6  Agency costs of government

Economic objective

The economic objective in this section is to minimise public sector agency costs.

Pinfield (1998) developed a simple model to demonstrate that the losses from “expenditure creep” – where an improving fiscal position increases the pressure for government spending – may outweigh the gains from tax smoothing. The model reflected that agency costs arise whenever Crown decision makers (politicians and bureaucrats) are imperfect agents of citizens.

In general, delegation of decisions from principal to agent tends to work well when the agent has good information about the principal’s best interests and strong incentives and capability to act accordingly. Conversely, agency costs tend to be high when agents have poor information, weak incentives, and wide opportunity for discretion.

Incentives

Public choice theory assumes that Crown decision-makers act in their self-interest. The theory predicts that:

• politicians (and bureaucrats), due to the need to win votes, have an incentive to promote government spending and investment favouring their special interest group constituents, even if such expenditure is inefficient;[23] and
• politicians and bureaucrats, due to their (non-marketable) human capital exposure and (possibly) asymmetric loss function[24], have an incentive to favour lower risk policies than otherwise would be optimal.

Opportunities

The opportunity for Crown decision-makers to act contrary to citizens’ interests may arise in several forms:

• free cash flow: Application of Jensen’s (1986) free cash flow model suggests that Crown decision-makers have greater opportunity to engage in inefficient spending and investments when substantial liquid assets have been accumulated on the Crown balance sheet and/or a “structural” budget surplus occurs;
• monitoring costs: A high risk strategy leading to greater volatility in the Crown’s earnings stream (and components of it) may inhibit effective monitoring. Highly complex strategies can also inhibit monitoring, e.g. Enron’s balance sheet transactions; and
• large player issues: Crown portfolio investments may result in the Crown acquiring dominant shareholding positions in private sector companies, providing opportunity for politicians and bureaucrats to pursue their interests to the detriment of value maximisation.

Key insights for policy

The key implications for Crown financial policy are:

• tax policy objective: Rather than tax smoothing, limit free cash flows at source by favouring tax rates closer to balanced budget;
• portfolio policy objective: Use the structure of the Crown balance sheet as a fiscal anchor. For example, set a lower bound on gross debt at a level that limits future borrowing capacity. Another example would be to place an upper bound on the level of fungible assets, so that any substantive build up in Crown net worth would be in the form of non-fungible assets (e.g. investment in roads or other assets with significant political hurdles against sale of the asset). Also, limit the share of any asset held by the Crown to avoid large player issues;
• institutional arrangements: To the extent that diversification implies the Crown should invest in liquid and fungible assets, institutional arrangements may reduce agency costs:
  • improve the incentives on political decision makers through legislative or other requirements to make more transparent both intentions and subsequent performance, e.g. Fiscal Responsibility Act 1994; and/or
  • shift decisions to non-political agents with better information, incentives and capability, and limit discretion remaining with politicians and bureaucracy, e.g. New Zealand Superannuation Act (NZSA) 2001 that establishes arrangements for the New Zealand Superannuation Fund.[25]

A “pecking order” may be applicable. First, an effective institutional arrangement that protects financial assets from political direction could alleviate the need to introduce balance sheet restrictions. Institutional arrangements such as mandatory requirements on government to pay into a fund (e.g. New Zealand Superannuation Fund) may also reduce the proportion of any budget surplus available as “free cash flow”, thereby reducing the risk of resources being diverted to inefficient government spending.

Second, in the absence of strong institutional arrangements, a portfolio policy that invests surplus cash in non-fungible assets helps to protect against future raiding of accumulated assets. To the extent that both institutional and portfolio policies are ineffective in reducing agency costs, the burden falls on tax policy in the sense of placing greater emphasis on balanced budget tax rates rather than tax smoothing.

A caveat to this analysis (which is also applicable to time-consistency issues) is that restricting opportunities does not remove the underlying incentives. Hence, use of the balance sheet and institutional arrangements as suggested above has the risk of inducing Crown decision makers to seek their desired outcomes through other mechanisms, possibly at greater cost in terms of economic efficiency.

Summary for agency costs

Economic objective

Minimise public sector agency costs

CFP objectives

Tax policy

Minimise free cash flow

Portfolio policy

Minimise fungible assets and capacity for further borrowing

Institutional policy

Ensure decisions are transparent and made by agents with best information, incentives and capability

Targets

1. Upper bound on cyclically-adjusted budget surplus (to trigger reduced tax rates)
2. Upper bound on fungible assets set at a level to buffer against shocks
3. Lower bound on gross debt set consistent with limiting borrowing capacity
4. Upper bound on share of assets held by the Crown

Instruments

• Tax rate
• Portfolio weights on fungible versus non-fungible asset classes
• Portfolio weights on total debt (gross or net depending on how constraint binds)
• Institutional arrangements (e.g. FRA 1994 and NZSA 2001)