only causes suffering for them and humans do not see much benefit – if any at all.

 

Environmental Policy Update:  Many contributors on this blog have written about climate change policy.  With the Supreme Court’s health care ruling yesterday, I thought this piece of news might fall under the radar.  On Tuesday, a federal appeals court rejected multiple challenges to new U.S. Environmental Protection Agency (EPA) rules that would reduce greenhouse gas emissions at large sources, such as power plants and large factories.  Michael Gerrard, director of the Center for Climate Change Law at Columbia University, said the decision was exceeded in importance only by the Supreme Court ruling five years ago that greenhouse gases could be controlled as air pollutants (source).

Breaking News: Supreme Court Upholds Individual Mandate

Posted by on Jun 28, 2012

Filed Under (Health Care, U.S. Fiscal Policy)

Hot off the Internet, the Supreme Court has upheld the “Obamacare” individual mandate, which requires most people to buy health insurance or else pay a tax.  The ruling isn’t available yet, but I have to say that I’m really, really impressed by this decision because it shows that the Supreme Court was able to look beyond the politics of the situation and the poor argument by the administration in defense of the bill, and rule according to the law.

The argument against the mandate was that it violated the Commerce Clause of the Constitution in that it regulated economic “inactivity” rather than activity.  That is, it forced people to participate in the individual insurance market even if they didn’t want to.  The administration flubbed its defense on this point by failing to show how health insurance markets are different than most other markets, giving the Supreme Court a limiting principle that would prohibit the ruling from establishing that Congress can regulate anything it wants.

It sounds like the Supreme Court did not buy the argument that the indivual mandate was justified under the Commerce Clause.  But, in some sense this is all a red herring.  The individual mandate is a tax, plain and simple.  People who do not buy health insurance must pay a fine to the IRS.  A fine paid to the IRS is a tax.  The Democrats and the administration tried to hide the fact that this was a tax while rallying support for the bill for obvious reasons.  Nobody wanted to be seen as raising taxes, and President Obama had promised during the campaign that he would not raise taxes for middle income Americans.  But, just because the Democrats wanted to pretend that this wasn’t a tax, that doesn’t make it true.  It’s a tax. And, Congress has the right to impose taxes.

Despite the fact that the administration did not emphasize the tax aspect of PPACA’s indivual mandate in either its presetation of the bill to the public or in its defense before the Supreme Court, the Court was able to step beyond the narrative that was being fed to them and identify the key legal principle involved.

Whether you support the bill or not, I think that in a post Bush v. Gore / Citizens United world, when people are wondering whether the Supreme Court really is an impartial arbiter of the law, you have to see this as a great moment for the Court.  Hooray for them.

More after I have a chance to look at the ruling.

Professor Tenure as Insurance: What the Wall Street Journal Debate Missed

Posted by on Jun 25, 2012

Filed Under (Uncategorized)

Today’s Wall Street Journal carried a piece called “Should Tenure for College Professors Be Abolished?”  It pitted two individuals with strongly held views against each other on the issue.  As so often happens when people are advocating rather than analyzing, both sides selectively examined the issue.

In favor of abolishing tenure, the WSJ featured Naomi Schaefer Riley, a critic of the tenure system who appears to believe that teaching is the only worthwhile activity in which academics engage.  It was a bit ironic for me to read this on a day in which I am sitting at an academic conference on consumer financial decision-making in Boulder, exchanging ideas with some of the nation’s top scholars from a diverse set of fields (including law, economics, marketing, psychology, law and public policy) regarding new research that is both widely read and enormously impactful in the real world.  As but one example, the conference was kicked off yesterday by Shlomo Benartzi at UCLA, who reminded audience members how academic research led to a revolution in retirement policy in the U.S., improving the retirement security of millions of Americans by increasing participation and contribution rates to 401(k) plans by leveraging the insights of psychology and behavioral economics.  Apparently, Ms. Riley does not believe that such activities add much value and that we academics should just stay on campus and teach.

Defending the tenure system was Dr. Cary Nelson, an English professor at my own academic institution (the University of Illinois) and President of the American Association of University Professors.  Dr. Nelson seems to believe that tenure is “the ultimate quality check” and that academic freedom would crumble if people were not granted lifetime tenure.  I am unaware of any compelling evidence supporting such claims, although I cannot refute them either.

