Economic Analysis of Public Law (Springer Textbooks in Law) 3662660881, 9783662660881

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Springer Textbooks in Law

Michael Rodi

Economic Analysis of Public Law

Springer Textbooks in Law

Springer Textbooks in Law compiles high-quality educational content aimed at undergraduate and graduate students in all areas of law. All self-contained volumes are authored by accomplished academics and suitable for use in class as well as individual study. Many of them include chapter abstracts, definitions of technical terms, cases and self-assessment exercises, as well as recommended reading sections. This series is an invaluable resource for students and lecturers alike and spans the full range of topics in international and European law, including fundamentals of law and comparative law. Special attention is paid to current and emerging topics such as IT law, intellectual property, human rights as well as dispute resolution, mediation, arbitration – and many more.

Michael Rodi

Economic Analysis of Public Law

Michael Rodi Institute for Climate Protection, Energy and Mobility (IKEM) Berlin, Germany Translated by Kate Miller Institute for Climate Protection, Energy and Mobility (IKEM) Berlin, Germany

ISSN 2509-999X ISSN 2510-0009 (electronic) Springer Textbooks in Law ISBN 978-3-662-66088-1 ISBN 978-3-662-66089-8 (eBook) https://doi.org/10.1007/978-3-662-66089-8 Translated and edited version of the German language edition: “Ökonomische Analyse des Öffentlichen Rechts” by Michael Rodi, # Springer-Verlag Berlin Heidelberg 2014. Published by Springer Gabler, Berlin, Heidelberg. All Rights Reserved. # Springer-Verlag GmbH Germany, part of Springer Nature 2022 This work is subject to copyright. All rights are reserved by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors, and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. This Springer imprint is published by the registered company Springer-Verlag GmbH, DE, part of Springer Nature. The registered company address is: Heidelberger Platz 3, 14197 Berlin, Germany

Preface

Law and economics is an Anglo-American discipline that has only slowly gained traction in continental Europe. At the same time, public law—as a phenomenon distinct from civil law—has its roots in Europe and is uncommon in the AngloAmerican world. Writing a book on the economic analysis of public law is an interesting challenge, as the main works written by scholars of law and economics address topics that, in continental Europe, fall under the umbrella of private or civil law, such as tort and liability law. Still, it seems promising to apply rational choice theory to phenomena like the state and the constitution, the administration and public organisations, regulation and legal fields characterised by state intervention, like fiscal or environmental law. The idea for this book grew out of many years of teaching, during which I observed that students showed great interest in this new field of research. They told me that they found knowledge of the topic especially useful in their later coursework on legal design. I am grateful to my students for all of the great discussions we shared in the lecture halls and seminar rooms over the years. I would also like to thank my colleagues at the Institute for Climate Protection, Energy and Mobility (IKEM), where I have the privilege of serving as a director. This book benefited enormously from your keen insight and expertise. I am continually inspired by your tireless work to develop a framework for law and policy that will advance the energy transition. Special thanks go to Kate Miller, who translated and edited the text meticulously and with great patience; it is our hope that this book will contribute to the discussion of law and economics in the English-speaking world. Thanks also to Lisa Cole, who provided valuable input during the revision process. Last but not least, thank you to Nils Baumann for preparing the manuscript for publication, as always in a reliable and efficient way. Berlin, Germany

Michael Rodi

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Contents

Part I 1

2

Basic Principles

Principles of an Economic Analysis of Public Law . . . . . . . . . . . . . . 1.1 A Study of Law from Outside the Legal Field: Functions and Orientation of an Economic Analysis of Law . . . . . . . . . . . . . . . . 1.1.1 Economic Analysis of Law: An Introduction . . . . . . . . . . . 1.1.2 Economic Analysis of Public Law and Related Sciences . . 1.2 Theoretical Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.2.1 Basic Methodological Principles . . . . . . . . . . . . . . . . . . . . 1.2.2 Methodological Foundations of the Economic Analysis of Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.2.3 The Theory of Market Failure . . . . . . . . . . . . . . . . . . . . . . 1.3 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3 4 4 6 10 10 17 32 52 52

State and Constitution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 2.1 Principles of an Institutional Economics of the State and Constitution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60 2.2 Normative Constitutional Theory in the Form of Contract Doctrine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61 2.2.1 An Interpretation of Constitutional Democracy Based on Contract Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62 2.2.2 Forms of Government as a Subject of Economic Theory . . . 65 2.2.3 Economic Theory of Democracy . . . . . . . . . . . . . . . . . . . . 66 2.3 Functions of the State . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81 2.3.1 Management of Institutions . . . . . . . . . . . . . . . . . . . . . . . 82 2.3.2 Typological Overview of State and Government Functions (Fields of Action) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83 2.4 State Structure (Specifically Federalism) . . . . . . . . . . . . . . . . . . . . 88 2.4.1 The Question of Who Should Control the State: Separation of Powers (Horizontal) . . . . . . . . . . . . . . . . . . . . . . . . . . . 89 2.4.2 Federalism: Separation of Powers (Vertical) . . . . . . . . . . . 91 2.5 Open Statehood . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 2.5.1 The Need to Open Up the State to the Outside World . . . . . 101 vii

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Contents

2.5.2 Principles of International Cooperation Between States . . . 2.5.3 Questions on the Content of International Law . . . . . . . . . . 2.6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

102 109 111 112

Economic Theory of Institutions and Organisations . . . . . . . . . . . . . 3.1 Basic Principles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.1.1 The Importance of Organisations . . . . . . . . . . . . . . . . . . . 3.1.2 Approaches in Organisational Theory . . . . . . . . . . . . . . . . 3.2 Key Topics in Organisational Economics . . . . . . . . . . . . . . . . . . . 3.2.1 Freedom and Restrictions in the Formation of Organisations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2.2 Decision-Making, Distribution and Control Problems in Organisations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2.3 External Relationships . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2.4 Regulatory Challenges Related to Internal and External Relationships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3 Types of Organisations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3.1 The Firm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3.2 Interest Groups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3.3 The Media . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3.4 Parties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

119 119 119 120 122

Theory of State Decision-Making . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.1 Decision-Makers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.1.1 Politicians . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.1.2 The Administration (Bureaucratic Theory) . . . . . . . . . . . . . 4.2 Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2.1 Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2.2 Capture Theory and Interest Groups . . . . . . . . . . . . . . . . . 4.2.3 Legal-Impact Research . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.2.4 ‘Good Governance’ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.3 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Part II 5

122 123 123 124 125 125 131 135 140 145 145 149 149 150 151 158 159 160 161 164 165 166

Focus Areas

Public Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.1 State Budget . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.2 Government Spending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.2.1 Normative Determination of the Optimal Government Share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.2.2 State Decisions on Government Spending . . . . . . . . . . . .

. 171 . 171 . 172 . 172 . 174

Contents

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7

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5.3

Government Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.3.1 Taxes and Fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.3.2 Government Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.4 Public Finances Under Federalism . . . . . . . . . . . . . . . . . . . . . . . . 5.4.1 Basic Principles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.4.2 Spending Power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.4.3 Revenue Powers, Especially Tax Sovereignty . . . . . . . . . . 5.4.4 Transfer Payments and Fiscal Equalisation Schemes . . . . . 5.4.5 Macroeconomic Responsibility . . . . . . . . . . . . . . . . . . . . . 5.5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

180 182 197 210 210 211 212 215 216 216 217

Public Economic Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.1 Basic Principles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.1.1 General Economic History . . . . . . . . . . . . . . . . . . . . . . . . 6.1.2 Constitutional and European Legal Framework for Economic Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.1.3 Topics in Legal Economics . . . . . . . . . . . . . . . . . . . . . . . 6.2 State and Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.2.1 Guarantee of Effective Competition Between Private Parties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.2.2 State Activities Related to Competition . . . . . . . . . . . . . . . 6.3 Economic Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.3.1 Basic Principles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.3.2 Macroeconomic Policies (Business Cycle or Economic Stabilisation Policy) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.3.3 Natural Monopolies and Options for State Regulation . . . . 6.3.4 Traditional Economic Oversight and Regulation . . . . . . . . 6.4 International Economic Relations and the Global Economic Constitution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.4.1 Basic Principles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.4.2 International Trade Law . . . . . . . . . . . . . . . . . . . . . . . . . . 6.5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

223 223 223

Environmental Economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.1 Principles of Environmental Economics . . . . . . . . . . . . . . . . . . . . 7.1.1 Market Failures in an Environmental Context . . . . . . . . . . 7.1.2 The Coase Theorem (Exchange and Negotiated Solutions) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.1.3 Valuation of Environmental Damage . . . . . . . . . . . . . . . . . 7.1.4 Evaluation Criteria for Environmental Policy . . . . . . . . . . . 7.2 Environmental Policy Measures . . . . . . . . . . . . . . . . . . . . . . . . . . 7.2.1 Environmental Regulatory Law (‘Direct Regulation’, ‘Command-and-Control Law’) . . . . . . . . . . . . . . . . . . . . .

224 225 227 227 229 247 247 248 251 256 257 257 259 266 267 273 273 273 275 277 285 287 288

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Contents

7.2.2 Environmental Liability . . . . . . . . . . . . . . . . . . . . . . . . . . 7.2.3 Environmental Taxes and Charges . . . . . . . . . . . . . . . . . . 7.2.4 Financial Support Programmes . . . . . . . . . . . . . . . . . . . . . 7.2.5 Environmental Certificate Trading . . . . . . . . . . . . . . . . . . . 7.2.6 Informal Instruments of Environmental Policy . . . . . . . . . . 7.3 Instrument Variety and Instrument Mix . . . . . . . . . . . . . . . . . . . . 7.4 International Aspects of Environmental Policy . . . . . . . . . . . . . . . 7.4.1 Dilemma Structure of Global Environmental Problems . . . . 7.4.2 Unilateral Measures by States . . . . . . . . . . . . . . . . . . . . . . 7.4.3 International Cooperation . . . . . . . . . . . . . . . . . . . . . . . . . 7.4.4 Climate Policy as an Example of International Cooperation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

291 295 300 302 309 315 321 321 322 323 324 330 331

List of Abbreviations and Acronyms

ACTA BTA CBA CEM CFCs CO2 COVID-19 CVM EADS ECJ EEG EIA EMAS EMU ETS EUT FIT GATS GATT GDP GG GNI GNP GSP IP ISO ITO MAI NDC NGO NOx NPE OECD

Anti-Counterfeiting Trade Agreement Border tax adjustment Cost–benefit analysis Continuous emission monitoring Chlorofluorocarbons Carbon dioxide Coronavirus disease 2019 Contingent valuation method European Aeronautic Defence and Space Company European Court of Justice Erneuerbare-Energien-Gesetz [Renewable Energy Sources Act] Environmental impact assessment Eco-Management and Audit Scheme Economic and Monetary Union Emissions trading system Treaty on European Union Feed-in tariff General Agreement on Trade in Services General Agreement on Tariffs and Trade Gross domestic product Grundgesetz [Basic Law for the Federal Republic of Germany] Gross national income Gross national product Generalised Scheme of Preferences Intellectual property International Organization for Standardization International Trade Organization Multilateral Agreement on Investment Nationally determined contribution Non-governmental organisation Nitric oxide New Political Economy Organisation for Economic Co-operation and Development xi

xii

OTC PFC RECLAIM RED II REMM ROB SGP SO2 SOE TFEU TRIMs TRIPS UMTS UmweltHG UNCITRAL UNFCCC US FAR UWG VAT WTO WWF

List of Abbreviations and Acronyms

Over the counter Perfluorocarbons Regional Clean Air Incentives Market Renewable Energy Directive Resourceful, evaluating, maximising man Regulatory oversight body Stability and Growth Pact Sulfur dioxide State-owned enterprise Treaty on the Functioning of the European Union Agreement on Trade-Related Investment Measures Agreement on Trade-Related Aspects of Intellectual Property Rights Universal Mobile Telecommunications System Umwelthaftungsgesetz [Environmental Liability Act] United Nations Commission on International Trade Law United Nations Framework Convention on Climate Change United States Federal Acquisition Regulation Gesetz gegen den unlauteren Wettbewerb [Act Against Unfair Competition] Value-added tax World Trade Organization World Wildlife Foundation

List of Figures

Fig. 1.1 Fig. 1.2 Fig. 1.3 Fig. 1.4 Fig. 1.5 Fig. 1.6 Fig. 2.1 Fig. 2.2 Fig. 2.3 Fig. 2.4 Fig. 5.1 Fig. 5.2 Fig. 5.3 Fig. 5.4 Fig. 6.1

Possible outcomes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Actor preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The prisoner’s dilemma in a neutral context . . . . . . . . . . . . . . . . . . . . . . . . . Dilemma situations and state action . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Public and collective goods. Based on: Towfigh and Petersen (2009), Table 4.18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Solutions to information asymmetries between private actors. Based on: Fritsch (2018), Figure 10.7 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Condorcet paradox . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Median voter theorem (unimodal voter distribution) . . . . . . . . . . . . . . . . Median voter theorem (bimodal voter distribution) . . . . . . . . . . . . . . . . . Median voter theorem in a multidimensional space (in the case of the German party system) . . . . . . . . . . . . . . . . . .. . . . . . . . . . . Macroeconomic overview of tax collection . . . . . . . . . . . . . . . . . . . . . . . . . . The Laffer curve. Based on: Blankart (2007), Figure 11.15 . . . . . . . . Shadow economy. Based on: Blankart (2007), Figure 11.15 . . . . . . . Global debt . . . . . . . .. . . . . . . . .. . . . . . . . . .. . . . . . . . .. . . . . . . . . .. . . . . . . . .. . . . . . . Types of subsidies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

37 38 39 39 45 49 74 78 78 78 184 193 194 198 242

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Part I Basic Principles

1

Principles of an Economic Analysis of Public Law

This book introduces a critical perspective on public law, the area of law that governs relationships between individuals and the state or its various government institutions and between different government institutions within the state. This perspective originates outside the field of public law—indeed, outside the framework of law entirely. This approach adopts the tools and methods of economics to interpret traditional questions of public law and is thus described as an economic analysis of public law. Because of its focus on the state and decision-making, it can also be characterised as a component of public choice theory. In an analysis of public law, the economic theory of public choice provides valuable insight into collective decision-making processes.1 Modern doctrine on the economic analysis of law developed in the United States, chiefly within the context of the Chicago School of Law and Economics,2 and has been dominated by Anglo-American researchers ever since.3 Its intellectual roots, however, lie in a European tradition of thought that early on combined political philosophy and constitutional law with economic discourse. It dates back to Jeremy Bentham in particular,4 but also to David Hume, Adam Ferguson, Adam Smith5 and John Stuart Mill.6 There has been much speculation as to why a school of thought so clearly descended from utiliarianism had an earlier impact in the US than in Europe. This development is especially surprising because the Free Law School (Freirechtsschule) and the theory of ‘legal realism’ initiated a parallel shift away 1

On applying the concept of public choice to public law, see Farber and O’Connel (2010), p. 1. See Rowley (2005), pp. 12 ff.; Grembi (2007), pp. 139 ff. (on the concept of ‘economic imperialism’); on this and later approaches (‘Yale School’, ‘Virginia School’), see Parisi (2004), pp. 264 ff. 3 In particular by Guido Calabresi, Ronald Coase and Richard Posner. See also Cohen and Wright (2009), chap. 1, 11 and 13. 4 On Jeremy Bentham’s theory of utilitarianism, see Mathis (2009), chap. 6, and Sect. 1.2.1.3 below. 5 On the roots of law and economics in Adam Smith’s thinking, see Peukert (1999); on Smith’s moral philosophy, Mathis (2009), chap. 5. 6 See, e.g., Rowley (2005), pp. 3 ff. 2

# Springer-Verlag GmbH Germany, part of Springer Nature 2022 M. Rodi, Economic Analysis of Public Law, Springer Textbooks in Law, https://doi.org/10.1007/978-3-662-66089-8_1

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1 Principles of an Economic Analysis of Public Law

from rigid conceptual legal thinking on both sides of the Atlantic in the 1920s and 1930s.7 In the US, Bentham had great personal influence on public opinion, and the ‘law and economics’ movement entered into a potent alliance with the liberaleconomic and anti-etatist currents of the 1940s and 1950s. In Europe, on the other hand, the opening of jurisprudence to the social and economic sciences was delayed by the persistent influence of the historical school of legal thought, idealism and material value-ethics, and an ideology of control (‘social engineering’) that was rooted in etatism and dated back to the social movement. The branch of science known as law and economics, or the economic analysis of law, has thus been shaped by Anglo-American legal principles. This influence is evident from the fact that the subjects of analysis are not only constitutional questions, but also questions that, from a continental European perspective, refer to areas of ‘civil law’ (e.g. liability, contract law and insurance law). It is therefore unsurprising that the first foundational studies in the economic analysis of law in Europe also concerned civil law.8 In the US, there is now a growing recognition that the economic analysis of law neglected classical fields of public law (e.g. state regulation and tax law) for too long and must make up for lost ground in these areas.9 For this reason, the economic analysis presented in this book draws on the independent and significant tradition of public law in Europe. The main focus of the discussion is thus the state, the constitution, the government, the administration and fields of administrative law; each is examined from an economic perspective. There are many subject areas to consider, and not all can be covered here. The fields selected—financial and tax law, public economic law and environmental law—are those that can be analysed most effectively using the tools of economic analysis.

1.1

A Study of Law from Outside the Legal Field: Functions and Orientation of an Economic Analysis of Law

It is first necessary to establish more precisely what is meant by an ‘economic analysis of law’, as well as the functions it can serve and how it differs from other approaches to public law that are rooted in perspectives outside the legal field.

1.1.1

Economic Analysis of Law: An Introduction

In this book, economic analysis is a social-scientific method. This is fundamentally different from the conventional understanding of economics. As defined here, economics is the science that analyses economic relationships, i.e. the traditional

7

See the detailed discussion in Likhovski (2003). Regarding the economic analysis of law in the German-speaking world, see, in particular, Schäfer and Ott (2020), Rodi (2014), Adams (2004), and Noll (2005). 9 See, e.g., Ulen (2007), pp. 31 f. 8

1.1 A Study of Law from Outside the Legal Field: Functions and Orientation of. . .

5

subject areas of the economic sciences: micro- and macroeconomics. Economic analysis applies the methodological instruments of the economic sciences to examine subjects outside of economics, such as politics or law. Economics, in this sense, is not an object-oriented ‘science of the economy’, but rather a methods-oriented model of human interaction. It is of course not strictly necessary to use the term in this way.10 Key features of the relevant fields can be combined in different ways to create four distinct research approaches:11 (1) economic analysis of economic relationships—the field of traditional economics; (2) non-economic analysis of economic relationships—such as public economic law, economic sociology or economic psychology; (3) non-economic analysis of non-economic relationships—the traditional social sciences, such as sociology, law and political science; and (4) economic analysis of non-economic relationships—such as environmental economics, the economic theory of politics, or the economic analysis of law (as developed by economists and specialists in related fields). The concept of economics applied in this analysis was first formulated in the 1930s by Lionel Robbins12 (1898–1984) as follows: ‘Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses.’ Today, resource scarcity is increasingly viewed in relative terms; the focus is generally on individual calculations of costs and benefits and the influence of this calculation on cooperation for mutual benefit. The social philosopher John Rawls views society as a ‘venture for mutual advantage’.13 Economics considers the possibilities and problems of social cooperation for mutual advantage under conditions of scarcity and competition.14 It aims to explain and organise the conditions and consequences of interactions based on individual cost-benefit calculations.15 Robbins’s early definition of economics was rigorously implemented after the Second World War by representatives of the Chicago School, most notably Richard Posner and Gary Becker. This approach applied the microeconomics-based economic analysis to all forms of human behaviour in various contexts (from politics to

10

See, e.g., the title of the well-known book by Bruno S. Frey: Economics as a Science of Human Behaviour: Towards a New Social Science Paradigm. 11 Kirchgässner (2008), pp. 2 f. 12 Robbins (1932/1935), p. 16. 13 Rawls (1972), p. 105. 14 In this sense, e.g., Homann and Suchanek (2005), I.1.4. 15 Homann and Suchanek (2005), p. 347.

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marriage, sex, prostitution and revolutions),16 which broadened the scope of economics and established it as a comprehensive social science. The expansion of the conventional subject matter of the field prompted criticism of economics as an ‘imperialist’ science.17 This critique may apply to normative perspectives that claim to represent ‘absolute truth’. The present text, however, views such approaches with a certain scepticism18 and attaches far greater importance to the integration of economics into a pluralist approach that applies a variety of methods in the appropriate context.19

1.1.2

Economic Analysis of Public Law and Related Sciences

An economics of law that is interpreted in such broad terms intersects many other legal and social-scientific disciplines. Some of these should be mentioned here: sociology of law, legal anthropology, legal psychology, comparative law, and finally legal dogmatics (including legal theory), which refers to jurisprudence in a narrower sense.

1.1.2.1 Sociology of Law The sociology of law examines interactions between law and society.20 The study of these effects can proceed in two different directions: the law can be considered as socially contingent or as a mechanism of social control. The sociology of law therefore poses essentially the same questions as a positive economic analysis of law.21 At times, the sociology of law is wrongly reduced to its empirical elements, including methods of empirical social research.22 To be taken seriously, even empirical approaches must be based on theoretical models. In the sociology of law, as in sociology as a whole, the macrotheories that are frequently cited assume a holistic view of society that regards people as embedded within a system of groups, roles, values and institutions; a prominent example of this is systems theory.23 Economic theory is now gaining recognition as a legitimate sociological method.

See, e.g., Becker (1976); Posner (2014), ‘Family Law and Sexual Regulation’, chap. 5, on questions of marriage and sex; Reynolds (1986) on questions of prostitution; and Apolte (2012) on revolutions. 17 On this debate, see Cooter (1982) and Grembi (2007). 18 See Sect. 1.2.1.3 below. 19 See Sect. 1.2.2.1 below. 20 On the sociology of law, see, e.g., Přibáň (2020). 21 Cf. van Aaken (2004), pp. 14 ff. 22 On the relationship between theoretical and empirical research, see Sect. 1.2.2.1 below. 23 Systems theory is closely associated with Niklas Luhmann, who, as a sociologist and jurist, also applied this concept to law as a social subsystem. See, e.g., Luhmann (1993, 2008); on Luhmann’s legal theory as a sociological ‘supertheory’, see Šubrt (2020). 16

1.1 A Study of Law from Outside the Legal Field: Functions and Orientation of. . .

7

A ‘sociological economics’,24 on the other hand, has existed since Max Weber.25 As is often pointed out, sociology and economics have a common starting point (seventeenth- and eighteenth-century social theory), a common focus (the coordination of action in social systems) and, increasingly, a new emphasis on the issue of institutions.26 The logical endpoint of this development was the creation of a ‘rational choice sociology’—led by James Coleman27—that primarily considers the influence of social norms on individual behaviour, the importance of socialisation and the individual’s striving for social status.28 Sociological theories of action thus demonstrate a clear tendency to combine micro- and macrotheories.29 Whether a common, integrated social science theory of action should be developed on this basis is an open question.30

1.1.2.2 Legal Anthropology Certain branches of anthropology study human behaviour from the perspective of biological determinism. Insight from this subfield of the discipline is naturally of interest for (legal) sociology as well as (law and) economics, to the extent that it can inform an understanding of decision-making processes. Law is made by and for humans. As a result, basic biological and psychological patterns influence law. Law can thus also be explained from an anthropological perspective—for example, as a striving for freedom or security. This is useful in explaining why and how people create law and how they react to legal rules.31 The first approaches to a systematic exploration of the interrelationship between law and reality emerged in the mid-1700s with Louis de Secondat, Baron de la Brède et de Montesquieu (1689–1755), whose work is regarded as fundamental to the concept of separation of powers. His seminal work, The Spirit of the Laws,32 breaks with the spirit of the age by examining the elements outside of law that influence the development of law. These include social phenomena (e.g. religion, trade, customs and traditions), demographic data (e.g. population size) and physical conditions (e.g. soil composition or climate): The laws have a very great relation to the manner in which the several nations procure their subsistence. There should be a code of laws of a much larger extent for a nation attached to trade and navigation than for people who are content with cultivating the earth. There should

24

See, e.g., Swedberg (2003). See Weber (1921). 26 See, e.g., Voigt (2009), and Sect. 1.2.2.3 below. 27 Coleman (1990). 28 For an overview, see, e.g., Ellickson (2007), pp. 7 ff. 29 See, e.g., Keizer (2015). 30 See, e.g, Esser (2015). 31 For an introduction to legal anthropology, see Goodale (2017). 32 Montesquieu, Charles-Louis de Secondat, Baron de la Brède et de Montesquieu (1748). 25

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1 Principles of an Economic Analysis of Public Law be a much greater for the latter than for those who subsist by their flocks and herds. There must be a still greater for these than for such as live by hunting.33

An anthropological approach has found its way into certain theoretical concepts of the sociology of law. Its influence is particularly striking in the works of Helmut Schelsky (1912–1984), who challenged the dominant thinking in systems theory with an approach invoking both philosophy and anthropology. His work foregrounds the human as an individual, not society as a whole or the social system—a perspective that serves as the reference point for his theory and for the field of legal economics today. His hypotheses are based on the following view of humanity (as economics is based on the model of rational behaviour): human beings, like animals, are controlled (unconsciously) by instincts (Freud), but unlike animals are ‘deficient beings’, or Mängelwesen (Gehlen), which are guided by instincts but can also set goals for themselves (Konrad Lorenz terms this ‘appetence behaviour’ (Appetenzverhalten)). Conscious of their deficits and striving to realise their goals, humans construct institutions; this initiates an interaction between the individuals— with their subjective motives, perceptions, drives and goals—and the institutions, with their constraints and limitations. This interaction intrigues Schelsky: The supra-individual institution of the legal system lives only because it is continuously manifested or animated by the will, the motivations and above all the emotions (sense of justice) of the persons who act in accordance with, seek and protect the law; and because, in turn, the objective, institutional legal order, the constitutions, laws, ordinances and their mechanisms for enforcement and administration, continuously define and influence the states of consciousness of the persons, their aspirations and values, decisions and renunciations.34

It is therefore unsurprising that the influence of legal anthropology on legal economics is becoming increasingly apparent, particularly in explanations of typical deviations from seemingly ‘rational behaviour’.35

1.1.2.3 Legal Psychology Psychological principles play a major role in law—just think of the interactions in the courtroom and the process of persuading the judge. As a result, it is almost astonishing how late and how slowly legal psychology has developed into an independent field of research.36 Psychological findings are taking on greater importance, especially in economics.37 This is logical: after all, economics is based on human behaviour and corresponding behavioural hypotheses. In recent years, an independent approach

33

Montesquieu, Charles-Louise de Secondat, Baron de la Brède (1793), p. 305. Schelsky (1980), pp. 1, 78 f. (translation by the author). 35 On ‘bounded rationality’, see Sect. 1.2.2.2.3.2 below. 36 See, e.g., Sales and Krauss (2015). 37 See, e.g., Homann and Suchanek (2005), 6.4.3. 34

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9

to law and economics has emerged, referred to in the English-speaking world as ‘behavioural law and economics’.38 This approach is revisited in greater detail below in a discussion of economic assumptions about rational behaviour (and the criticism of these assumptions).39

1.1.2.4 Comparative Law Today, comparative law40 is increasingly functional and is no longer applied in a merely descriptive or explanatory way. It is used to make evaluative assessments based on the premise that law fulfils a social function. The comparison begins with a specific substantive problem. For an analysis of this kind, comparative law requires a tertium comparationis, which can be developed through social-scientific methods or economic analysis. A comparative perspective is playing an increasingly important role in legal science and in economics. Accordingly, the significance of comparative law and economics is growing as well.41 In this book, too, economic statements are generally not intended to refer to a specific legal system in isolation, but to overarching or common legal institutions; this is particularly appropriate in light of the emerging European legal system. In this sense, this text contributes to a comparative economic analysis of law. It is no coincidence that the specialised influences of various disciplines are becoming apparent in behavioural economics and the comparative economic analysis of law. In general, the field of economics, particularly law and economics, is oriented towards interdisciplinary collaboration.42 In economics, the cost-benefit calculation is projected onto various problems as a formal instrument for analysing human interaction, but the field does not (and cannot) ignore insight from related disciplines in the subsequent analysis. 1.1.2.5 Legal Dogmatics The concrete application of the law is based on a legal dogmatic method.43 Legal dogmatics systematises and classifies the legal norms in a given legal system so that they can be applied to specific situations. It is intended to capture the normative meaning of the law—the ‘legal ought’. Questions on the normativity of law establish what law is ‘applicable’ in each situation. This approach is scientific if the answer is

38

See, e.g., Sunstein (2000), Schmid (2004) and Zamir and Teichman (2018). See Sect. 1.2.2.2.3.2 below. 40 See Husa (2015) for an introduction to comparative law, Rosenfeld and Sajó (2012) for an introduction to comparative constitutional law, and Rose-Ackerman and Lindseth (2010) for an introduction to comparative administrative law. 41 For a general overview, see Mattei (1997), chap. 1, and Ramello (2016); see Faure and Skogh (2003) regarding the field of environmental law and economics. 42 On the necessary interdisciplinarity of economics and the relativisation of the ‘imperialism’ critique, Homann and Suchanek (2005), 6.4.1. 43 On legal dogmatics, see, e.g., Hanson (1999). 39

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obtained through generally accepted methods that reflect various legal methodologies. Law aspires to be internally consistent, which means logical and free of contradictions. Because it works exclusively with language, it uses terms and expressions that are combined to form a mental construct. These structural elements are the subject of (analytical) legal theory, which offers more than simply a methodology. Due to the central role of language, current legal theory is strongly influenced by linguistic analysis.44

1.2

Theoretical Concepts

If the field of law and economics is so closely linked to its neighbouring disciplines, what is unique about its theoretical approach? The ‘core’ of the discipline—economic reasoning—is outlined below, along with its distinctions from other (primarily social-scientific) approaches.

1.2.1

Basic Methodological Principles

1.2.1.1 The Importance of Jurisprudence in a Narrower Sense (Legal Dogmatics) Within Economics It should be noted here that the economic analysis of law is more than a quasimechanical transfer of economic methods to the social phenomenon of law, because the specific legal questions examined in a given study have an impact on the applied method. When scholars consider what law is and what purpose a legal rule serves in a specific case, they are considering questions of jurisprudence. In the field of law and economics, no analysis of an issue (e.g. the effectiveness of an ecological tax reform) can be conducted without an examination of the purpose of the laws in terms of their intended effects—that is, without an application of the methodology of jurisprudence. Of course, an economic analysis can also lead to a criticism of the purpose of the law itself, for example if that purpose is found to be insufficiently ambitious. A sophisticated economic analysis of law ultimately aims to integrate the methods of economics with those of jurisprudence. 1.2.1.2 Jurisprudence and Economics as Phenomenological and Normative Sciences In jurisprudence and economics, as in other sciences, there are two distinct approaches: on the one hand, an examination of a particular subject in the sense of a phenomenological science; and on the other, the normative valuation of that subject, or the development of ideal alternatives, in the sense of a normative science. Traditional jurisprudence is a fundamentally normative science that derives its 44

E.g. through the philosophy of language of H. L. A. Hart (1907–1992).

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judgements from legal norms—above all, the constitution and laws. Methods based on a ‘phenomenological science’ play a subordinate (though non-negligible) role in the process of making and implementing laws. In economics, however, there is a more fundamental distinction between two concepts: especially in the context of law, statements can be objective (in positive analysis) or evaluative (in normative analysis).45

1.2.1.3 Normative Analysis of Law Normative analysis is useful in assessing and providing (evaluative) economic criticism of state measures (and thus the law).46 Normative economic theory aims to establish whether a law is ‘good’ or ‘right’. This is primarily determined on the basis of efficiency, which is interpreted as aggregate total benefits of a situation or measure relative to total costs.47 It is informative to compare this with the central normative criterion of jurisprudence—fairness—in order to identify similarities or even common (philosophical) roots.48 Fairness is measured in terms of distribution between certain individuals. This basic concept can be illustrated with a pie: efficiency refers to the size of the pie, while fairness refers to the distribution of its slices among individuals.49 In this context, there would be no contradiction between efficiency and fairness only if the larger pie could be redistributed among individuals at no cost; however, doing so is generally expensive and complicated.50 The normative economic evaluation of social conditions and law has its roots in classical welfare economics. It assesses the allocation of generally scarce resources on the basis of the greatest possible benefit to society; the central valuation standard is social welfare. Allocative efficiency is essentially operationalised as two influential concepts: the Pareto criterion and the Kaldor-Hicks criterion.51 The Pareto efficiency criterion, named for Vilfredo Pareto (1896), states that a government measure is justified if it makes at least one person better off without making anyone worse off. While this may seem intuitive, an outcome of this sort is relatively rare in practice. Therefore, the economists Nicholas Kaldor and John Hicks (1939) developed a principle according to which any action is justified if, at least theoretically, those made better off by the measure can compensate those made worse off: the net balance of positive and negative effects must be positive. If multiple measures meet this condition, the one with the best cost-benefit ratio is of course preferable.52

On this dichotomy, see Posner (2014), part 1, § 2.2; McAdams and Rasmusen (2007), pp. 1588 ff. See Mackaay (2013), pp. 13 ff. 47 Polinsky (2011), p. 7. 48 For an overview, see Towfigh (2015), pp. 28 ff.; for greater depth, Mathis (2009). 49 Polinsky (2011), pp. 7 ff. 50 Ibid., 13 ff., 157 ff. 51 See, e.g., Malloy (2019), pp. 35 ff. 52 Revesz and Stavins (2007), pp. 505 ff. 45 46

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The theoretical foundation of this approach is utilitarianism (from the Latin utilis, useful), a doctrine generally traced back53 to the works of Jeremy Bentham.54 These principles became influential in the English-speaking world, particularly in the US.55 Utilitarianism evaluates actions or rules as ‘good’ (moral) if they maximise the utility of the individual or the total utility of the society. At the societal level, preference is given to rules that increase the (total or) average utility of the society. To determine whether it makes sense for a society as a whole to shift from social condition x to social condition y, the negative consequences experienced by those who are disadvantaged by the shift must be subtracted from the positive consequences experienced by those who benefit.56 Schäfer and Ott use the image of a ‘welfare thermometer’ to explain the basic principle of utilitarianism in concrete terms: ‘imagine that each member of society carries a thermometer in their pocket that displays their individual well-being on a scale. The sum of the values of all thermometers indicates the overall well-being. From a utilitarian standpoint, a law or any other governmental decision is justified if it raises the temperature reading on the social-welfare thermometer.’57 Of course, as this comparison indicates, there are significant objections to the application of the normative efficiency criterion to law and legislation.58 After a century in which utiliarianism had dominated the field of economics, Lionel Robbins criticised the fundamental principles of the doctrine in his Essay on the Nature and Significance of Economic Science, published in 1932.59 Most of Robbins’s criticism concerned the possibility of evaluating utility numerically as well as the ability to make interpersonal comparisons.60 For example, what methods could accurately measure the changes in utility associated with pride or shame or the perception of fair or unfair treatment?61 Wealth maximisation, which is often explicitly or implicitly used as benchmark, is only a rough proxy, as it cannot be more than a means to other ends, like happiness or health.62 To address questions like these, it is necessary to draw on the findings of happiness research.63 Identifying relevant preferences of people (regardless of whether these preferences can be aggregated) proves to be equally difficult. This comparison on the basis of well-being implies that monetary units and ‘benefit units’ are not equal. The Kaldor-Hicks criterion for efficiency—‘willingness to pay’—necessarily leads to indeterminate results because of the