As an economist, I think that both authors – neither of whom I found particularly persuasive – missed an obvious way to frame this issue.  Namely, tenure is a form of insurance.  And like any insurance, it has both positive and negative effects.  Here are a few:

  1. Tenure reduces the cost of hiring faculty.  Tenure – insurance against job loss – is highly valuable, and therefore substitutes for other forms of compensation. In a competitive labor market (and, contrary to what many non-academics believe, the market for faculty is extremely competitive), tenure means that institutions do not have to pay faculty as much in the form of cash or benefits.  If we abolish tenure, the new market equilibrium would result in higher average salaries, thus further increasing the cost of education.
  2. Tenure creates moral hazard:  Moral hazard is the well-established phenomenon that people behave differently when they have insurance than when they do not.  Because tenure provides insurance against the loss of a job  – in spite of Dr. Nelson’s protests to the contrary – tenure can have the effect of making some faculty members reduce effort.

To be clear, I honestly do not believe this reduction in effort is the case with the vast majority of the tenured faculty members that I know – in fact, most of us lament the fact that, post-tenure, our work hours and the demands on our time increase.  Indeed, I think the selection effect is huge – gaining tenure is so difficult at the top institutions that the only people who make it are, by their nature, extremely driven individuals.  Most of these people do not shut-down after tenure – it is simply not in their DNA.  So, one way to view the tenure process is that it creates enormously strong incentives to excel for during the probationary, pre-tenure period (that typically lasts anywhere from 6-10 years).  This is not all that different from many partnerships – law firms, accounting firms, etc. – that work their junior associates to the bone in exchange for eventually becoming a partner.  I am not suggesting that partners have indefinite tenure, only that the incentive effects early in one’s career make untenured assistant professors some of the hardest working people I have ever met.

However, although it is the exception rather than the norm, all of us in the academy know members of the faculty – thankfully, far fewer in numbers than most non-academics imagine – that take advantage of their protected status by slacking.  Their research productivity declines, they spend less time preparing for classes, and they are less engaged in their departments and professions.  This “dead wood” – while not exceedingly common – is exceedingly costly when it occurs.  Most of us in universities would love to rid ourselves of this problem.

I may be in a minority of faculty, but I would personally not mind having a conversation about abolishing tenure and replacing it with a system of, say, 5-year renewable contracts, but not for the naïve and misguided reasons that Ms. Riley states.  Rather, I believe that for the highly productive among us, our salaries would increase and we would have an effective tool for eliminating the deadwood in our ranks.

Granted, the “tenure as insurance” framework is far from the only set of factors that ought to be considered.  Some of the issues raised by Ms. Riley and Dr. Nelson – how tenure affects risk-taking, teaching quality, and so forth – are incredibly important considerations.  It would just be nice to have some solid empirical evidence on the size and direction of these effects before taking a final stand on the issue.  Until I see it, I am going to head back downstairs to the behavioral decision-making context to see some of the research that I honestly believe is going to help improve lives.

Cigarettes and the government budget

Posted by on Jun 24, 2012

Filed Under (Health Care, U.S. Fiscal Policy)

Cigarettes are heavily regulated in America. Federal and state cigarette taxes account for 44% of the retail price of cigarettes (Tax Burden on Tobacco 2011). This percentage is even higher if one accounts for local taxes like New York City’s $1.50 per-pack tax. (A pack of cigarettes retails for $6.01 on average.) Many local and state governments have also banned smoking in bars, restaurants, and workplaces.

Some libertarians oppose these taxes and regulations. They argue that consumers should have the freedom to make their own choices without interference from the government. Many public health officials oppose this viewpoint in the case of cigarettes. They argue that many consumers do not properly account for the negative future consequences of their smoking behavior, which causes them to consume too many cigarettes. In addition, second-hand smoke is a negative externality that annoys and potentially harms others. Finally, cigarettes may raise the cost of government healthcare systems like Medicaid and Medicare. These are all important points, but today I will focus on the last one.

Calculating the costs that a smoker imposes on society is difficult because we do not know for certain what would have happened if she were not a smoker. For example, smokers who die from lung cancer impose large costs on Medicaid and Medicare. However, if those individuals had never begun smoking then they may still have imposed costs on government healthcare systems by contracting a different disease such as Alzheimer’s. The analysis becomes further complicated if we try to account for the fact that smokers die about seven years earlier than non-smokers and thus tend to collect fewer social security payments. This is a morbid observation but it must be accounted for in order to estimate properly the effect of smoking on government spending.