53

See, e.g., Posner (2005). On Bentham’s concept of utilitarianism, see Crimmins (2014) and Mathis (2009), chap. 6. 55 See Rowley (2005), pp. 7 f., 18 ff. 56 On the ways and means to do so, see Stiglitz and Rosengard (2015), pp. 173 ff. 57 Schäfer and Ott (2020), chap. 2.7. (Translation by the author.) 58 See Driesen and Malloy (2017). 59 Robbins (1932/1935). 60 Described as a ‘measurement problem’ in Mathis (2009), chap. 3.III.2. 61 See, in particular, McAdams and Rasmusen (2007), pp. 1593 f. and further reference. 62 Driesen and Malloy (2017), pp. 301 ff. 63 See Frey and Stutzer (2002). 54

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disparity between willingness to pay and willingness to accept.64 In addition, it is unclear how to account for the fact that norms influence individuals’ preferences, making their effect on welfare part of a feedback loop.65 The critiques conclude from this that the efficiency criterion is interminate because we cannot rely on an ‘economic truth’.66 Even if the fundamental deficiencies of the efficiency criterion are ignored, the application of this benchmark to law and legislation is highly problematic. Law cannot determine how resources are allocated; it can only provide a framework of rules that may influence allocation.67 Cost-benefit analysis is also subject to uncertainties regarding the future effects of legal instruments.68 Recent financial crises have shown that systemic risks pose a greater threat to wealth maximisation than do possible inefficiencies. Macroeconomic theories should be prioritised over normative efficiency analysis that treats law as a general framework for avoiding systemic risks and maximising economic opportunities.69 The efficiency criterion does not only present methodological deficiencies; it also raises problems when it is applied to law and the legislature. Critics argue that fundamental normative principles must be considered in addition to an equitable distribution of goods, above all human rights and democratic principles; a democratically legitimised legislature thus cannot be overlooked when determining what qualifies as ‘fair’ in a given situation. It is always a dangerous situation when legislators use arguments of truth—economic or otherwise—to justify law. Political decisions are essentially based on value judgements,70 and in democracies, such choices must be transparent and justified. Relevant values include justice, equality, fairness and access. Politicians and lawyers must assess whether and to what extent efficiency promotes these values in specific situations. Driesen and Malloy conclude: ‘Thus, instead of treating law as a subject of economic analysis. . .legal professionals should be treating economics as a subject of law.’71 In addition, a constitutional tradition based on human rights—and human dignity in particular—does not allow for a numerical, interpersonal comparison of benefits. As Peter Häberle72 has stated, in this sense, the values enshrined in the constitution restrict the ‘economisation’ of legal relations. The ongoing debate over the viability of efficiency as a legal principle is largely unproductive. Proponents contend that, when considered as a whole, individual constitutional provisions (such as the

Driesen and Malloy (2017), p. 301. On bounded rationality and the disparity between ‘willingness to pay’ and ‘willingness to accept’, see Sect. 1.2.2.2.3.2 below. 65 See, in particular, McAdams and Rasmusen (2007), pp. 1594 f. and further reference. 66 Driesen and Malloy (2017), p. 309. 67 Ibid., 303. 68 Ibid., 304 f. 69 Ibid., 302. 70 Driesen and Malloy (2017), p. 301. 71 Ibid., 307. 72 Häberle (1984), p. 45. 64

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budgetary principle of economic efficiency) validate efficiency as a legal principle. If an independent legal principle is established on the basis of this kind of ‘overall view’, however, it can go no further than its positive legal components. Against this background, efficiency criteria appear to play a relatively minor role in the suite of values guiding the legislature. With regard to equity and justice, there is a suspicion that efficiency tends to favour the wealthy, as willingness to pay depends heavily on ability to pay.73 On the other hand, there are good reasons to assume that equality may increase efficiency due to the relationship between utility and the distribution of income: transferring resources from rich to the poor may increase overall utility because the marginal utility of the same quantity of resources will be greater for people of limited means.74 But the reality is worse: efficiency, as indicated by the Kaldor-Hicks criterion, is based on the assumption that an increase in wealth can be used to compensate those who are disadvantaged. Although measures are premised on the possibility of compensation, it is uncertain whether compensation will actually be provided in practice.75 Normative law and economics based on the efficiency principle and utilitarianism has never been uncontroversial, even in the US. This is reflected in dramatic fashion in the shifting views of the ‘patriarch’ of economic analysis, Richard Allen Posner.76 Initially, Posner assumed77 that the normative foundations of the economic analysis of law were based on utilitarianism but did not examine this assumption in greater detail or reflect on its implications. This changed with his essay ‘Utilitarianism, Economics, and Legal Theory’, published in 1979,78 in which he developed the concept of wealth maximisation (although the distinction he tried to draw between this and utilitarianism was largely artificial). In the early 1980s, he attempted to defend this approach using consensus theory.79 Since the 1990s, however, he has taken a pragmatic approach that is based on a positive understanding of the efficiency criterion and views it as one of several legal principles.80 Indeed, the main objections to the central role of (allocative) efficiency are valid only for its use as a material criterion within normative law and economics. In this context, it is a goal in itself—or, in the terminology of Mercuro and Medema, a ‘firstorder rule’.81 In its positive variant (as a ‘second-order rule’), it is a part of the

73

Driesen and Malloy (2017), p. 302 and further reference. Ibid., 304 and further reference. 75 Ibid., 301 and further reference. 76 Presented well in Mathis (2009), chap. 8. 77 See, e.g., the first edition of his textbook Economic Analysis of Law, published in 1972. 78 Posner (1979), pp. 103 ff. 79 See, e.g., Posner (1985), pp. 85 ff. For further detail on approaches that are based on social contract theory and consensus theory, see Sect. 2.2.1.1 below. 80 On this point, see also chap. 3, ‘Normative law and economics: from utilitarianism to pragmatism’, in Posner (2001), pp. 95 ff. 81 Mercuro and Medema (1997), pp. 183 ff. 74

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positive economic analysis of law82 and only a means by which non-economic goals are pursued. ‘Efficiency’, in a positive context, denotes the extent to which a law actually produces an efficient allocation of scarce resources in society. It suggests possible pathways to achieve the goals of a society—as formulated by the legislature—in the least costly manner.83 Efficiency, in this sense, cannot be measured in absolute terms, but is an optimisation method that necessarily entails a comparison between different institutional settings or instruments.84 This can be a useful tool when legal policymakers evaluate options for new laws. In this respect, the efficiency criterion is an important component of normative decision theory as an interdisciplinary research field.85 It is generally understood as the assumption that the legislature strives to create efficient laws, which makes efficiency one of the goals of legal acts and instruments.86 In the past, the positive variant of the efficiency principle figured prominently in criticism of environmental law and in the development of new (primarily economic) instruments of environmental policy.87 Thus, from an economic perspective, the (lack of) allocative efficiency has become an effective addition to existing criticism of environmental regulatory law: other instruments were shown to achieve certain environmental policy objectives at considerably lower total economic costs. Because environmental protection measures generally entail (high) financial costs—borne not necessarily by the state, but by social actors—more efficient instruments can offer greater environmental benefits at the same price. Economic evidence on environmental liability provides a second example. Findings have shown that increasing the severity of liability is not in itself an ideal solution. As the scope of liability expands, companies incur greater aggregate abatement costs. Under a strict liability regime, these costs may even be considerably higher than the (avoided) costs of damage.88

1.2.1.4 Positive Analysis of Law The positive analysis of law also originated in the US89 but has been of central interest in Europe from the very beginning. Positive analysis serves as the basis for statements on elements of existing law, including the reasons for its creation, its structure and the mechanisms through which it has its effect.90 This analysis serves

82

See Sect. 1.2.1.4 below. Mercuro and Medema (1997), pp. 183 ff. 84 Richter and Furubotn (2014), X.2.5. 85 Van Aaken (2004), pp. 28 ff. 86 Kornhauser (2017), 1.3., makes the provocative statement that the legislature could theoretically also adopt non-efficiency as a criterion for selecting a legal rule. 87 See the detailed discussion in Sect. 7.2.1.2 below. 88 For further detail, see Sect. 7.2.2.3 below. 89 Friedman can be viewed as one of its founding fathers. In his 1953 essay ‘The Methodology of Positive Economics’, he draws comparisons with the natural sciences; this could serve as a model for similar applications. 90 For an overview, see McAdams and Rasmusen (2007), pp. 1588 ff. 83

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as a theory of human choice that examines behaviour and actions and makes it possible to issue empirically verifiable statements on the behaviour of agents. The positive analysis of law gained additional momentum with the strengthening of institutional economics91 and with the efforts of other disciplines to develop an overarching theory of action.92 Kornhauser identified three strands of the positive economic analysis of law: policy analysis, political economy and doctrinal analysis.93 The first area, policy analysis, focuses on an analysis of the effects of legal rules and institutions on outcomes. It provides legal-impact analysis as a tool to assess the consequences of law or legal norms.94 Economic theory seems especially suitable for this application because, at its core, it engages with questions of human behaviour. As a rule, however, the effectiveness of a law is determined by the behaviour of those subject to the legislation. The effectiveness of legal norms can also be analysed empirically ex post, as is often the case in the sociology of law. An advantage of economic analysis is that it can be used in ex-ante evaluations as well. This is especially useful in addressing the crucial question of how a legislative goal can be achieved in the best way possible (with the fewest possible adverse effects). Because legal-impact assessments in law and economics are based on analytical models, they can also help avoid the often-great expense of empirical social research. Of course, there is no reason not to test these findings empirically, even if tests are conducted only on a random basis. The second strand of positive economic analysis of law, which can be called political economy, examines the operation of political institutions such as electoral systems, legislators, the executive or administrative agencies. The aim of this form of analysis is to explain how laws are created and why laws exist as they do. These explanations can serve as the basis for theories about legislators, bureaucracy or interest groups.95 This allows law and economics to play a key role in the development of improved governance systems or a more rational legal policy. The third strand of the positive analysis of law refers to doctrinal analysis.96 Impact orientation can also be meaningful in examining the application of law.97 Impact-based or consequence analysis plays an important role in teleological evaluations of the significance of goal-oriented norms (which are, after all, designed to produce certain outcomes).98 For example, the efficient allocation of emission allowances is an essential objective of emissions trading law—an objective that can,

91

For further detail, see Sect. 1.2.2.3.2 below. See e.g. Coleman (1990). 93 Kornhauser (2017), 1.3. 94 Regarding research on the effects of law, see, e.g., Rodi (2002). 95 For further detail, see Sects. 3.3.2 and 4.1 below. 96 Kornhauser (2017), p. 2. 97 On the role of economics in dogmatic jurisprudence, see Tontrup (1998), pp. 41 ff. 98 On impact-oriented assessment, see van Aaken (2003), pp. 150 ff. 92

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and indeed must, be considered when developing specific schemes for allocation.99 An impact-based application of law is very important with regard to basic rights. The question of whether a law conflicts with basic rights can only be answered if the (probable or potential) effects of the law have been clarified in advance. Thus, in the German Federal Constitutional Court’s decision on pharmacies (Apothekenurteil),100 for example, the central question was whether and to what degree the restriction on the ‘freedom of establishment’ of pharmacies actually has a positive effect on public health that would justify the regulation. Another notable example is the Makwanyane judgement of the South African Constitutional Court, which established whether the death penalty violated the right to life guaranteed under the South African Constitution.101 In this case, the extent to which the death penalty serves as a deterrent was crucial for its justification. Empirical evidence thus has a wide variety of important applications, including in the context of legal dogmatics.

1.2.2

Methodological Foundations of the Economic Analysis of Law

Analysis in the field of law and economics, as in any other scientific discipline, must be guided by a methodological framework. This section introduces the main features of its scientific approach.

1.2.2.1 Theoretical and Empirical Research As in other areas of the social sciences, there is an essential connection between theoretical and empirical research:102 a mere observation of reality without theory leads to an accumulation of facts, but not to an advancement of knowledge that can explain the findings. A mere consideration of theories as l’art pour l’art, on the other hand, is like a ‘glass bead game’ (Hesse) that fails to incorporate the very object of its analysis: reality.103 For a scientific investigation of reality, it is necessary to have a theoretical foundation and a model. A 1:1 representation of reality is not science. Science is made possible only by systematically reducing complexity. This requires a selection based on an evaluation of alternatives. The need for a selection reflects the insight

99

See the detailed explanation in Sect. 7.2.5.4 below. Decisions of the Federal Constitutional Court (BVerfGE), vol. 7, 377; Bumke and Voßkuhle (2019), pp. 985 f., 1020. 101 S. v. Makwanyane, 1995 (3) SA 391 (CC); on this example, see Petersen and Towfigh (2015), p. 7. 102 On the relationship between theory and practice in law and economics, see Cserne (2020), pp. 13 ff. 103 This comparison is not intended to discredit Herman Hesse’s Glasperlenspiel. Nowhere else in literature is there such a passionate plea for the integration of individual scientific disciplines and thus for interdisciplinarity. 100

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articulated by Hans Albert—‘he who wants to see everything, sees nothing at all’.104 The further one abstracts from reality in the models, however, the more vulnerable one becomes to criticism of the resulting simplifications. Much of the art of scientific research lies in balancing this dilemma of proximity and distance—in viewing reality from a position that is as close as possible and as far away as necessary. In this respect, theories can be compared using ‘lenses’ of varying strengths.105 Guy Kirsch has vividly described the nature and function of scientific theories by comparing them to fishing nets: Just as what you pull ashore from the sea depends not only on what swims in the water, but also on the nature of the net, so too does knowledge of reality depend on the type of theory you have applied. Whoever uses a coarse mesh net will not catch small fish; it would be unwise to deduce from this that there are only large ones. Whoever uses a certain theory will only grasp certain aspects of reality; he cannot say that other aspects do not exist. If you want to be as informed as possible about the animals living in the sea, you must cast a variety of nets.106

The image of the fishing net also illustrates that there can be no ‘correct’ theory. Scientific theories must be suited to the problem addressed.107 This may require the simultaneous application of multiple theoretical approaches—the principle behind ‘methodological pluralism’.108 ‘Theoretical monism’ must be rejected; law and economics necessarily represents a plurality of interdisciplinary exchanges.109 It is only natural that, as a new scientific approach, economics was at first most strongly occupied with the development of its theoretical principles. The discipline has made considerable progress since then—especially in recent decades, as will become clear later in this text. Theory and model assumptions make it possible to develop statements on problems, which are issued in the form of hypotheses. It is important to remember that, although these should ideally be tested empirically, it is not always possible to do so because empirical social research is typically costly and time-consuming. There is, however, some indication that Ulen may be correct in his prediction that there will be much more empirical work in law and economics in the coming years.110

1.2.2.2 The Economic Paradigm and the Concept of Homo Economicus Methodological approaches in law and economics are diverse and divergent (as is evident from the discussion of normative and positive analysis). Nevertheless, the

104

Albert (1978). Dehling and Schubert (2011), pp. 23 ff. 106 Kirsch (2004), p. 2 (translation by the author). 107 Relatedly, Friedman (1953), p. 36: ‘Everything depends on the problem.’ 108 On methodological pluralism (particularly the combination of economics and systems theory), see Kirsch (2004), pp. 49–53. 109 Cserne (2020), pp. 9 ff. 110 Ulen (2007), pp. 21 ff. 105

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field is based on microeconomic principles: it is rooted in classical welfare economics111 as well as in decision theory and in theories of voter choice. This approach reflects the following heuristic assumption: individuals decide on the basis of their preferences to maximise their benefits, taking limitations into account; in short, they maximise their benefits under constraints. The analysis of law applies two premises and two principles of microeconomic theory: the premises of methodological individualism (see Sect. 1.2.2.2.1) and resource scarcity (Sect. 1.2.2.2.2), as well as the fundamental principle of the behavioural model of homo economicus (the assumption that individuals act in a rational, self-interested way) (Sect. 1.2.2.2.3). These are also the basis for more advanced approaches that are particularly suitable for an economic analysis of public law, such as the New Political Economy (public choice) and institutional economics.112 1.2.2.2.1 Methodological Individualism The primary methodological foundation of any economic analysis is the assumption that decisions made by individuals are the root of all social and economic interactions. This approach is called methodological individualism, a term coined in 1908 by Joseph Schumpeter.113 Methodological individualism is regarded as the foundation of welfare economics and of modern economics more generally. Social macro phenomena like cooperation, solidarity and trust are explained as the result of individual behaviour; organisations and societies are analysed in terms of the aggregate behaviour of the individuals comprising them. This does not mean that organisations cannot be perceived as independent actors: the actions of organisations are attributed to the behaviour of the individuals acting within the organisational framework.114 Unlike (social) psychology, economic theory cannot and does not claim to be able to evaluate or predict the behaviour of specific individuals. It is based instead on behavioural patterns identified in the aggregate. These patterns are based on the average behaviour of a large number of actors who are in the same decision-making situation, i.e. on the behaviour of a ‘typical’ human being.115 It thus considers actions in terms of the dominant or representative behaviour, which give rise to theoretical explanations that apply ‘in general’, though not necessarily in individual cases.116