These issues are addressed in a recent report from the Congressional Budget Office (CBO) that analyzes the effect of a hypothetical cigarette tax increase on the federal budget. The main effect is a large increase in excise tax receipts: a total of $38 billion within the first ten years. Because an increase in the cigarette tax decreases the smoking rate, and thus increases the health of the population, the researchers at the CBO also account for the tax’s effects on Medicaid, Medicare, and Social Security spending. They estimate that total government spending would decrease in the short run, mostly due to Medicaid savings resulting from better health among pregnant women and young children.

In the long run, however, the report estimates that the increase in longevity due to less smoking will cause a nontrivial increase in annual government spending equal to 0.012 percent of GDP ($1.8 billion using 2012 GDP) by 2085. The CBO’s finding that a reduction in smoking would actually increase spending on Medicare and Social Security is consistent with economist Kip Viscusi’s finding that smoking does not have negative financial externalities. The annual excise tax receipts are estimated to equal 0.018 percent of GDP ($2.7 billion using 2012 GDP), however, so the proposed tax is beneficial overall for the government’s budget.

Although it does not appear that cigarette smoking creates negative financial externalities for the government, there may be other reasons (mentioned above) to tax and regulate smoking. Regardless, Americans have largely accepted cigarette taxes and smoking regulations and thus these are likely to remain in place.

The issue of whether and how to best regulate consumer health, however, will continue to resurface for other products. For example, Mayor Bloomberg’s recent proposal to ban sugary drinks in containers larger than 16 ounces is justified by many on the grounds that consumers lack self control when making dining decisions and that obesity imposes costs on the government. (Sound familiar?) Sugary drinks, of course, are not the same product as cigarettes. There is no such thing as “second-hand drink” and the health effects of drinking soda every day are not as well known as the effects of smoking every day; quantifying the effect of a sugary drink ban on the government budget is therefore difficult. I expect we will see more research (and more debate!) on this topic in the future.

Simple Logic is Enough

Posted by on Jun 15, 2012

Filed Under (Finance, U.S. Fiscal Policy)

Despite being in a Department of Finance, my own background and research is in economics and public policy (hence the “Center for Business and Public Policy” in our department).  I don’t claim expertise in finance, per se.   On the other hand, it seems that both sides of the JP Morgan debate are using discussion of the Volcker Rule and their other financial expertise to obscure the basic logic of government bank regulation.  It is a basic logic of incentives, which does not require expertise in finance!

JP Morgan wants to make money; we can hardly blame them for that.  In economics generally, we let companies try to make money, as they have the expertise in their own line of business to determine the risk-reward tradeoff.  If they lose money, then they lose money.  They might even be able to buy various kinds of insurance – that’s between the company and their insurer.  A person or company with insurance might have incentive to undertake riskier activities, since any gains are retained, while losses go to the insurer.  But the insurance company might enter the deal willingly, to charge premiums, especially if it can require the company or person to limit some of their riskier activities.  Your auto insurance has co-insurance and deductibles, to make you pay at least part of a loss and to restore some of your incentive for precaution.  

But when a bank becomes “too big to fail”, the U.S. government is thrown into the role of insurer, without being able to collect premiums, co-insurance, or deductibles.  It is not a “deal” between the bank and their insurer, because the government has no choice.  Because of financial contagion, a single major bank failure could bring down the whole system and cause horrific recession.

Given that the bank’s biggest losses must be covered by their insurer (the U.S. government), the bank has more incentive to undertake even riskier activities: they get any profits, and they don’t suffer the worst losses.   Any private insurer would require the bank to limit their riskiest activities, in order to be willing to sell that insurance.  But the government is the insurer by default, with no private “deal” allowing the government to require limits on the riskiest activities in order to be willing to offer that insurance.

To be sure, the bank still must be careful about some risks, as many different kinds of losses would reduce their profits without requiring government bailout.  The recent JP Morgan case did not create danger of bankruptcy or bailout, because their $2 billion loss on that one operation only offset part of their positive profits!  But any bank that is “too big to fail” has less incentive to avoid the really big losses that could cause bankruptcy, because that would require the government to bail them out.

The government could pass laws and regulations to limit the banks’ riskiest activities, and that is the purpose of the much discussed Volcker Rule.  I will leave the discussion of the details to the experts in finance.  For example, the Volcker Rule may or may not be the best way to regulate banks.  The effects depend a lot on the rule’s design, implementation, and enforcement!  Maybe some other rule or incentive-management would be better.  I will leave those details to the experts.  Instead, the point here is just the simple logic that the government is not a private insurer who would require limitations on risky activity to be willing to sell insurance.  The government must provide insurance, so they must have some kind of regulation to limit banks’ risky activities: higher capitalization requirement, Volcker rule, or other regulations.   

I did in fact talk to some of the finance department’s experts, like Jeff Brown and George Pennacchi.  George notes that “the incentive to take big risks declines as a bank finances itself with more shareholders’ equity (capital), and in JPMorgan’s defense they are one of the most highly capitalized banks, which helped them survive the crisis.”  He adds that “If banks carry government deposit insurance, whether explicit or implicit due to Too-Big-to-Fail, then the government should limit their activities to protect taxpayers from losses.”  Moreover, “it is noteworthy that, prior to the establishment of deposit insurance in 1933, banks had much greater capital (financing via shareholders’ equity) and made much less risky loans. … Indeed, there are several recent “narrow bank” proposals to greatly limit the activities of banks that issue insured deposits.”  He has a review of the topic on his website (forthcoming in the Annual Review of Financial Economics).

The bottom line is that in a private deal between a bank and its insurance company, the bank would have to agree to limit risky activity in exchange for being able to buy this insurance.  With government as insurer, they get the insurance regardless.  So just look at their incentives!  The banks have incentive to make money, and so they have incentive to take more risks since they can keep any profits and not cover the biggest losses.  AND they have incentive to lobby Congress to avoid government regulations.  We switch from a private market “deal” to the world of politics!  If they can get Congress to limit regulation of banks, they can make riskier investments, make more money, and not have to cover the biggest losses.

So just think about those incentives, next time you hear a bank executive use the jargon of financial expertise to make the case against “unfair interference by government regulators into the private market”.

Illinois Public Pension Reform: A Simple but Radical Idea

Posted by on Jun 4, 2012

Filed Under (Retirement Policy, U.S. Fiscal Policy)

After a week of legislative wrangling that had more twists and turns than Hawaii’s famous “Road to Hana,” the Illinois General Assembly failed to come to agreement last week on a pension reform package in time for yesterday’s May 31 deadline.  As a result, they will return to Springfield – possibly this week – for a special session facing an even larger hurdle for passing reform legislation: by Illinois law, bills passed after May 31 require a three-fifths vote rather than a simple majority.

Agreement fell apart over the issue of who should pay for the “normal cost” of future public pension accruals.  “Downstate” lawmakers objected to shifting all of the costs onto school districts, public universities and community colleges on the grounds that this would lead to higher property taxes to fund teacher pensions and do grave damage to the ability of our university system to compete for academic talent.  Once Democratic Governor Quinn agreed to pull this cost-shifting out of the bill, Democratic House Speaker Mike Madigan withdrew his support of the bill.

As I wrote this past Wednesday, one of the grave concerns I have about the leading proposals is that so many of our elected officials seem perfectly content to shift all of the costs onto universities and school districts while maintaining legislative control over the design of the benefits package.  This is a mistake on so many levels.  The separation of responsibility and control is a recipe for fiscal shenanigans.  It is also highly disrespectful of the employer-employee relationship that Bob Rich and I wrote about in our pension reform proposal earlier this year.  

Although I still like the plan that Bob Rich and I put out, it seems clear that the General Assembly has gone another route.  But given that they are stuck on the cost-shifting issue, I thought it might be useful to put forth a more radical proposal that would respect the constitutional constraints, appropriately align the incentives of all the affected parties, respect the employer/employee relationship, and still save the state billions.  Perhaps most importantly from a political perspective, it might overcome the cost-shifting stalemate, because it shifts the costs but offers something very valuable in return.  This proposal would apply to those institutions – such as school districts, universities and community colleges – that, while public, are not part of the state government apparatus itself.  