111

See, e.g., Cooter and Ulen (2016), chap. 2. See Sects. 1.2.2.2.3.2 and 1.2.3.7 below. 113 Schumpeter (1908), pp. 88 ff.; see Heertje (2004). Schumpeter uses the term ‘methodological individualism’ to distinguish a value-neutral analysis from political individualism on the grounds that the former reduces economic processes to individual decisions, while the latter demands greater civil liberties; see Schumpeter (1908), p. 90. The intellectual history of this approach can be traced back to Locke and Hobbes; see Hodgson (2007). 114 For further detail, see Sect. 3.1 below. 115 Towfigh (2015), pp. 18 f. 116 Kirchgässner (2008), pp. 12 ff., 18 f. 112

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In order to avoid misunderstandings, it is important to point out that methodological individualism refers to a formal and value-neutral approach to gain scientific knowledge. It must be strictly distinguished from normative individualism, which evaluates social phenomena through a theoretical reconstruction and aggregation of individual values.117 This is the assumption applied in contract theory, for example.118 Normative individualism plays an important role in law, and especially in modern constitutions, which are grounded in basic rights and the principle of human dignity. The counterpoint to methodological individualism is collectivism, which also has a positive variant (e.g. systems theory) and a normative variant. Methodological collectivism searches for explanations and patterns of behaviour not in the actions of individuals, but in the actions of groups, including classes, ethnic groups and societies as a whole.119 1.2.2.2.2 The Premise of Resource Scarcity Another fundamental premise of the economic sciences as a whole, and economics in particular, is the assumption of scarce goods (resource scarcity).120 Human wants are virtually unlimited, but the resources available to satisfy them are limited. This applies not only to tangible goods, but also to intangible goods like security, knowledge and the legal system.121 Time and available information can also be scarce in this sense. When individuals make a choice, they are operating under conditions of scarcity, i.e. in the context of limited resources. This basic assumption has lost importance in modern economics. The limited resources available to maximise benefits should be regarded as one of the constraints in the decision-making process.122 Thus, each decision must be seen in the context of the alternative options not taken, which are passed up at a price (‘opportunity costs’).123 1.2.2.2.3 The Homo Economicus Model of Behaviour At the core of economic methodology is the behavioural or action model of homo economicus, which assumes that individuals (‘actors’) act rationally and in their own self-interest to maximise their own benefits. The rationality paradigm applied in economics is an extension of a long tradition of thinking.124 This behavioural model is an assumption, not a hypothesis.125 It is therefore not an empirically testable assertion, but a pre-empirical explanatory model.126 It is a

117

For an ethical perspective, see Von der Pfordten (2012). See Chap. 2 below. 119 Spicker (2020), I.2. 120 See Mackaay (2013), pp. 36 ff. 121 Towfigh (2015), pp. 19 f. 122 See Sect. 1.2.2.2.3.3 below. 123 In this context, Cirace (2018), pp. 11 ff. 124 Sent (2018), pp. 1371 ff. 125 Towfigh (2015), pp. 24 f. 126 Schreck et al. (2020), pp. 406 f. 118

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heuristic to explain behaviour, and in this respect serves as a ‘template for interpretation’; it cannot be empirically refuted.127 As a model, the behavioral assumption of homo economicus (or the ‘economic man’) is a theoretical construct. It is not based on any specific conception of humanity.128 Criticism of the homo economicus model as an inaccurate portrayal of human beings129 does not sufficiently distinguish between (normative) views of humans and (empirical) models of behaviour. Therefore, the allegation that this behavioural model is incompatible130 with the image of humanity reflected in law (including in the Basic Law) is void from the outset. The model assumes only a few very weak basic characteristics of humans, which primarily refer to to their ability to act strategically; people can imagine the possible consequences of different behaviours in interactions and base their behaviour on these perceptions as they act in accordance with their specific intentions.131 The fact that their actions are motivated by the desire to maximise their own benefits connects them to all living beings on a fundamental level; this is essentially a core anthropological assumption. After all, it is a truism that the human being, as a ‘political animal’ (zoon politikon), is also social by nature; it realises its existence only in a social context and can therefore be conceptualised in terms of interaction theory. Ralf Dahrendorf’s ‘homo sociologicus’132 is thus much less an analogue to than an extension of homo economicus. Recent research based on behavioral experiments has not resulted in a ‘Requiem for Homo Economicus’;133 it has reconciled the pre-empirical assumption of the rational choice model with the fact that humans also have clear tendencies to act morally and cooperatively.134 This ability has even been a comparative evolutionary advantage of humankind. 1.2.2.2.3.1 Maximisation of Utility as a Basic Assumption of the Rational Choice Model

The rational choice model is based on two underlying assumptions: first, that individuals evaluate their decision-making options in accordance with their own interests (self-interest theorem) and, second, that individuals attempt to maximise their utility (the rationality assumption).135 They set goals for themselves and try to achieve these in the best possible way within the limits of the available options; rational action is therefore necessarily goal-oriented rational action. It is implied that

127

See also Kirchgässner (2008), pp. 17 f.: theoretically, the rationality assumption can also be seen as a hypothesis, but due to its generality, testing may be difficult. In this sense, Vanberg (2004) differentiates between a purely heuristic rationality principle and a refutable rationality hypothesis. 128 Homann and Suchanek (2005), pp. 371, 374 f. (6.3.4.3). 129 See the attempt in Niemann (2011) to criticise economics from an ethical and moral perspective. 130 See, in particular, Fezer (1986), pp. 817 ff., 821. 131 Homann and Suchanek (2005), 6.3.4.3. 132 Dahrendorf (1958/1971). See Kühne and Leonardi (2020), pp. 85 ff. 133 O’Boyle (2007). 134 This concept is referred to as ‘homo socio-economicus’ in Schreck et al. (2020). 135 See, e.g., Towfigh (2015), pp. 21 ff.; Kirchgässner (2008), pp. 12 ff.

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the ‘economic man’ reaches decisions on the basis of all available information (the principle of complete information). In modern economics, the concept of utility is understood broadly and by no means only in monetary terms. Utility depends on personal preferences. Here, too, economic analysis is neutral and accepts preferences of all kinds: a manager might act with an eye towards their company’s total revenue; a politician might pursue reelection; a third party might view their utility as ‘altruistic’ in promoting the wellbeing of others (‘personal utility functions’). Self-interestedness must therefore be distinguished from egoism.136 The behavioural assumption of utility maximisation means that a decision-maker chooses the option that provides the greatest benefit given his or her specific interests or preferences. 1.2.2.2.3.2 The Rational Behaviour Assumption: Criticism and Modifications

The rational behaviour assumption has long been met with fundamental objections. According to critics, the assumption that individuals always make fully informed decisions is as unrealistic as the assumption that their decisions are always rational. These arguments are only partly relevant to economic analysis, however, because economics has developed and refined its instruments to take these objections into account. Relativising the Assumption of Complete Information Unlike classical theories of welfare economics, modern economics has abandoned the assumption that actors have complete information.137 It simply reflects the reality that individuals do not, and in fact cannot, always behave as utility maximisers. Instead, due to their limited knowledge, they ‘only’ pursue a reasonable course of action to attain a certain degree of satisfaction from reaching a specific level of aspiration. As soon as it seems advantageous to them, they expand their knowledge through processes of seeking and learning. There are costs associated with obtaining information, and it is rational to weigh these additional costs against the risk of making decisions that are disadvantageous. This is one reason why human behaviour is largely based on institutionally embedded routines that are questioned only in exceptional cases, an observation that can be verified rationally as well as empirically.138 The costs of acquiring information and the impossibility of obtaining complete information in practice can also be understood as constraints on action. Robert H. Frank identifies a paradox here: it would often be irrational to be fully informed.139 The interesting phenomenon of customary or habitual behaviour points to the influences of both economic rationality and anthropological or psychological perspectives. Psychologists now consider it self-evident that the frequency of past behaviour influences current conduct.140 This naturally plays an important role in

136

Towfigh (2015), p. 22. See, e.g., Towfigh (2015), pp. 24 f. 138 North (1990a); North (1990b), pp. 17 ff., 20 ff. 139 Frank (2005), p. 14. 140 Dawnay and Shah (2011), pp. 79 ff. and further reference. 137

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simple, often-repeated actions of daily life. But even in complex decision-making scenarios where consequences are difficult to anticipate, individuals more or less consciously fall back on simple, tried-and-tested rules for decision-making. A tendency to base actions on schemas (i.e. habits or frames) is not necessarily irrational if it enables the individual to avoid considerable analytical costs and facilitates the orientation of their actions in complex contexts.141 Economics can— and must—take this into account in its behavioural assumptions and in policy recommendations. It is not enough to provide incentives; incentives must be strong enough, either on their own or in combination with other measures, to break old habits and replace them with new ones. The significance of this effect was underestimated in the liberalisation of the electricity market, for example, as the vast majority of customers remained with their original electricity supplier out of habit. Bounded Rationality It is clear from the paragraphs above that incomplete information and habitual behaviour can—to a certain extent—be understood as rational behaviour. Still, modern economics recognises that people can, and often do, behave irrationally.142 Different kinds of behaviour may appear as irrational at first sight. ‘Irrationality’ that is due to psychopathological deviation is not examined in economics, as it is not useful in models predicting aggregated behaviour. Behaviour based on the unconscious is of greater interest in economics; initial (though burdensome) efforts have been made to integrate such behaviour into economic theory and an economic analysis of law.143 ‘Limited’ or ‘bounded’ rationality represents another deviation from classical rational behaviour.144 These are patterns that could be explained by psychologists at a more general level as part of a new branch of research called behavioural economics.145 To the extent that behavioural patterns—whether rational or irrational—can be predicted, they can be integrated into economic models. This kind of ‘regularly irrational behaviour’146 can be used to develop more sophisticated theories.147 It can also be described as ‘predictable irrationality’148 or ‘quasi-rationality’.149 If ‘irrational’ behaviour proves to be significant in the aggregate, it can

Korobkin and Ulen (2000), pp. 1113 ff., emphasises that, in addition to ‘rational’ habits, there are also habits based on tradition and ‘bad’ habits, like addictions; these must be treated differently by economic analysis. On addiction, see the discussion of ‘bounded willpower or self-control’ below. 142 For an overview of typical forms of non-rationality, see Congdon et al. (2011), pp. 32 f. 143 See Dailey (2017) and further reference. 144 The work of Simon (1990) is groundbreaking on this topic. 145 For an overview, see Bernheim et al. (2018). 146 See Ariely (2010). 147 See, e.g., Congdon et al. (2011), chap. 2, and Frank (2005), pp. 13 ff., on systematic deviations from rational behaviour. 148 Ariely (2010). 149 Thaler (1991). 141

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provide the basis for ‘tendency statements’150 that should be considered in law and economics, e.g. in the design of legal policy instruments. These factors can be incorporated into the rational choice approach if biased choices are recognised as such and attempts are made to ‘debias’ them ex ante to improve predictions. This insight can be traced back to the 1940s.151 Herbert A. Simon defined the term bounded rationality in 1947: The principle of bounded rationality [is that] the capacity of the human mind for formulating and solving complex problems is very small compared to the size of the problems whose solution is required for objectively rational behaviour in the real world – or even for a reasonable approximation to such objective rationality.152

Since the 1970s, psychological research has focused extensively on the phenomenon of systematically irrational human behaviour. In groundbreaking studies based on empirical (and above all experimental) data, Kahnemann and Tversky compiled an entire catalogue of decision-making situations in which systematic deviations from rational behaviour are observed.153 This work has established an interesting and productive entry point for scientific exchange between economics and psychology— the classical science of human behaviour154—and laid the foundation for a new branch of economics: behavioural law and economics. The connection between these fields was made clear when, in 2002, Daniel Kahneman became the first psychologist to be awarded the Nobel Memorial Prize in Economic Sciences.155 In light of these developments, it is hardly surprising that new insights from neurology have increasingly been incorporated into not only psychology, but also economics (‘neuroeconomics’).156 Modern economics seeks to absorb relevant findings from empirical behavioural sciences and systematically integrate them into model assumptions.157 Bounded rationality158 is associated with this line of research.159 Jolls, Sunstein and Thaler have argued persuasively that a psychologically informed behavioural model recognises that rational behaviour is limited, or ‘bounded’, in three respects: (1) bounded self-interest, (2) bounded willpower and (3) bounded rationality. The

150

Medema (2007), pp. 246 ff., with reference to Alfred Marshall. See, e.g., Kirchgässner (2008), pp. 186 ff. 152 Simon (1947), p. 198. 153 See, e.g., Tversky and Kahnemann (1974), pp. 1174 ff.; Tversky and Kahnemann (1981), pp. 453 ff. 154 See also Altman (2009), pp. 164 ff. 155 See, e.g., Jolls (2007), pp. 10 ff. 156 On the foundations of ‘neuroeconomics’, see Glimcher (2003); on the relevance of this concept to law, McCabe et al. (2005). 157 Trachtman (2008), p. 1 and further reference. 158 Simon (1955), pp. 99 ff. 159 Kirchgässner (2008), 2.2 (25 ff.), is recommended reading on this point. 151

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latter category can be further divided into bounded judgements and bounded decision-making.160 ‘Bounded rationality’ can describe limits to self-interested behaviour (e.g. modifications based on beliefs about morality and fairness)161 as well as the inconsistent ranking of preferences and the failure to act rationally to reach utilitymaximising decisions. Modern economics does not turn a blind eye to the complexity of human beings, including the anthropological or cultural influences on their thinking and feeling or the societal influences resulting from their social ties. Decision-making is affected not only by the goal of maximising utility, but also by basic human needs and instinctive behaviours. These insights reflect findings from anthropology. The effects of feelings and emotions on individual decisions is particularly interesting in this context.162 The influence of morals and perceptions of fairness on individual decision-making behaviour, for example, plays a major role in the analysis of ostensibly ‘irrational’ taxpayer honesty.163 Moral positions can also be conceptualised as restrictions on action.164 Humans dislike it when their decisions contradict their value system (‘cognitive dissonance’) and may prefer economically disadvantageous action over this outcome.165 Moral action can thus also be interpreted as rational in a broader sense. The theory of rational decisions can be contrasted with a theory of rational rule-compliance that emphasises preferences for actions and rules over purely outcome-oriented decisions.166 Moral beliefs also play a certain role in the context of ‘crowding-out effects’, though with an opposite result: intrinsic motivation to behave altruistically can be devalued or eliminated if a monetary incentive is presented.167 In addition to these anthropological influences on individual behaviour, cultural influences are of course highly significant. Denzau and North have identified the important role that ‘shared mental models’ like myths, ideologies and diverse thought systems play as selective filters for decisions.168 These are conveyed consciously or unconsciously in the education of adolescents and shape the socialisation of individuals. Shared mental models are further strengthened by the specific communication networks into which individuals are integrated. In an increasingly complex world, such models provide essential guidance. Our decisions reflect this cultural influence.

160

Kahnemann (2003). Zamir and Teichman (2018), pp. 72 ff.: ‘behavioural ethics’. 162 Vanberg (2008), pp. 241 ff. 163 On questions of tax evasion, see the works of Marta Orviska and Sect. 5.3.1.4.3.2 below. 164 See Sect. 1.2.2.2.3.3 below. 165 Dawnay and Shah (2011), p. 84. 166 Vanberg (2008), pp. 241 ff., is informative on this point. 167 See Dawnay and Shah (2011), pp. 81 ff. 168 Denzau and North (1994), pp. 3 ff. 161

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This builds a bridge to the entire spectrum of social norms and thus to an important research field within the sociology of law.169 Orientation towards the social environment and role models was described above as a possible strategy that would be ‘informationally efficient’. In early childhood, humans learn appropriate behaviour much less through theory than through an alignment with the (presumably tried and tested) behaviour of others. Imitation of behavioural patterns can thus be understood as a kind of ‘procedural rationality’.170 Social standards can affect preferences in individual cases. Empirical evidence shows, for example, that people contribute more to public goods than was assumed under neoclassical theory, such as by purchasing low-emission vehicles despite considerable additional costs.171 People also demonstrate limited rationality simply because they ‘calculate poorly’.172 The more that individuals have invested in a decision, the less likely they are to abandon it, even if the ‘sunk costs’ are no longer relevant to future decisions.173 There is also strong empirical evidence that people tend to overestimate current gains and losses relative to future ones on the basis of an adequate discount rate. In certain respects, addiction can be addressed in these terms as well, because in such cases future advantages (e.g. the absence of illness) are valued (too) little relative to current benefits (i.e. satisfying the addiction). (Memory) errors also arise with regard to the past (‘hindsight bias’); as a result, people tend to regard outcomes that have already occurred as more probable than alternative courses of events. People generally overestimate their ability to influence certain consequences and consider their influence to be significant even in situations that are primarily determined by chance (‘illusion of control’).174 Today, it is clearer than ever that the need to process an increasing flood of information overwhelms the human brain, which responds by developing alternative, informationally efficient strategies to do so. Individuals filter information according to certain criteria (‘frames’), develop routines and ‘rules of thumb’ and base their decisions on those of social leaders or organisations (‘agenda-setters’, ‘trendsetters’).175 When individuals have difficulty ranking preferences consistently, it is generally due to the fact that it is not easy to boil these down to one ‘common denominator’, which would make them commensurate with one another.176 One phenomenon observed at this level is that humans are generally ‘loss-averse’; people perceive the pain of losing something as greater than the pleasure of equivalent gains.177

169

See Sect. 1.1.2.1 above. Dawnay and Shah (2011), pp. 75 ff. 171 See, e.g., Grolleau et al. (2012). 172 Dawnay and Shah (2011), pp. 88 ff., is informative on this point. 173 On the ‘sunk cost’ effect, see Kahnemann and Tversky (1979) and Arkes and Blumer (1985). 174 See Langer (1975). 175 Ørsted (2012), pp. 444 f. and further reference. 176 Ibid., 444 and further reference. 177 On loss aversion, see Kahnemann and Tversky (1979). 170

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Accordingly, people weight the utility of a thing more heavily if it is already in their possession (‘endowment effect’178). A significant consequence of this tendency is that the maximum monetary amount that individuals are willing to pay to acquire a good (‘willingness to pay’) is generally lower than the minimum amount that they are willing to accept to surrender an identical good already in their possession (‘willingness to accept’).179 Empirical evidence has demonstrated that, in keeping with this effect, there is a difference between the willingness to buy and the willingness to sell an identical good.180 In summary, decision-making and the development of preferences are parts of a highly complex process. It is somewhat unfortunate that the concept of bounded rationality has gained general acceptance in this context because, in a broader sense, real-world actions can often be understood as entirely rational. Other concepts have thus far captured this complexity only to a limited extent, however, such as the designation of the ‘new model man’ of economic theory as the ‘resourceful, evaluating, maximising man’ (REMM).181 Herbert Simon, who has contributed greatly to research on the concept of bounded rationality, developed a ‘satisficing model’ to account for alternative behaviour.182 The purpose of this model is to show that humans are not always able to choose the optimal solution; instead, they strive for ‘satisfactory solutions’ and may lower the ‘aspiration level’ if no such solutions are found and any further attempt to optimise their prospects seems too burdensome. Regardless of the specific terminology used, it is important to note that newer findings have made economics more compatible with other disciplines, including those outside the life sciences. These developments have not refuted the rational behaviour model. Instead, they have strengthened it and made it a more accurate reflection of reality. Bounded self-control can be interpreted differently, for instance as the instability of preferences over time or as a reversal of preference.183 Addictive behaviour, for example, has been characterised as an inconsistent ranking of preferences. This inconsistency leads to ‘interpersonal externalities’ or ‘internalities’.184 1.2.2.2.3.3 Constraints and Preferences

The principle of rationality assumes that utility is maximised as a result of individual preferences that are determined with full knowledge of possible restrictions

See Frank (2005), pp. 16 f. The discussion of the ‘endowment effect’ is based on Thaler (1980). See Dawnay and Shah (2011), pp. 86 ff. 180 See also Medema (2007), p. 241. 181 See Brunner and Meckling (1977), pp. 70–85 (71); Brunner and Meckling (1986), pp. 335 ff. 182 See Sidney G. Winter, ‘satisficing’, in: The Palgrave Encyclopedia of Strategic Management, 2018 edition. 183 For a good overview, see Jolls (2007). 184 Congdon et al. (2011), pp. 120 ff. 178 179

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(constraints).185 The totality of constraints, as they are perceived by the individual, is referred to as the ‘situation’. Rationality, after all, means that humans systematically react to incentives. Incentives, as ‘situation-dependent, action-determining expectations of benefits’, are nothing other than the reasons that actors have for their behaviour. Constraints limit the options that individuals have when choosing an action. In essence, constraints refer to anything that restricts the individual’s virtually unlimited wants; these may include budget constraints, technical constraints and/or social constraints. Informal constraints, such as customs and cultural or religious guidelines for action, can be distinguished from formal constraints, like economic or legal requirements.186 In such cases, external influences are combined with anthropological factors, leading self-regulatory mechanisms like feelings of guilt, pride and shame to act as constraints.187 In the example of tax morality mentioned above, a citizen acts in accordance with the law not only because the the advantages of breaking the law are outweighed by the sanctions expected if the transgression is discovered. In this context, morality and the belief in the importance and/or legitimacy of state institutions are in fact much more salient factors.188 Methodologically, it is important to draw a strict distinction between preferences and constraints. (Individual) preferences are not only difficult to ascertain; they are also generally not easy or quick to alter. It has already been mentioned that the preference structures of individuals should by no means be considered unchangeable; they become exogenous over time and can thus be shaped through policy instruments. Neither constraints nor preferences are immutable. If we look at the time axis in terms of constraints and preferences, we can see the multiple feedback effects between individual behaviour and the institutional framework. Individual behaviour is influenced by institutions, but the institutions are themselves the product of collective actions by individuals. This cycle is the focus of evolutionary theories.189 These observations make it clear that the state can affect individual behaviour, not only by imposing and designing restrictions but also by influencing preferences. In the long run, the fact that people integrate moral norms into their preference structures is desirable, in part because it makes these norms more sustainable.190 This is essentially the aim of public education through schools or universities. In certain cases, exogenous incentives can displace intrinsic motivations in a manner that overrides the desired behavioural effect. This situation is referred to as

185

The distinction between preferences and restrictions can also be problematic in individual cases; see Kirchgässner (2008), 2.1 and 2.3. 186 According to North (1990a), pp. 36 ff. and 46 ff. 187 McAdams and Rasmusen (2007), pp. 1579 ff. 188 On the law-abiding citizen, see, e.g., Orviska and Hudson (2006). For further commentary on issues of tax morality and tax evasion, see Sect. 5.3.1.4.3.2 below. 189 See, e.g., Schmid (2004), pp. 8 ff. 190 Kirchgässner (2008), pp. 33 ff.

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‘crowding out’.191 Especially with regard to environmental regulation, the extent to which this effect suppresses the motivation for voluntary environmental protection is the subject of ongoing debate.192 It is nevertheless remarkable that public choice theories regard preferences as given and constant. The modification of restrictions is the basis of state regulation. Legal norms operate like prices, making certain alternative courses of action more or less expensive relative to others. Friedman expressed this in concrete terms by referring to law as a ‘gigantic price machine’.193 There is also, however, a need for political action based on the order of individual preferences. It is therefore not trivial to aggregate and evaluate preferences (such as those of voters) realistically, because the preferences (seemingly) expressed by individual decisions are not necessarily identical, for example in the case of a possible preference for greater redistribution.194 Of course, the legislature can also attempt to intervene in the structure of preferences, such as through specific educational approaches in schools. A particularly delicate issue for behavioural economics concerns the treatment of preferences that are presumably or actually ‘distorted’: should such preferences be accepted or should there be a ‘paternalistic’ attempt to change them?195 This question arose, for example, with regard to ‘consumer sovereignty’ in the demand for media content, especially with regard to the public’s television-viewing habits.196 Thaler and Sunstein, in particular, have indicated the importance of ‘soft paternalism’:197 people often have ‘self-control problems’ and could therefore benefit from a ‘little nudge’. This concept of ‘nudging’ has since been incorporated into legal economic research.198

1.2.2.3 Institutional-Economic Foundations of Public Law To some extent, the economic analysis of public law remains fundamentally limited to microeconomics-based neoclassical welfare economics (especially the influential Chicago School).199 Particularly in an analysis of public law, it is reasonable, if not essential, to address modern developments in economics, such as newer findings on the assumption of rational behaviour.200 Institutional economics201 and the

191

See Sect. 7.2.6 below. See Frey and Oberholzer-Gee (2009); Grepperud (2007), pp. 135 ff. 193 Friedman (1984), pp. 13 ff. 194 Congdon et al. (2011), pp. 56 ff. 195 Ibid., 60 f. 196 See Sect. 3.3.3.1 below. 197 Thaler and Sunstein (2008). 198 See, e.g., Renda (2011), 4.4.2. 199 See, e.g., Faure and Skogh (2003). 200 See Sect. 1.2.2.2.3.2 above. 201 See Sect. 1.2.2.3.2 below. 192

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characteristics of economics as a theory of interaction202 are of particular interest, especially in public law. 1.2.2.3.1 Economics as a Theory of Interaction As discussed above, economics is a theory of human behaviour and actions; it is therefore a decision theory. Decisions often must be made under conditions of scarcity. But resource scarcity is no longer the central axiom of modern economics. It has been replaced by interaction, or transaction, as the basic unit of economic analysis.203 In economics, social interactions are viewed as exchange relationships. The purpose of the exchange is to obtain benefits from cooperation and interaction. Economics considers the opportunities and problems of social cooperation for mutual benefit from this perspective. The analysis focuses primarily on these problems and failures of interaction—which jeopardise potential benefits from cooperation—and on the methods by which state institutions can overcome these obstacles. There are also forms of cooperation that are not in public interest (e.g. cooperation between criminals or cooperation between competitors on a market); these are typically the target of suppressive measures by the state.204 The theory of interaction must take multiple contingencies into account because interaction and cooperation make action conditional on other agents: that is, (other) humans become ‘living constraints’. This has two practical consequences. First, there are common and conflicting interests in every exchange and interaction. The common interest is directed towards the exchange or the cooperation, which can benefit both sides. Conflicting interests arise with regard to the terms of exchange and the distribution of gains from cooperation; this conflict breeds competition. A second practical consequence is that interaction problems can cause the exchange to fail. Typical examples are information problems, transaction costs and incentive problems. A key objective in economics, especially in the field of law and economics, is to design the legal system in such a way that the law can be used as a control mechanism to alleviate interaction problems like these. In economics, the concept of market failure was established to refer to these problems in a market context.205 The concept of the market that is analysed in modern economics has little to do with a traditional weekly or farmers’ market. It refers, in a general and abstract way, to all of the exchange processes that result from the meeting of consumers and suppliers (actors). Markets (or, more precisely, market processes) can be observed in nearly all areas of life in which actors have leeway in decision-making and attempt to use this freedom to enter into exchange relationships that fulfil their own objectives. In cases where self-interest and social norms are sufficient to facilitate social welfare and gains from cooperation, state action and the establishment of legal rules

202

See Sect. 1.2.2.3.1 below. See Schmid (2004), 21.1. 204 Schreck et al. (2020), pp. 410 f. 205 For an overview, see Salanié (2000). 203

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are superfluous;206 in fact, in these instances, state measures would only generate transaction costs and squander resources. However, a market failure of the kind discussed above may present the need for state action. This can also be described using the concepts introduced by Adam Smith: the invisible hand converts individual choices into desirable societal outcomes, provided that there is a functional ‘market of cooperation’. By contrast, public choice and the theory of market failure are generally used to interpret cases of collective pathology. It is precisely when the invisible hand has failed that the government must act.207 The basic types of market failure are outlined below.208 1.2.2.3.2 Principles of Institutional Economics To overcome market failures, institutions are created to systematically change incentive structures. Here, the term ‘institutions’ should be interpreted in its narrower sense,209 i.e. as systems of rules that influence individual actions in order to solve the most important frequently recurring interaction problems. Institutions are durable, standardised solutions to interaction problems and provide social stability.210 It should be noted that, outside of everyday usage of the term, institutions in this sense are not organisations (although certain institutions require organisational embeddedness and support).211 Institutional economics, which was originally embedded in welfare economics, has a long tradition.212 This field considers institutions to be a central element of social sciences, including economics, for analyses of the functioning of societies and economies, especially regarding the predictability of human behaviour. ‘New Institutional Economics’, which takes as its starting point Oliver Williamson’s book of 1975, marks the transition from welfare economics to principles of methodological individualism.213 Institutions comprise regulative, normative and cultural-cognitive elements that, together with associated activities and resources, provide stability and meaning in social life.214 It is useful to distinguish between internal and external institutions.215 The key distinction is the origin of the institutions: internal institutions are rules that 206

McAdams and Rasmusen (2007), p. 1575. Farber and O’Connel (2010), p. 2. 208 See Sect. 1.2.3 below. 209 Institutions are sometimes interpreted in a broad sense to include phenomena like language, customs and traditions. Schotter (1981), for example, defines institutions as regularities in social behaviour (11). This definition borders on the broader concept of restrictions in general, however, and loses the more specific meaning. 210 On various attempts to find a definition, see Richter and Furubotn (2014), 1.1.g; Voigt (2009), pp. 26 f. 211 Kasper et al. (2012), pp. 107 f. 212 See Crespo (2017), pp. 116 ff. 213 Crespo (2017), pp. 118 ff. 214 Scott (2014), p. 56. 215 Kasper et al. (2012), pp. 108 ff. 207

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evolve within a group through experience (e.g. customs and social norms), while external institutions are rules designed outside the group and imposed on it from above through political action (primarily state regulation). Because institutions govern action, they can be implemented to overcome interaction problems. Government measures can systematically change incentive structures in the course of institution-building. There are many possible approaches to such changes and thus a diverse set of legal tools to implement them (regulatory legislation, economic or informal incentives, etc.). These may include a prohibition of non-cooperation/defection (in some cases reinforced by criminal prosecution) or the establishment of economic advantages and disadvantages, such as through subsidies or regulatory taxes. The formation of government laws and institutions is also relevant to contexts that are more or less value-neutral, as Brennan and Buchanan make clear with regard to traffic laws, particularly the ‘drive left/right’ rule.216 This institutional-economic approach can also be applied to issues of international relations.217 Here, governments essentially act as a special form of organisation that is able to reach its own decisions.218

1.2.3

The Theory of Market Failure

The theory of market failure has been one of the most consistent and influential strands of economic theory since the works of Adam Smith.219 As discussed above, the concept of market failure is generally the basis for assessing the need for state intervention. Like economics as a whole, the theory of market failure has been successfully applied to phenomena outside of classical economic markets—such as to politics and the state in the framework of public choice. In this context, the term ‘market failure’ may be overly narrow, and its meaning is perhaps better expressed as ‘cooperation failure’ or ‘institutional failure’.220 Because ‘market failure’ continues to be used in the literature, it is also employed in this book; ‘markets’ is interpreted here in a broad sense. The main types of market failure are presented below.221 This typology is not based on clearly distinct groups; categories blend and overlap with one another. In addition, there is no definitive catalogue of cases of market failure; it is entirely 216

Brennan and Buchanan (1993), chap. 1 IV. See Trachtman (2008), pp. 9 ff. 218 For further detail, see Sect. 2.5.2 below. 219 For a good overview of this history, see Marciano and Medema (2015); for the vast literature associated with it, see the articles collected recently (2020) by Stephen Martin in three volumes. 220 Furton and Martin (2019) refers to this as institutional ‘mismatch’; the reference to the term ‘institutions’ correctly implies that private cooperation fails only because institutions are not designed to avoid it. 221 For a comprehensive overview of possible cases of market failure, see Stiglitz and Rosengard (2015), part 2, chap. 4. 217

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possible that new aspects will be ‘discovered’. In light of these factors, the following representation should be considered a (judgement) sample. This discussion will address the following subjects: (1) dilemma structures (mutually beneficial cooperation is prevented); (2) external effects (advantages and disadvantages of cooperation or non-cooperation affect third parties or the general public, which distorts incentive structures); (3) public goods (exclusive property rights cannot be assigned for certain resources, which prevents cooperation); (4) transaction costs (costs impede or prevent cooperation); (5) lack of information (individual actors have incomplete information, which hinders or prevents cooperation); (6) incomplete markets and monopolies (market anomalies, like the formation of monopolies or cartels, impede cooperation); and (7) ‘government failure’ (in accordance with the conclusions of the New Political Economy, the government is no longer understood as a neutral and well-intentioned entity as in classical economics, but is questioned critically regarding its actual interests and actions).