While “radical,” the idea is deceptively simple.  Here it is in 4 simple steps:

1.       The state agrees to pay 100% of all pension benefits that have been accrued by public sector retirees and current workers as of 7/1/2013.  Whether the state wishes to do this by paying down the amortized unfunded liability, or simply provide the cash as need to pay benefits, is immaterial, so long as they respect the constitutional guarantee and pay it.  Not only does this respect the constitution, but it would also be fair to the generations of workers and retirees who consistently paid their share to the pension fund while the politicians enjoyed their “pension funding holidays.”    

2.       The existing public pension plans – for example, TRS and SURS – are closed to all further accruals as of 7/1/2013.  No new benefits will be earned under any of the plans.

3.       Going forward, each state employer is given 100% autonomy – free from the shackles of state regulation and political interference – to construct a benefits package that is optimally designed for its own employees.  In order to comply with federal law that applies when a state like Illinois opts out of Social Security, each employer would be required to provide a retirement package that is at least as generous as Social Security.  Beyond that, it would be up to each employer to determine the optimal mix of wages, pensions, and other employee benefits that would be required to attract, retain, motivate, and manage the retirement of their workers.  If similar employers wished to joint together as a group (e.g., all community colleges) to provide a common pension plan, or if unions wanted to provide multi-employer pensions funded by a group of employers, they would be permitted to do this.  But if the University of Illinois decided that its needs differed sufficiently from other public universities, they would have the freedom to go their own way.  

4.       The state would agree to a pre-determined, annual “block grant” (basically, an extra appropriation) to each employer that would start out as an amount equal to the “normal cost” of providing pensions, and would gradually decline to zero over a 20-year period of time.  This would slowly shift the entire financial burden of providing pensions from the state to the employers themselves.  

In essence, this plan calls for 100% cost-shifting, but with two critical differences relative to the reform package being debated last week.  First, and most importantly, it accompanies the cost-shifting with a freedom from political interference.  Second, it spreads the cost-shifting out over a much longer period of time (twenty years instead of approximately eight or so) in order to ensure that employers can adapt.

If there is anything I have learned from observing our Illinois state government in action, it is that it cannot relied upon to design a sensible pension package that is fiscally sustainable, credible to employees, and meets the diverse needs of our public employers.  So if they are so eager to get out paying for pensions, let’s take this idea all the way – aside from atoning for their past sins by making good on constitutionally guaranteed promises that they have so far failed to fund – let’s have the state get out of the pension business altogether.  

Doing so would free employers and employees from being subject to the unpredictable whims of the states’ politicians.  And that freedom, it seems to me, is priceless. 

Perfect Substitutes: New Meat for a New Age

Posted by on Jun 1, 2012

Filed Under (Environmental Policy, Other Topics)

In a previous post, I examined a United Nations report urging reductions in the consumption of animal-based foods in order to mitigate climate change and avoid world hunger (here).  The report states, “Unlike fossil fuels, it is difficult to look for alternatives: people have to eat. A substantial reduction of impacts [from agriculture] would only be possible with a substantial worldwide diet change, away from animal products.”  Luckily, the concern with finding “alternatives” to eating animals now is no longer a major issue, thanks to a new, plant-based meat alternative developed here in the United States.

Beyond Meat is a Maryland based company that invented a plant-based chicken alternative called Veggie Chicken Strips.  In taste tests, “people either don’t notice the difference [from animal-based chicken], or love it and request it again (source).”  The Strips are relatively healthy with 19 grams of protein, 3 grams of fiber, 25% of recommended daily iron, and only 1.5 grams of non-saturated fat per 100 calorie serving (about 3 ounces).  The secret for this close-to-perfect substitute is a patented processing technique that combines soy and pea protein into the plant-based chicken.  Plans are in the works for beef and pork alternatives too.

The plant-based meat revolution has already begun in Europe.  The extraordinary growth of a Dutch company called The Vegetarian Butcher lead The Independent to ask “Is this the end of meat?”  Opened in 2010, The Vegetarian Butcher’s products now sell in 180 Netherlands outlets, with 500 more outlets coming this Summer and plans for international distribution soon.  Again, their vast array of plant-based meat fools the traditional animal eater.  In a taste test outside one of the Butcher’s shops, not one person guessed the smoke “mackerel” was not fish.