1.2.3.1 Coordination Problems and Dilemma Structures (Theory of Market Failure I) In general, interactions involve several individuals whose behaviour cannot be predicted reliably. In these situations of ‘strategic interdependence’, the outcome of an action depends on the reaction of the other actors, who have both common and conflicting interests. This produces strategic uncertainty, which makes decisionmaking difficult. Cooperation tends to work well when participants know that the cooperation will be repeated in the future. Otherwise, there is a danger that people will exploit the advance contributions of others to their advantage. Mancur Olson has described this phenomenon as the ‘free-rider dilemma’.222 These revelations, which were inspired by Gordon Tullock in particular,223 established the dilemma structure224 as a key analytical framework within interaction economics.225 Such structures are theoretical assumptions that reduce complexity and provide schemas to explain reality; they can then be used as a basis for empirical tests.226 Discussion: Game Theory

The concept of the dilemma structure is a part of game theory, which is a general theory of rational decision-making in strategic interactions or a theory of interdependent decisions.227 It refers to situations in which an individual’s best choice 222

Olson (1965). Tullock (1974). 224 According to Kirchgässner (2008), it ‘is by far the most often applied solution concept in economic analyses’ (205). 225 For an overview and explanation of the methodology, see Manski (2000). 226 Regarding experiments, see Holt et al. (2015). 227 The concept can be traced back to von Neumann and Morgenstern (1944). For an introduction, see Magen (2015); Binmore (2007); Mackaay (2013), chap. 3; Cooter and Ulen (2016), chap. 2, VII. 223

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depends on what other actors do. Because it, too, is based on an assumption of rational behaviour, it is a natural element of economics. Game theory attempts to reduce interactive situations to their essential components in order to predict the behaviour of (rational) actors in corresponding decision-making situations. There are many different game situations, which can be divided into the following categories: (1) Conflict or zero-sum games (one player’s gains are equal to the losses of the other participants):228 Hegemonic actors use their power to settle conflicts according to their respective interests.229 In problematic cases, this situation can lead to total war. The law tends to play a reduced role under such circumstances, so conflict games are less relevant to an economic analysis of law. (2) Coordination games:230 Both actors are better off coordinating their choices and thus avoiding conflict. For example, it does not matter whether vehicles drive on the right- or left-hand side of the road, provided that the behaviour is coordinated; in this case, coordination is preferable to collision. Coordinated behaviour can arise automatically, even without state interference: the corresponding norms are self-enforcing. Additional examples of simple coordination situations include languages, money and calendars. (3) Mixed coordination and conflict games:231 The games are mixed-motive model situations in which the interests partially coincide and partially conflict. Mixed-motive games are well-known from the ‘battle of the sexes’ constellation.232 The conflict jeopardises coordination, because each player will try to establish a different equilibrium that is more advantageous to him or her. An important case of application are problems of standardisation.233 When a standard must be chosen, a coordination situation will arise if there are several standards already in use (e.g. loading standards in the field of electromobility: all parties are interested in coordination to avoid additional uncoordinated investments, but their interests diverge with regard to the specific approach). Another mixed coordination and conflict game is the hawk-dove game.234 This game involves disputes (conflicts) that can be solved through compromise and would otherwise lead to material or immaterial costs, including destroyed trust that would endanger further cooperation. This means

228

See Magen (2015), pp. 72 f. Regarding international relations, see Sect. 2.5.2 below. 230 See Magen (2015), pp. 73 f. 231 Ibid., 74 ff. 232 See Sect. 1.2.3.1.3 below. 233 On standardisation in the context of game theory, see Magen (2015), pp. 68 ff., 83 ff. 234 See Magen (2015), pp. 74 ff. 229

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potentially high costs of coordination failure. Increasing losses may push the players towards a cooperative solution in the sense of mutual yielding. Stag hunt situations235 are named after a parable by Rousseau. In these situations, hunters can either hunt a stag together (with a sizeable communal benefit) or hunt rabbits alone (with small individual benefits). Both options are individually rational, but the stag hunt is risky, while the rabbit hunt is without risk. It is a coordination game that does not involve conflicting individual interests or a conflict between individual and collective rationality. Strategies and outcome will depend on different factors, like the size of the payoffs and the risk preferences of the players. These situations are not self-enforcing but are at least ‘self-propelling’. In all of these coordination situations, there is a good opportunity for a bottomup development of norms, which is an interesting research field in the development of customary (international) law.236 (4) Cooperative games: These games are the most relevant to an economic analysis of public law.237 In these situations, as in coordination games, cooperation is preferable to all participants. Unlike coordination games, however, cooperative games have a strategic element: cooperation may not be automatic if it is in a player’s interest to strategically withhold cooperation. In the context of a society (or a group of states), individual and collective rationality contradict each other. Corresponding market failures are dilemma situations or problems associated with public goods.238 It should be noted here that there are two fundamental distinctions in game situations:239 (1) Games can refer to a single and unique situation or to a long-term cooperation. (2) Games can take place between individuals or groups (e.g. parties or states).

◄ 1.2.3.1.1 The Concept and Typology of Dilemma Structures A dilemma structure exists when actors forgo the opportunity for mutual gains from cooperation because they fear exploitation. They are afraid to cooperate lest others ‘defect’ and leave them worse off than if they had not agreed to cooperate.

235 See Magen (2015), pp. 76 f. and Sect. 2.5.3.2 below regarding international cooperation in the fight against terrorism. 236 See Sect. 2.5.2.1 below. 237 See Magen (2015), pp. 77 ff. 238 See Sects. 1.2.3.1.1 and 1.2.3.3 below. 239 See Sect. 1.2.3.1.3 below.

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The concept of the dilemma structure rests on the assumption that individual behaviour is based on self-interest. The perception that people represent ‘living constraints’ on cooperation is important here.240 It can help explain higher-level, collective structures as well, such as the behaviour of states in the international community.241 Dilemma structures are common, especially in the context of public law (including international public law), a field that aims to promote common interest (in economic terms: public goods). Such structures can prevent potential benefits of cooperation from being realised, as in the following situations: (1) taxes and the public good of sound public finances: people evade taxes out of fear that others will not pay; (2) behaviour within insurance systems, such as the health insurance system: people use excessive services out of fear that others are doing so as well; (3) commuter decisions: people opt for private transport instead of public transport, which is more environmentally friendly, out of fear that others will not give up their private vehicles; (4) climate change: entities refuse to participate (e.g. in the framework of the Kyoto Protocol) for fear of free riders, even though cooperation is crucial for the survival of all humans. In each of these cases, ‘individual’ rationality leads to a ‘social trap’. This puts the actors in a worse position than they were in at the beginning. 1.2.3.1.2 The ‘Prisoner’s Dilemma’, as Presented by Albert W. Tucker The prisoner’s dilemma is a model of game theory attributed to Albert W. Tucker.242 The premise of the prisoner’s dilemma is that two prisoners stand accused of committing a series of crimes together. The prosecutor has little evidence and, without a confession, will only be able to convict both prisoners for relatively minor offences (with two-year sentences). Because a leniency programme is in place, however, the prosecutor attempts to persuade each prisoner to testify against the other in exchange for a reduced sentence. The prisoners are unable to communicate with one another and face the following situation: if both prisoners confess, both will be punished harshly with a sentence of 10 years each. If neither confesses, each will receive a comparatively light sentence of two years. If only one confesses, however, the prisoner who confesses will be granted immunity as a state’s witness, while the other prisoner receives a harsh sentence of 12 years. It would make sense for both prisoners to behave ‘cooperatively’ and refuse to confess. However, because neither can be sure that the other will not in fact confess,

240

On the relevance of constraints, see Sect. 1.2.2.2.3.3 below. See Sect. 2.5 below. 242 Axelrod (1980) and Kirchgässner (2008), pp. 45 ff., are informative on this topic. 241

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Fig. 1.1 Possible outcomes

it is most sensible (individually rational) for each to confess to ensure a better outcome for themselves, regardless of what the other prisoner does. The ‘payoff matrices’ in Figs. 1.1 and 1.2 summarise the possible outcomes for the prisoners.243 This situation leads to the following outcome: if B’s behaviour is uncertain, A will defect to avert the risk of Outcome II. B defects in order to prevent the outcome that would be most damaging to B (Outcome III). Both A and B ‘forfeit’ their obvious preferences (Outcome I) due to their fear of outcomes II and III, respectively. It is therefore rational for each prisoner to ‘defect’ (Outcome IV) in order to avoid facing the worst possible outcome. The original version of the prisoner’s dilemma was presented here because it is almost always introduced in this form. It should be emphasised, however, that this constellation has a fundamental flaw, particularly in the context of public law. Public law aims to advance cooperation in pursuit of the common good. As a result, it is unfortunate that this process is described as a deal between criminals to evade state punishment. This situation shows that not every ‘cooperation’ that is motivated by the pursuit of individual benefits is in the public interest; in some instances, it can lead to socially undesirable outcomes (e.g. cartel formation).244 This raises a question of significant interest in the context of public law and general welfare: will actors comply with a social norm that benefits both parties? In

243 244

See, e.g., Kirchgässner (2008), p. 46. Kirchgässner (2008), p. 47.

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Fig. 1.2 Actor preferences

this situation, actors benefit from non-compliance with the norm, as shown in Fig. 1.3. As in the situations discussed above, the dominant strategy here is non-compliance with the norm. However, in this situation, compliance with the norm is not simply a matter of upholding a social agreement; it is a matter of public interest. The state can therefore take steps to ensure compliance and justify its actions as necessary to protect the common good. For example, the state can establish the norm as a legal imperative and sanction non-compliance (e.g. as an administrative offence). It can also encourage compliance by creating an economic incentive, such as by charging a tax for failing to comply with the norm. We can take the above scenario a step further by creating a formal representation of changes to incentive structures through state measures (see Fig. 1.4).

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Fig. 1.3 The prisoner’s dilemma in a neutral context

Fig. 1.4 Dilemma situations and state action

This (modified) schema indicates that compliance with the norm is now expected to be the dominant strategy. 1.2.3.1.3 Variations The basic model of dilemma structures refers to the interaction of two individuals in one round (‘one-shot game’). This standard model can change, particularly if the actors participate in repeated games (e.g. the ‘iterated prisoner’s dilemma’), if many actors participate (‘multiple players’) or if the interaction of groups is at stake rather than that of individuals. Ever since the work of American political scientist Robert Axelrod was published in The Evolution of Cooperation (1984), the idea that dilemma structures can

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produce very different outcomes in repeated interactions (‘long-term games’) has entered the mainstream.245 Whether and to what extent cooperation can be expected in such situations is heavily disputed. Cooperation is relatively improbable in finitely repeated games;246 it is more likely to occur in infinitely repeated constellations due to the influence of reputation- and trust-building.247 These interactions are typical of situations in families and partnerships. In game theory, such situations are reflected in the ‘battle of the sexes’.248 Discussion: Battle of the Sexes

The ‘battle of the sexes’ is a well-known example of a mixed conflict and coordination game. Imagine a husband and a wife who want to enjoy a common activity in the evening but cannot agree whether to see a football match (the husband’s preference) or go to the opera (the wife’s preference). They could solve the conflict either by not going out (preventing a ‘payoff’ for either party) or by flipping a coin to determine who will decide. Another alternative would be for the husband and wife to recognise that they want to go out more often and agree on one option for this evening and the other option for another evening. This would make the ‘payoffs’ for each similar and positive.249 This scenario is particularly relevant to interactions between groups like companies or states, such as in the creation of international legal standards.250 Actors can respond to the previous moves of their counterparts by choosing to cooperate or to defect (although the later is often a cause of conflict). Evidence shows that, if the option to defect is chosen, ‘tit for tat’ is the dominant strategy. An alternative would be for one party to begin by cooperating but threaten to return to a ‘tit-for-tat’ strategy if others fail to follow suit. In another variation to the standard model, the relevant interaction involves many actors (‘multiple players’) rather than two (or a small group of) individuals.251 As the number of players increases, it becomes more and more difficult to observe the behaviour of other actors, and the resulting anonymity makes it easier for players to ‘free ride’. There is still a chance, however, that cooperation will become the dominant strategy in multi-player games, as defections by only a few actors will not have a significant impact on the outcome. ◄

245 Axelrod (1984). See, e.g., McAdams and Rasmusen (2007), pp. 1583 f.; Mackaay (2013), pp. 88 ff.; Magen (2015), pp. 81 ff. 246 See, e.g., Embrey et al. (2018). 247 See, e.g., Honhon and Hyndman (2020). 248 For an outline, see, e.g., Kirchgässner (2008), pp. 47 ff. 249 For a payoff matrix, see, e.g., Kirchgässner (2008), Fig. 2.3. 250 See Sect. 2.5.2 below. 251 Mackaay (2013), pp. 96 ff.

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In practice, of course, interactions do not only involve individuals. Participants often include organisations like enterprises or states and other groups that can develop a collective will and interact in a legally relevant way.252 The basic principles of rational choice apply here as well: these groups tend to maximise their predefined utility. At the same time, the behaviour of groups differs somewhat from that of individuals.253 On the one hand, group behaviour tends to be more stable and thus more reliable. On the other hand, the behaviour of any one group is in many ways dependent on the members of that group. Whether groups are more open to cooperation is an interesting research question; empirical studies have thus far produced divergent results.254

1.2.3.2 The Concept of Externalities (Theory of Market Failure II) 1.2.3.2.1 The Importance of External Effects External effects are the consequences of decisions that positively or negatively affect parties other than the one that made the decision or helped bring it about (positive or negative externalities).255 Positive external effects can arise, for example, in the case of basic research, when third-party companies profit from the result without having contributed to its costs. An example of a negative external effect is the impact of private transport (e.g. harmful health effects or damage to buildings as a result of air pollution), which must be borne by third parties and not by the drivers themselves. External effects are undesirable for several reasons. From an economic perspective, they lead to a suboptimal allocation of resources because they are not included in the cost-benefit calculations of the participants (i.e. too much or too little is paid). They also generally have undesirable consequences for distributive policies: third parties are affected by the advantages and disadvantages of a cooperation that did not include them. 1.2.3.2.2 Strategies to Prevent Undesirable Consequences of Externalities In theory, externalities could be internalised ‘voluntarily’ through negotiations. This important point is described in the Coase Theorem, which is discussed in greater detail below in connection with environmental policy issues.256 This concept is largely theoretical, however, because it presupposes that actors have perfect information and disregards transaction costs. In most cases, the prevention of externalities

252

See Chap. 3. See also Kroll et al. (2013). 254 Fink and Kessler present results showing a tendency for professional structures characterised by more intense forms of interaction to promote trust and thus favour cooperation. See Fink and Kessler (2010) and further reference. 255 See, e.g., Harrison and Theeuwes (2008), pp. 53 ff. With reference to environmental law, see Preiss (2012). 256 See Sect. 7.1.2 below. 253

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requires help from institutions, which are typically provided or created by the state. There are three basic approaches to the prevention of externalities:257 (1) ban the production of external effects: actions that result in external effects are prohibited. (2) internalise external effects: external effects are borne by the parties that cause them. (3) prevent external effects: the parties impacted by the effects are included in decision-making. 1.2.3.2.2.1 Avoiding the Production of External Effects Through Rules and Prohibitions

The state can demand or prohibit certain actions in order to prevent decisions from having external consequences. For example, immissions are not permitted to exceed the level set by law in most countries; noncompliance leads to sanctions, such as the revocation of the plant permit. Environmental damage that is particularly severe may even be punishable by law. The state can only react to the emergence of external effects conservatively and to a limited extent. Nearly every decision by social actors produces external effects of some form; this is simply a consequence of living in modern society. In addition, there is a risk that prohibitions might suppress positive external effects in addition to negative ones. It is also important to consider that the use of prohibitions suffers from all of the shortcomings of command-and-control instruments;258 not even criminal law is 100% effective in preventing certain actions. As a rule, regulatory approaches do not represent the best solution for society as a whole: from an economic perspective, such approaches tend to be inefficient. The justification of private property rights is closely connected to the state’s ability to react to external effects.259 Unlike state prohibitions, private property rights give owners the discretion to decide whether to prevent damage (for which they can invoke state legal protection) or tolerate it in exchange for payment. In this case, negotiations can be initiated between private parties.260 1.2.3.2.2.2 Internalising External Effects

The measures described above are distinct from those that cause the person responsible for producing externalities to bear their effects. These effects are internalised and therefore included in the actor’s cost calculations. Here, too, there are various approaches. An interventionist approach requires an ex-ante cost allocation. A prime example is the Pigouvian Tax. Before external effects (in this case negative ones) arise, rules

257

For an overview, see, e.g., Schavell (2004), chap. 5. On environmental regulatory laws, see Sect. 7.2.1.2 below. 259 Congdon et al. (2011), pp. 130 f. 260 On the Coase Theorem and environmental economics, see Sect. 7.1.2 below. 258

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are established at the political level to specify how the producer will pay for the externalities that it creates (e.g. through environmental taxes).261 If there are positive external effects, the producer must receive the economic equivalent, e.g. in the form of subsidies.262 In situations that involve specific relationships between particular persons, the state can empower those affected by the external effects to demand compensation. A typical example is liability for environmental damage.263 In this case, the affected party has the discretion to determine whether and to what extent they will make use of this opportunity or reach some other agreement with the person responsible. The state can also introduce a regulatory solution. The classic example of a regulatory approach is emissions allowances.264 Social relationships are organised in such a way that the party causing the damage compensates the affected party without the intervention of another entity; the internalisation of costs and benefits that were initially external thus takes place ‘automatically’ in a competitive market. 1.2.3.2.2.3 Preventing External Effects Through Mergers of Affected Parties or the Collective Provision of Services

In the cases discussed in Sects. 1.2.3.2.2.1 and 1.2.3.2.2.2 above, parties affected by actions become part of some form of cooperation. In the case discussed here, parties affected by an action become actors or participants. The original decision-making process integrates parties whose ability to achieve objectives is expected to be impacted; the parties affected by specific decisions form a decision-making collective. Because these parties become participants in decisions, by definition the term ‘external effects’ no longer applies. While Sects. 1.2.3.2.2.1 and 1.2.3.2.2.2 address the problems of externalities at the level of private individual decisions, this section focuses on the goal of collective action. The following example makes this rather abstract description more concrete. The construction of a cement plant causes negative external effects due to environmental pollution. This can be addressed through a variety of legislative options: at least under certain conditions, the legislature can prohibit construction (e.g. on a nature preserve or in a residential area). Still, the cement plant may purchase emissions permits entitling it to pollute the environment. The cement plant may also be required to pay an environmental tax, with the resulting tax revenue used to compensate parties affected by its construction. Finally, parties within the area potentially affected by the externalities may have the right to decide on the nature and extent of environmental pollution in the management of the plant. It may well be advantageous to bring producers and those affected by their externalities together to form a single economic entity. This is the case, for example,

261

For further detail on environmental taxes, see Sect. 7.2.3. On internalisation through taxes and subsidies, see Fritsch (2018), 5.2.5; on subsidies, see Sects. 6.2.2.3 (economic policy) and 7.2.4 (environmental policy). 263 See Sect. 7.2.2 below. 264 For further detail, see Sect. 7.2.5 below. 262

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when beneficiaries of basic research collectively organise related activities (producing ‘club goods’). One interesting example for public law is the interaction between cities and the surrounding communities (‘exurbs’), which are generally affluent suburbs. Incorporating the surrounding communities into the central city or town is one way to prevent external (positive) effects and free riding, because it allows for the joint provision of infrastructure. In practice, however, it is difficult to form economic entities in a way that eliminates all external effects. A merger of heterogeneous groups of stakeholders (such as businesses and consumers) also often faces insurmountable practical problems; at the very least, the transaction costs of the merger are often considerable.