So the “alternative” to eating animals does exist.  The taste and texture of these plant-based meats are the same as the animal-based meats, but without the animal cruelty or environmental degradation.

Putting aside animal rights and the environment, the development of plant-based meat substitutes can help the average household as well.  Prices in the United States for animal-based meat will likely keep increasing as world-wide demand continues to rise (source), and Americans are already feeling the pinch as per capita animal consumption has fallen for 4 consecutive years, a trend expected to continue in 2012 (source). Meanwhile prices for these new, plant-based meats will fall as production increases and techniques are mastered.  These economic trends will lead to increases in plant-based meat consumption by non-vegetarians, but don’t worry, it’s a perfect substitute!

Brief Update on Illinois Pension Reform

Posted by on May 31, 2012

Filed Under (Retirement Policy, U.S. Fiscal Policy)

After last night’s somewhat surprising announcement that Speaker Madigan has agreed to the Governor’s request to remove from the pension reform legislation the provision that would have shifted normal costs onto school districts, universities and community colleges, it now appears that particular provision is dead.  Along with it, it appears that the ability of employers to replace the inadequate Tier II pension (for those hired after 1/1/11) wit a new cash balance plan is also dead.

The main provision of forcing a possibly unconstitutional choice between giving up one’s cost-of-living adjustments after retirement or giving up retiree health insurance, however, is still intact.  As is the provision that would freeze pensionable earnings for those that want to keep their current COLA.  And, rumor has it, the legislature is looking for other ways to save costs as well … so look for some additional benefit changes in the final package.

Also, people who don’t work with compound versus simple growth rates on a daily basis may not realize just how big the COLA changes are.  So here is a simple but useful example.  Suppose someone retires at age 60 and lives until age 85.  Under the current law, they receive 3% COLA each year compounded.  Under the proposed law, they get a 0% COLA for the first 5 years, followed by half of inflation or 3%, whichever is less.  If inflation runs at 3% per year, this is a 1.5% non-compounded (i.e., simple) interest.

This may not sound like much.  But don’t be misled — at age 85, this person’s pension would be 37% LOWER UNDER THE PROPOSED LEGISLATION.  If we compute a present value using a 4-6% nominal discount rate, it is a 20% reduction in lifetime pension payments.  This is why the proposal saves so much money.  It is also why it is pretty clearly an impairment or diminishment of benefits!

 

The Choice Between Two Unconstitutional Options is Not Constitutional

Posted by on May 29, 2012

Filed Under (Other Topics, Retirement Policy, U.S. Fiscal Policy)

As I’ve said before, I’m not a lawyer.  But, since the Illinois House Democrats have decided to move into incentives, why not?  The details of the pension reform proposal that passed an Illinois House committee today are still vague, but here is a write up about it.

Simply put: the proposals currently under consideration in which members are offered a “choice” between options, as currently constructed, are not constitutional.  Here’s why.

The Illinois Constitution says that membership in a state pension program is a contractual relationship the benefits of which shall not be diminished or impaired.

Any contractual relationship has to have, well, a contract.  In this case, the terms of the contract are spelled out in the Illinois Pension Code.

The Illinois Pension Code specifies the way in which pension benefits will be calculated.  The details are slightly different for different pension funds, but I’ll talk about the part that pertains to Tier I participants in the State Universities Retirement System (SURS).  In particular, the amount of the retirement annuity is specified in Section 15-136 of the Pension Code.  Here it is:

Rule 1: The retirement annuity shall be … for persons who retire on or after January 1, 1998, 2.2% of the final rate of earnings for each year of service.

That seems pretty clear.  The “final rate of earnings” is defined in Section 15-112.  For a person who first becomes a participant before Jan. 1, 2011 (i.e., Tier I participants), the final rate of earnings is defined as:

For an employee who is paid on an hourly basis or who receives an annual salary in installments during 12 months of each academic year, the average annual earnings during the 48 consecutive calendar month period ending with the last day of final termination of employment or the 4 consecutive academic years of service in which the employee’s earnings were the highest, whichever is greater. For any other employee, the average annual earnings during the 4 consecutive academic years of service in which his or her earnings were the highest. For an employee with less than 48 months or 4 consecutive academic years of service, the average earnings during his or her entire period of service.

That also seems pretty clear.

One more excerpt from the Pension Code.  This one has to do with annual cost of living adjustments (COLAs).  From Section 15-136

The annuitant shall receive an increase in his or her monthly retirement annuity on each January 1 thereafter during the annuitant’s life of 3% of the monthly annuity provided under Rule 1, Rule 2, Rule 3, Rule 4, or Rule 5 contained in this Section. The change made under this subsection by P.A. 81-970 is effective January 1, 1980 and applies to each annuitant whose status as an employee terminates before or after that date.

Beginning January 1, 1990, all automatic annual increases payable under this Section shall be calculated as a percentage of the total annuity payable at the time of the increase, including all increases previously granted under this Article.

This part of the Pension Code also seems clear: COLAs are to “include all increases previously granted under this Article.”  In other words, COLAs compound rather than being based on the original amount of the annuity.  And, COLAs start the January after retirement.

So, let’s review.  The Illinois Constitution says that membership in a pension system is a contractual relationship. The terms of that contract are given by the Pension Code, and the Pension Code specifies the way in which final pension benefits should be computed.  In particular, it specifies that the final rate of earnings is average earnings over the final 4 years of service, or the 4 consecutive years in which earnings were the highest.  Thus, the Pension Code states that future pay raises will be included in future pension benefits.  The Pension Code also states that COLAs are to begin immediately after retirement and be computed on a compound basis.

So, let’s return to the “choice” that would be offered to members of the pension system under the proposal.  Details are sparse, but the basic choice to be offered to members will be:

(A)  Keep the current pension plan, but give up the state subsidy for retiree health benefits and having future raises be included in pension benefits, and

(B) Keep the state subsidy for retiree health benefits, but receive a less generous cost of living adjustment (COLA) where annual increases are based on the pension payment at the time of retirement rather than the most recent year’s pension.  That is, the COLA is not compounded over time.  Further, the COLA will not kick in until 5 years after retirement or age 67, whichever comes first.  There is also language in at least the governor’s proposal that will limit the COLA to a simple 3% or ½ the increase in the consumer price index, whichever is lower.

Now, supporters of this approach claim that is constitutional because it offers participants a choice.  This claim is invalid.  While a choice might be constitutional, in order for this to be the case, it must be that one of the options does not impair or diminish the benefits of the current pension system.  This is not true here.  Option (A) denies members their contractual right to have the final annual rate of earnings be based on their highest 4 years of earnings, which would include future raises.  Option (B) denies members their contractual right to have COLAs be 3% compounded each year.  Since both options impair and diminish the benefits of the pension, if members are forced to make a choice between A and B, their pension benefits will necessarily be reduced.

Constitutionally speaking, two wrongs don’t make a right.

Consequently, to me it seems clear that the proposals are not constitutional.  Given that so many of our legislators are backing these proposals, there must be an argument for why the proposal is constitutional.  I can’t see it, though.

ADDENDUM (5/30/12):  This isn’t a post about whether it is right or fair to reduce retiree health benefits (it isn’t), but rather whether it is constitutional (it probably is).  Retirees who began working for the State of Illinois before April 1986 (at least in the case of SURS) may not be eligible for Medicare Part A.  In this case, removing health insurance benefits would leave workers exposed to significant financial and health risk even after the age of 65.  The state also does not contribute to Social Security, so state workers who retire are also not eligible for Social Security (unless it is by virtue of having worked for another employer).  Obviously, removing employer-sponsored health benefits and reducing the COLA is going to expose retirees to substantial new risks, and the proposal becomes much more complicated and controversial in this case.

Why YOU may LIKE Government “Theft”

Posted by on May 18, 2012

Filed Under (Finance, Retirement Policy, U.S. Fiscal Policy)

Or, alternatively, “Why I Love Teaching”!  First, teaching lets me grandstand a bit, if that help students really think about the world around us.  Second, it lets me pretend to be an expert in fields other than economics, even fields such as philosophy (see below).  Third, trying to teach about a topic forces me to think hard about that topic myself!  A case in point is the standard lecture on “Justifications for Government Policy to Redistribute Income”, otherwise known as “Robin Hood”, otherwise known as government “theft” from the rich to give to the poor.   

One thing currently happening in the world around us is a heightened political debate about whether the top income tax rate is too low or too high.  See the diagram below.  So this “lecture topic” is not just textbook irrelevance.  It might even help YOU to think about what you read in the newspaper!  Then please decide for yourself.