1.2.3.3 The Theory of Public Goods (Theory of Market Failure III) The availability of public (or collective) goods is another important case of market failure for state functions.265 Typical public goods include public roads, ocean fish stocks and the Earth’s atmosphere, which is a global public good. A public good is one that can be used or consumed by everyone—even by those who do not contribute to its costs, i.e. pay a price. As a result, there is a danger that such goods will not be available in sufficient quantities. The existence of a public good leads to a number of problems. For example, where existing public goods (e.g. clean water) are concerned, there is a risk of overuse or free riding. There is then no natural interest in producing new public goods (‘market failure’), such as by developing new environmentally friendly technologies or organising fire brigades. This problem has been termed the ‘tragedy of the commons’.266 Public goods can best be described by contrasting them with private goods. Only those who contribute to the cost of (i.e. pay a price for) private goods may obtain them. Public goods lack at least one of two characteristics of private goods: (1) the exclusion principle, according to which anyone who is not authorised or willing to pay the price to consume a private good can be excluded from its consumption; (2) rivalry, a characteristic that prevents a good consumed by one person from being consumed by another. Owners of private goods ‘pay as they use’; this sometimes resolves the problem of externalities. Examples of public goods can be identified in all policy areas in which the state pursues public interests. Notable cases include the entire state infrastructure and an intact environment. A particularly important public good that has recently become the focus of attention is an intact global climate.267 Opportunities to apply ‘public goods’ as an analytical tool are hardly limited: Apolte has persuasively reconceptualised revolutions as an issue of collective goods.268 The assumption that ‘public bads’ lead to corresponding negative externalities will not be applied

265

Stiglitz and Rosengard (2015), chap. 5 (101 ff.), and Magen (2015) are informative on the theory of public goods. 266 Hardin (1968), pp. 1243 ff. 267 See Sect. 7.4.4 below. 268 Apolte (2012), pp. 230 ff.

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Fig. 1.5 Public and collective goods. Based on: Towfigh and Petersen (2009), Table 4.18

here, because public bads are simply a mirror image of public goods and can be modelled in the same way. For example, on the issue of global warming, greenhouse gas emissions are public bads, while the atmosphere is a public good. The terms public goods and collective goods are synonymous. One example is common (pool) goods, like fish stocks or natural resources, which are rivalrous (and at least theoretically excludable). Club goods are like public goods in that they are not rivalrous. In contrast to public goods, however, club goods are excludable, and self-interested private financing is possible (as in the construction of a private toll road). If the consumption of a good is clearly non-rivalrous and non-exclusive, it is a pure public good (e.g. national defense).269 For a summary of the different types of goods, see Fig. 1.5. The principles of excludability and rivalry are not fully applicable in practice. In many cases, the state is able to allocate costs and benefits according to individual usage (albeit at significant expense), such as by charging tolls for road use or by instituting a fee for use rights (e.g. rights to fish). In addition, the concept of non-rivalry is vague. It can only reasonably apply to situations in which the use of a good by an additional consumer results in minimal or no marginal costs, as when one additional vehicle uses a nearly empty street; but when the street becomes congested, marginal costs of additional usage may become quite high. The existence of public goods can be described in terms of dilemma structures and external effects. Specifically, under these circumstances, behaviour that is individually rational induces people to free ride (i.e. to profit from the good without contributing); in this case, individual interests diverge from collective (social) interests. Private provision of public goods also leads to (positive) external effects.270 Because the availability of public goods overlaps with market failures

269 On the distinction between pure and impure public goods, see Stiglitz and Rosengard (2015), p. 107. 270 Stiglitz and Rosengard (2015), pp. 105 f.

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based on ‘dilemma structures’ and ‘external effects’, it is sometimes argued that this should not be categorised as a separate form of market failure.271 This, however, would mean ‘throwing the baby out with the bathwater’. But because the concept is well established in the literature, it can be applied in other fields and illustrates the concept clearly.

1.2.3.4 Transaction Costs (Theory of Market Failure IV) Today, transaction costs play a central role in economics in general, particularly in the economic analysis of law. Although Ronald Coase introduced the basic concept of transaction costs as early as 1937, it was incorporated into economics only after an elaboration by Arrow in 1969.272 The systematic investigation of transaction costs as a phenomenon, and the development of the concept within economics, was primarily driven by Oliver Williamson in the late 1970s.273 The concept of transaction costs is based on the observation that, as in the utilisation of any institution, transactions on the market tend to be associated with costs that may hinder cooperation and advantageous transactions.274 These may be associated with information costs, negotiation and decision costs, and monitoring and enforcement costs. In addition to classical costs ‘on the market’, the concept of transaction costs has increasingly been carried over by the New Political Economy to the analysis of political decisions.275 This is justified, especially because considerable inefficiencies arise on ‘political markets’. From a neo-institutional perspective, transaction costs can also be understood as the use of resources for the creation, maintenance, use and modification of institutions and organisations.276 For an economic analysis of state action, the framework applied by the Organisation for Economic Co-operation and Development (OECD) is useful: it categorises transaction costs as (1) non-policy-related transaction costs that actors must bear in voluntary (market) transactions or (2) policy-related transaction costs associated with policy implementation.277 Transaction costs are not productive as such; the resources expended could be used profitably elsewhere in the socio-economic system. The optimisation of transaction costs has thus become the focus of state action to prevent market failures, with two main emphases. Positive analysis examines the outcomes and implications that guide the actions of institutions of all kinds, with a particular interest in identifying 271

Congdon et al. (2011), p. 131, views the theory of public goods as a subcategory of the theory of external effects. 272 For an introduction, see Richter and Furubotn (2014), Chap. II; Crals and Vereeck (2005), pp. 199 ff. 273 Williamson (1979), pp. 233 ff. Crals and Vereeck (2005), pp. 203 ff., is informative on the development of the principles of transaction costs. 274 By some estimates, transaction costs can amount to 50–60% of the net national product in modern market economies. 275 See North (1990b), pp. 355 ff. 276 See Richter and Furubotn (2014), II.2.3, pp. 43 ff. 277 OECD (2001).

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which institutions minimise transaction costs more than others.278 Normative analysis then generates recommendations for an appropriate design of these institutions. The level of transaction costs incurred in a state is ultimately an important indicator in an assessment of the quality of the state’s institutions.

1.2.3.5 Information Failure As noted above, the abandonment of the axiom of actors’ perfect information has been a key characteristic of the shift to modern economics.279 In real markets, decisions are often made with information that is nowhere near perfect. The ‘information failure’ category of market failure focuses on those cases in which the market players are uninformed to such a degree that it significantly affects market functioning and the market ‘fails’. Discussion: The Market for ‘Lemons’

In his landmark paper ‘The market for “lemons”: quality uncertainty and the market mechanism’ (1970), George A. Akerlof elaborated the effects of asymmetric information.280 In colloquial American English, a ‘lemon’ is a car that is found to be defective only after it has been purchased. It is one example of the many ‘experience goods’ typically found on second-hand markets: consumers can assess the quality of the good little by little only after they have purchased and used the good. At an average price, sellers will tend to offer ‘lemons’ and withhold ‘peaches’ (i.e. better products). As a result, over time, good products leave the market. When consumers experience low-quality products, the market might be brought down altogether. It is thus necessary to resolve the underlying information asymmetry regarding product quality. ◄ There are several types of information failure.281 These can be divided into two basic categories: ignorance and uncertainty. Ignorance exists when market players have incomplete information but could eliminate this lack of knowledge by acquiring the relevant information. Uncertainty is a condition in which future developments cannot be predicted with sufficient certainty, even with the greatest effort (e.g. economic developments, natural disasters). Uncertainty may also exist regarding the intentions of the transaction partner, whose behaviour may violate the terms of the contract during its execution (‘moral risk’).282

278

The significance of determining or estimating transaction costs increases accordingly; see Voigt (2019), 2.4. 279 See Sect. 1.2.2.2.3.2 above. 280 Akerlof (1970); see also Kirchgässner (2008), pp. 64 ff. 281 For empirical evidence, see Mihalache and Bodislav (2019). 282 Hindriks and Myles (2013), 10.2., differentiate between ‘hidden knowledge’ and ‘hidden action’ in this context.

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Asymmetrically distributed information is the most significant class of information failure due to ignorance.283 A major cause of information asymmetry is the lack of a sufficient incentive for the better-informed party to share its information with the other party. In sales transactions, for example, the supplier generally has an informational advantage with regard to product characteristics. Information asymmetries can also put the supplier at a disadvantage, as when buyers of insurance know more than the insurance companies about the insured risks. Today, there is a growing recognition that, for the state, remedying informational deficiencies is an important policy tool; for example, the state can increase the buyer’s knowledge of the expected utility of a product by requiring product labels.284 Information failure is particularly relevant in two basic situations, which are addressed in separate theories: the principal-agent problem and moral hazard. These are discussed below. Discussion: The Principal-Agent Theory (‘Hidden Action’)

The principal-agent theory, or economic theory of representation, provides a general analytical framework for the problems associated with asymmetrically distributed information.285 It can be used to examine the relationship between the principal (ordering or represented party) and the agent (contractor or representative) as a contractual relationship between two rational actors. A classic example is the relationship between employer and employee. In general, it is difficult for the principal (employer) to monitor the labour input of the agent (employee). There are, however, many constellations relevant to public law that can be reframed as principal-agent relationships, such as the relationship between voters and their elected representatives or the relationship between parliament and the administration (‘bureaucrats’).286 At the core of these relationships is the ‘agency problem’: the agent, to whom the principal delegates decision-making powers, has informational advantages and can use these in its own interest. Here, ‘hidden information’ becomes ‘hidden action’. The principal lacks the relevant information and is therefore unable to make an accurate assessment of the agent’s actions. To solve the agency problem, a contract must establish the principal-agent relationship in a way that minimises agency costs, including control and monitoring costs, contract costs and residual costs (welfare losses of the principal). If a principal-agent problem (and thus an asymmetric distribution of information between actors) is detected, the parties involved typically employ certain solution strategies; the state also has recourse to these strategies (summarised in

283

See Hindriks and Myles (2013), chap. 10. See Sect. 7.2.6.3 below. 285 For an introduction, see Voigt (2009), 3.3; for further reading, Richter and Furubotn (2014), V.3. 286 See Sect. 4.1.2.3 below. 284

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Fig. 1.6 Solutions to information asymmetries between private actors. Based on: Fritsch (2018), Figure 10.7

Fig. 1.6). These can increase the information available to the principal, for example by reformulating the contract terms accordingly (‘screening’);287 by compelling the agent to disclose information, as through a guarantee agreement (‘signalling’);288 or by harmonising the interests of both sides, as through profitsharing or vertical integration of organisational structures. In general, information asymmetries can be mitigated but not eliminated. ◄ Discussion: Moral Hazard

In economic theory, moral hazard is a situation in which the behaviour of one party can change in a way that damages the other after completing a transaction. A particularly interesting aspect of such situations is the willingness to accept risks that will affect the other party or third parties.289 This is the case, for example, when an insured person takes risks that compromise the interests of the insurance company because the individual will not have to bear the consequences. As a description of this problem, the term ‘moral hazard’ is far from perfect. For example, despite the use of the word ‘moral’, ‘moral hazard’ does not refer to

287

See Hindriks and Myles (2013), 10.5. Ibid., 10.6. 289 For an overview, see Kirchgässner (2008), pp. 67 ff. 288

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a moral evaluation of behaviour. That was indeed the case when the term was coined in the seventeenth century, but it took on the meaning of ‘subjective’ endangerment over the next 100 years. Today, it is used as a neutral designation for inefficiencies.290 Moral hazard occurs when individual rational behaviour leads to unintended social consequences. Although the term is somewhat misleading, it is used here because it is internationally accepted. Moral hazard is essentially characterised by the tendency of individuals or institutions to behave less cautiously when they do not bear full responsibility and thus will not bear the full consequences of their actions; these consequences will instead fall to third parties. These situations are also cases of asymmetric information, because the acting party has an information advantage with regard to their own actions and motivations, as well as the associated risks. Moral hazard also typically occurs in principal-agent problems when the agent acts in a risky manner. ◄ As noted above, the theory of moral hazard was developed primarily in connection with the insurance industry. It therefore plays a large role in public law, especially with regard to social security systems and, more specifically, to health insurance.291 The regulation of natural monopolies is another interesting area of application.292 Recently, the phenomenon was most apparent in connection with the financial crisis, and in particular with the (risky) actions of the banks responsible.293 Many banks generated exorbitant profits by taking greater and greater risks in financial markets; when those risks materialised, however, the banks could count on the state to rescue them because of their status as ‘too big to fail’. Much of this risk was ultimately borne by taxpayers.

1.2.3.6 Incomplete Markets and Monopolistic Structures Finally, market failure can result from various market imbalances and market anomalies. There may be market adjustment problems that disrupt or prevent the creation of market equilibrium (e.g. price inelasticity). Cases of market power in which the market tends towards cartel and monopoly formation are traditional topics within the fields of competition policy and competition law.294 One subject of particular interest in public law is market failure resulting from indivisibilities, which allow natural monopolies to be established.295 There is no competition between infrastructure networks (e.g. rail networks, telecommunications networks and energy networks) because there is no way to

290

Dembe and Boden (2000). See, e.g., Davies and Kuhn (1992). 292 Joskow (2007), pp. 1301 ff.; see also Sect. 1.2.3.6 and Sect. 6.3.3 below. 293 See, e.g., Myerson (2012), pp. 847 ff. 294 See, e.g., Kaplow and Shapiro (2007), pp. 1078 ff. 295 See Joskow (2007), pp. 1229 ff. 291

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compete in such cases at a reasonable cost. As a result, there can only be regulated competition ‘for the network’ or ‘within the network’.296

1.2.3.7 ‘State Failure’ and the New Political Economy It is generally assumed that the political system can and should correct market failures and compensate for their negative effects. The political system can be characterised as a set of institutions that is intended to satisfy demand for ‘public goods’ and creates a legal and political framework for doing so. In this sense, the system can be considered a kind of ‘regulation market’ with citizens (voters), interest groups, businesses and other organisations on the demand side, and politicians, parties and bureaucrats on the supply side.297 The state, which is the institution that produces binding decisions for society, is at the centre of the political system. Today it is widely acknowledged that, with regard to its role in cooperation within civil society, the state can no longer be viewed as a neutral entity operating in the interest of overall well-being. Instead, the basic methodological foundation for economics—the assumption that actors maximise their benefits under constraints—is also applied to the behaviour of politicians and bureaucrats.298 It would therefore be a mistake to assume that each market failure could and should be corrected by the state. Desirable cooperation can be thwarted not only by ‘market failure’, but also by ‘state failure’:299 without an adequate incentive structure, rational actors will not reach ideal decisions about institutional arrangements. State failure can occur at different levels. It materialises in various forms: as constitutional failure, government failure, parliamentary failure, and administrative failure. This basic concept can also be applied to international relations.300 In this context, it refers to cooperation between self-interested states and the citizens and politicians backing them, as well as interactions between international organisations and international firms and interest groups (including the people who constitute and represent them). The phenomenon of ‘bounded rationality’301 makes political instrumentation still more complex because even politicians and bureaucrats act rationally only to a limited extent.302

296

See Sect. 6.3.3 below. The idea that legal regulation can be viewed as a good that is subject to the laws of supply and demand can be traced back to Stigler (1971). 298 On the motives and interests of politicians, see Voigt (2019), pp. 83 ff. 299 In Anglo-American terms, this is referred to as a ‘regulatory failure’; see, e.g., Ogus (1994), p. 30. Furton and Martin (2019) suggests the notion of ‘institutional mismatch’, which also constitutes ‘market failure’; this terminology is intended to imply that in such cases institutions do not fail per se but are not designed correctly. See Magen (2015), pp. 76 f., and Sect. 2.5.2.2 below regarding treaties within public international law. 300 Trachtman (2008), pp. 9 ff. 301 See Sect. 1.2.2.2.3.2 above. 302 Congdon et al. (2011), p. 56. 297

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1.3

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Summary

Economics is a social-scientific method that, in the case of law and economics (‘economic analysis of law’), is used to study law. In this respect, it supplements legal sociology, legal anthropology, legal psychology, comparative law and legal dogmatics. Like jurisprudence, law and economics can be practised as a positive science to analyse reality or as a normative science to improve it. As a normative analysis of law, it seeks to discern ‘right’ or ‘efficient’ law. As a positive analysis of law, it serves to examine the reasons for the origin of law and legal institutions, as well as the effects of law. The methodological foundation of law and economics is the economic paradigm (‘homo economicus’). In keeping with the principle of methodological individualism, a theoretical individual serves as a reference point in explanations of decisions and behaviour. In the traditional economic paradigm, individuals make decisions that maximise their utility in the face of scarce resources (‘assumption of rationality’). Modern economics has abandoned the fiction of perfect information, however, and acknowledges certain limits to rational behaviour (‘bounded rationality’) based on the principles of behavioural psychology. Homo economicus reacts rationally to constraints and incentives. Institutional economics addresses interaction problems in the context of a broadly understood market model. Analysis in this field is based on cases of ‘market failure’ and the associated concepts of dilemma structures, external effects, public goods, transaction costs and information failure (principal-agent theory). In these areas, the state can and must take measures to enable individuals to profit from cooperation.