I see four possible justifications, any one of which may or may not ring true to you.  If one or more justification is unconvincing, however, then perhaps a different justification is more appealing. 

1.)    As described below, some in the field of “moral philosophy” have found ethical justifications for extra help to the poor.

2.)    Even if the poor are not deemed special in that way, and all individuals receive equal weight, it may still be that a dollar from a rich person is relatively unimportant to that rich person, while a dollar to a poor person is very important to that poor person (higher marginal utility).  If so, then equal weights on everybody would still mean that total welfare could increase by taking from the rich in order to help the poor. 

3.)    If incomes are generally uncertain, so that any individual might do well in some years and not in other years, then government might actually make all of us happier by the provision of implicit “insurance” – taking premiums in good times in order to help any person who suffers bad times.

4.)    A reduction in income equality could be a “public good”, like the classic example of a lighthouse that benefits all ships whether they have helped to pay for it or not.  Everybody’s individual incentive is therefore not to pay (to “free ride”).  The private market never exists.  But government can raise welfare for all shippers by taxing all ships and using the funds to build and operate the lighthouse.  Similarly, if many people would LIKE to have more income equality in society, they could “free ride” on others who do give voluntarily to help the underprivileged. If so, then government could fix that market failure by taxing everybody and using the funds to improve income equality.

Having used up several paragraphs already, I will miss the chance to explain all four of these important points adequately in this one blog, and so I’ll save a few for the next blog.  Let’s just start with the first one.

In the field of moral philosophy, some libertarians such as Robert Nozick believe that theft itself is ethically wrong, that each person is morally entitled to the fruits of their own labor.  No person is allowed to steal from a rich neighbor, even to give to the poor, so why would government be allowed to do so?  If theft is morally wrong in itself, then government should not be redistributing from rich to poor, no matter how needy the poor nor how worthy the cause.  On the other hand, by the way, government steals from individuals through taxes in order to build highways and provide for national defense, and so one may wonder why theft is justified for some purposes and not others.  One way out of that problem is to decide that a tax for public purposes is not in fact “theft”.

In contrast, John Rawls argues that the moral choice is to help the poor.  Actually he has two important ideas.  One is that those who are already rich have no moral justification to argue for reducing taxes on the rich, just as those who are poor have no moral justification to argue for raising taxes on the rich.  Such positions are merely self-interested.  Therefore, a useful thought experiment is to put yourself in what Rawls calls the “Original Position”, at the beginning of the World, before places have been assigned in the wide distribution of incomes and well-being.  That is, suppose resources are limited, and that the world will inevitably have a distribution of different human abilities and disabilities.  You don’t yet know your IQ, or whether you will have any particular talents in music, sports, the arts, or management.  Our job in this “original position” is to write a constitution, a set of rules for government and human interaction.

The purpose of this thought experiment is to try to strip away self-interest and think about how rules “ought” to be designed.  And then, Rawls’ second idea is about what any of us would likely decide to do in such a position.  He argues that the only natural choice, indeed the only logical choice, is to be extremely risk averse.  We are not talking about twenty bucks you might lose at the Casino, where risk is fun.  Instead, we are talking about your entire life’s prospects, where risk is not fun.  It must be great to be Brad Pitt, but what if you end up with little talent or ability.  You could end up homeless, or worse.   Given that risk, he argues, one should design the rules such that society would take good care of those who are disadvantaged, unlucky, or disabled.  You might well be the person on the bottom of the totem pole.

His treatise, called “A Theory of Justice” is 600 pages, so I haven’t even read it all!  So I won’t try to explain all the reasoning, but the interesting point is the connection between risk aversion and redistribution.  Rawls himself is extremely risk averse, saying we ought to maximize the welfare of the poorest person with the minimum income – the “maximin” strategy.  That does not mean perfect equality, as he points out that the poorest person’s welfare might be improved by giving the most talented individuals plenty of incentive to work hard and invent new technology that generates plenty of profits, market success, and economic growth.  But cutting the tax rate on the rich is only justified for Rawls if that really does improve the welfare of the poorest.

Well, out of space for today, so I’ll save the other justifications for next time.  But in case you don’t like the justifications of Rawls, those other justifications (#2 through #4) are completely different!