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Niemann HJ (2011) Der Nutzenmaximierer. Der aufhaltsame Aufstieg des Vorteilsdenkens. Mohr Siebeck, Tübingen Noll J (2005) Rechtsökonomie. Eine anwendungsorientierte Einführung. Verlag Österreich, Wien North DC (1990a) Institutions, institutional change and economic performance. Cambridge University Press, Cambridge North DC (1990b) Transaction cost theory of politics. J Theor Polit 2:355–367 O’Boyle EJ (2007) Requiem for Homo Economicus. J Mark Moral 10:321–337 Ogus A (1994) Regulation - legal form and economic theory. Hart, Oxford Olson M (1965) The logic of collective action: public goods and the theory of groups. 21st print 2003. Harvard University Press, Cambridge Ørsted NH (2012) Bounded rationality in an imperfect world of regulations: what if individuals are not optimizing? In: Milne JE, Andersen MS (eds) Handbook of research on environmental taxation. Edward Elgar Publishing, Cheltenham/Northampton, pp 439–455 Orviska M, Hudson J (2006) Quiet in the Cathedral: who is the law abiding citizen? Homo Oeconomicus 23:129–152 Parisi F (2004) Positive, normative and functional schools of law and economics. Eur J Law Econ 18:259–272 Petersen N, Towfigh EV (2015) Economic methods and legal reasoning. In: Towfigh EV, Petersen N (eds) Economic methods for lawyers. Edward Elgar Publishing, Cheltenham, Ch. 1, pp 1 Peukert H (1999) Adam S (1723 -90). In: Backhaus JG (ed) The Elgar companion to law and economics. Edward Elgar Publishing, Cheltenham/Northampton, pp 455–482 Polinsky AM (2011) An introduction to law and economics, 4th edn. Wolter Kluwer, New York Posner RA (1979) Utilitarianism, economics, and legal theory. J Leg Stud 8:103–140 Posner RA (1985) Wealth maximazation revisted. Notre Dame J Law Ethics Public Policy 2:85– 105 Posner RA (2001) Frontiers of legal theory. Harvard University Press, Cambridge/London Posner RA (2005) The law and economics movement: from Bentham to Becker. In: Parisi F, Rowley CK (eds) The origins of law and economics. Essays by the founding fathers. Edward Elgar Publishing, Cheltenham/Northampton, pp 328–349 Posner RA (2014) Economic analysis of law, 9th edn. Wolters Kluwers Law & Business Preiss P (2012) Externalities research. In: Milne JA, Andersen MS (eds) Handbook of research on environmental taxation. Edward Elgar Publishing, Cheltenham/Northampton, pp 139–157 Přibáň J (ed) (2020) Research handbook on the sociology of law. Edward Elgar Publishing, Cheltenham/North Hampton Ramello GB (2016) The past, present and future of comparative law and economics. In: Eisenberg T, Ramello GB (eds) Comparative law and economics. Edward Elgar Publishing, Cheltenham/Northhampton, pp 3–22 Rawls J (1972) A theory of justice. Oxford University Press, Oxford Renda A (2011) Law and economics in the RIA world. Improving the use of economic analysis in public policy and legislation. Intersentia, Cambridge/Antwerps/Portland Revesz RL, Stavins RL (2007) Environmental law. In: Polinsky AM, Shavell S (eds) Handbook of law and economics, vol 1. North Holland, Amsterdam et al., pp 499–589 Reynolds H (1986) The economics of prostitution. Springfield, Ill. USA Richter R, Furubotn EG (2014) Institutions and economic theory: the contribution of the new institutional economics, 2nd edn. University of Michigan Press, Ann Arbor Robbins L (1932/1935) On the nature and the significance of economic science, 1st and 2nd edn. Macmillan, London Rodi M (2002) Recht und Wirkung. Greifswalder Beiträge zur Rechtswirkungsforschung. Carl Heymanns Verlag, Köln u. a. Rodi M (2014) Ökonomische Analyse des Öffentlichen Rechts. Springer Gabler, Wiesbaden Rose-Ackerman S, Lindseth PL (eds) (2010) Comparative administrative law. Edward Elgar Publishing, Cheltenham

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Rosenfeld M, Sajó A (2012) The Oxford handbook of comparative constitutional law. Oxford University Press, Oxford Rowley CK (2005) An intellectual history of law and economics: 1739–2003. In: Parisi F, Rowley CK (eds) The origins of law and economics. Essays by the founding fathers. Edward Elgar Publishing, Cheltenham u.a., pp 3–32 Salanié B (2000) Microeconomics of market failures. The MIT Press, Cambridge Sales BD, Krauss DA (2015) The psychology of law. Human bahavior, legal intitutions, and law. American Psychological Association, Washington, DC Schäfer HB, Ott C (2020) Lehrbuch der ökonomischen Analyse des Zivilrechts, 6th edn. Springer, Berlin/Heidelberg Schavell S (2004) Foundations of economic analysis of law. Harvard University Press, Cambridge Schelsky H (1980) Die Soziologen und das Recht: Abhandlungen und Vorträge zur Soziologie vom Recht. Westdeutscher Verlag, Opladen Schmid AA (2004) Conflict and cooperation. Institutional and behavioral economics. Blackwell Publishing, Oxford et al Schotter A (1981) The economic theory of social institutions. Cambridge University Press, Cambridge Schreck P, Van Aaken D, Homann K (2020) “There’s Life in the Old Dog Yet”: the Homo economicus model and its value for behavioral ethics. J Bus Econ 90:401–425 Schumpeter JA (1908) Das Wesen und der Hauptinhalt der theoretischen Nationalökonomie. Duncker & Humblot, Leipzig Scott WR (2014) Institutions and organizations. Ideas, interests, and identities. Sage, Los Angeles et al Sent EM (2018) Rationality and bounded rationality: you can’t have one without the other. Eur J Hist Econ Thought 25:1370–1386 Simon HA (1947) Administrative behavior: a study of decision-making processes in administrative organization. The Macmillan Company, New York Simon HA (1955) A behavioral model of rational choice. Q J Econ 69:99–118 Simon HA (1990) Bounded rationality. Palgrave Macmillan, London Spicker P (2020) Thinking collectively: social policy, collective action and the common good. Policy Press Scholarship Online Stigler GJ (1971) The theory of economic regulation. Bell J Econ Manag Sci 2:3–21 Stiglitz JE, Rosengard JK (2015) Economics of the public sector, 4th edn. W. W. Norton, New York/London Šubrt J (2020) The systemic approach in sociology and Niklas Luhmann: expectations, discussions, doubts. Emerald Publishing Limited, Bingley Sunstein CR (2000) Behavioral law and economics. Cambridge University Press Swedberg R (2003) Principles of economic sociology. Princeton University Press, Princeton and Oxford Thaler RH (1980) Toward a positive theory of consumer choice. J Econ Behav Organ 1:39–60 Thaler RH (1991) Quasi rational economics. Russel Sage Foundation, New York Thaler RH, Sunstein CR (2008) Nudge: improving decisions about health, wealth, and happiness. Yale University Press, Yale Tontrup S (1998) Ökonomik in der dogmatischen Jurisprudenz. In: Engel C (Hrsg) Methodische Zugänge zu einem Recht der Gemeinschaftsgüter. Nomos, Baden-Baden, pp 41–120 Towfigh EV (2015) The economic paradigm. In: Towfigh EV, Petersen N (eds) Economic methods for lawyers. Edward Elgar Publishing, Cheltenham/Northhampton, pp 18–31 Trachtman JP (2008) The economic structure of international law. Harvard University Press, Cambridge and London Tullock G (1974) The social dilemma: the economics of war and revolution. University Publications, Blacksburg Tversky A, Kahnemann D (1974) Judgment under uncertainty: heuristics and biases. Science 185: 1124–1131

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Tversky A, Kahnemann D (1981) The framing of decisions and the psychology of choice. Science 211:453–458 Ulen TS (2007) The future of law and economics. In: Cafaggi F, Nicita A, Pagano U (eds) Legal orderings and economic institutions. Routledge, London et al., pp 21–45 Van Aaken A (2003) “Rational Choice” in der Rechtswissenschaft. Zum Stellenwert der ökonomischen Theorie im Recht. Nomos, Baden-Baden Van Aaken A (2004) Vom Nutzen der ökonomischen Theorie für das öffentliche Recht: Methode und Anwendungsmöglichkeiten. In: Bungenberg et al (Publisher) (2004) Recht und Ökonomik. Beck, München, pp 1–31 Vanberg VJ (2004) The rationality postulate in economics: its ambiguity, its deficiency and its evolutionary alternative. J Econ Methodol 11:1–29 Vanberg VJ (2008) Wettbewerb und Regelordnung. In: Goldschmidt N, Wohlgemuth M (eds) Wettbewerb und Regelordnung. Mohr Siebeck, Tübingen Voigt S (2009) Institutionenökonomik, 2nd edn. Fink, Paderborn Voigt S (2019) Institutional economics. An introduction. Cambridge University Press, Cambridge Von der Pfordten D (2012) Five elements of normative ethics – a general theory of normative individualism. Ethic Theory Moral Pract 15:449–471 Von Neumann J, Morgenstern O (1944) Theory of games and economic behavior. Princeton University Press, Princeton Weber M (1921) Wirtschaft und Gesellschaft. Grundriss der verstehenden Soziologie, (5th Ed. 1972, revidiert von Johannes Winckelmann, Tübingen, Mohr Siebeck) Williamson OE (1979) Transaction-cost economics: the governance of contractual relations. J Law Econ 22:233–261 Winter SG (2018) Satisficing. In: The Palgrave encyclopedia of strategic management. Palgrave Macmillan, Basingstoke Zamir E, Teichman D (2018) Behavioral law and economics. Oxford University Press, Oxford

2

State and Constitution

The state is the central actor and the conceptual focal point of public law. In the modern state, however, the constitution is equally significant: it establishes the structure of the state, enshrines the rule of law and provides a framework and binding rules for the political process. The state and constitution thus go hand in hand— which makes the question of which came first, or which is more important, largely irrelevant. Today, there is little doubt that constitutional frameworks are just as fruitful a topic of economic analysis as the political process and the decisions resulting from it.1 This broadens the focus of the analysis from the process of making choices under constraints to the choice of the constraints themselves. Rational analysis of the state and constitution is by no means new; in fact, it has a long history. The first comprehensive scientific attempt to synthesise economic, social, political, philosophical and legal perspectives on this subject2 appeared at least as early as Adam Smith’s contributions to the study of jurisprudence.3 The work of Knut Wicksell marks a milestone in the development of a constitutional political economy or, more narrowly, of an economic analysis of the state and constitution. In Finanztheoretische Untersuchungen,4 he emphasised the significance of the rules under which political actors reach decisions, as well as the need to direct reform efforts towards modifying these rules. Even in this early work, the consensus of the governed—a consensus theory—served as a central perspective for evaluating state action. In The Calculus of Consent (1962), Buchanan and Tullock took up and refined this approach.5 They and in particular the contract theories of 1

For an introduction to the economic analysis of state and constitution, see Buchanan (1991) and Voigt (2020). See also Marciano and Josselin (2005). 2 Traces of a rational, economically oriented examination of the state and constitution can of course be detected even earlier; see Rowley (2005), chap. 1. 3 For an introduction to the work of Adam Smith, see, e.g., Mathis (2009), § 5. 4 Wicksell (1986); see Vanberg (2020), pp. 344 ff. 5 Buchanan and Tullock (1962). For a brief overview of these developments, see van den Hauwe (2005). # Springer-Verlag GmbH Germany, part of Springer Nature 2022 M. Rodi, Economic Analysis of Public Law, Springer Textbooks in Law, https://doi.org/10.1007/978-3-662-66089-8_2

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John Rawls, in particular, both influenced and reinforced the normative theory of state and constitution that emerged from such work; they have also motivated a great deal of research ever since.6 Due to the sheer abundance and variety of such research, the following discussion can focus only on select topics. The main emphases of this section are constitutional theories from the perspective of contract theory, particularly regarding forms of government (Sect. 2.1); theories of democracy (Sect. 2.2); functions of the state (Sect. 2.3); state structure, specifically with regard to federalism (Sect. 2.4); and, finally, the blurring of state boundaries as a result of ‘supranational integration’ (Sect. 2.5).

2.1

Principles of an Institutional Economics of the State and Constitution

The following discussion uses a general ‘rubric’ to evaluate the advantages and disadvantages of the state and constitution.7 This evaluation is based on the principles of methodological individualism, rationality and institutional economics, which means that: (1) The state is not presupposed; instead, it is treated as the object of analysis with the goal of developing and improving its design. In accordance with the principles of methodological individualism, the inquiry focuses not on the state itself, but on the citizens as the subjects of the state and other institutions.8 This means that the ‘myth of the benevolent state’ is rejected: there is not an abstract common good that can only be scientifically identified, nor are there agents per se who naturally orient their behaviour towards the public interest.9 (2) The state is understood as a complex, durable network of relationships between individuals who seek to overcome dilemma structures and achieve and secure gains from cooperation. From this perspective, the state can have a monolithic structure (as a legal person) or a composite structure.10 The constitution thus stabilises a normative system that guides individual and corporate behaviour and can be modified only under certain conditions. (3) As an organisation,11 the state becomes an independent actor with a specific process of will-formation [Willensbildung]. This has consequences for the

For an introduction to John Rawls’s theory of justice, see, e.g., Mathis (2009), § 7. See, e.g., Richter and Furubotn (2014). 8 On the principles of methodological individualism, see Sect. 1.2.2.2.1. 9 Brennan and Buchanan (1993), chap. 3. 10 Breton (1996), p. 11. 11 On the basic principles, see Sects. 3.1 and 3.2 below. 6 7

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economic analysis of international relations, which continues to focus primarily on states.12 Like law and economics in general, there is a normative and a constitutional economics consists of a normative and a positive approach.13 The positive branch seeks to explain (1) the economic effects of different constitutional rules and (2) the emergence and modification of constitutional rules. Traditionally, normative constitutional economics has been dominant; its main focus is on contractarian theories.

2.2

Normative Constitutional Theory in the Form of Contract Doctrine

The foundational text mentioned above, The Calculus of Consent, was written by James M. Buchanan and Gordon Tullock (1962) as an economic analysis of constitutional democracy, a concept further elaborated in Buchanan’s subsequent work.14 The Calculus of Consent, published in 1962, can serve as a starting point for a discussion of a modern application of contract theory to the constitutional theory of democracy. From these perspectives, constitutions are viewed as formulations of basic rules that govern social exchange and cooperation schemes. The terms of a constitution can be interpreted as agreements that establish trust for future cooperation.15 These play a foundational role because they contain rules about rulemaking. The central purpose of a constitution is to ensure stability and endurance of the state and its institutions.16 At the same time, constitutions must be flexible enough to adapt to new challenges. It is therefore clear that the significance of a constitution depends directly on the process and the ease or difficulty with which it can be modified.17 According to Germany’s Basic Law (Grundgesetz (GG)), certain fundamental principles cannot be altered at all (Art. 79(3), the ‘eternity clause’); unamendability clauses18 like this are intended to establish a high degree of reliability. Of course, no constitutional provisions can prevent a constitution from being replaced with a new one, as any such replacement is a fundamentally revolutionary act. In Germany, the Basic Law even contains a provision that nullifies the existing Constitution only if a new one satisfies certain preconditions

12

For further detail, see Sect. 2.5 below. Voigt (2017). 14 See, e.g., Brennan and Buchanan (1993), pp. 42 ff. 15 Cooter (2000), p. 63. 16 Ginsburg (2010), pp. 265 ff. See Ginsburg (2011) on the question of normative rigidity and flexibility in reference to endurance. 17 For an overview and discussion of functions and problems associated with rules for constitutional amendment in a comparative perspective, see Dixon (2011). 18 On constitutional unamendability, see Tushnet (2014), pp. 28 ff. 13

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(Article 146 GG). The replacement of a constitution is, of course, associated with high transaction costs.

2.2.1

An Interpretation of Constitutional Democracy Based on Contract Theory

2.2.1.1 The Foundations of Contract Theory Ever since it became impracticable for society to appeal to higher powers to form a state and rule over it, the prevailing principle has been that the binding force of rules and laws can only be established and justified by the will of those concerned; it is thus systematised on the basis of collective, voluntary commitment. This view is based on social contract theory, which can be traced from its roots in antiquity through Kant to James Buchanan and John Rawls. Social contract theory envisions the state and social order as the product of a hypothetical contract among members. This contract was formed in order to justify the origin of the state as well as to provide a basis for critique of its design.19 A contract of this kind is, of course, not a historical, empirical fact. According to Kant, it is: an idea of reason, which. . .can oblige every legislator to frame his laws in such a way that they could have been produced by the united will of a whole nation and to regard each subject, in so far as he can claim citizenship, as if he had consented within the general will. This is the test of the rightfulness of every public law.20

In the tradition of Kant, contract theories are based on the philosophy that every human being has value and constitutes an end in itself. This approach stands in marked contrast to the fundamental assumptions of utilitarianism.21

2.2.1.2 Consensus as a ‘Regulative Idea’ Because of the (theoretical) need for unanimous consent, the assumptions of contract theory presuppose or simulate consensus: individuals submit to the binding force of rules as the price they must pay for others to do the same. This makes their behaviour calculable (and prevents the bellum omnium contra omnes described by Hobbes). Consensus thus becomes the central ‘regulative idea’. Processes must be sought to imitate or simulate this idea. This theoretical simulation of consensus also originated with Kant, who argued that one could test the generalisability of rules by applying the categorical imperative, as a ‘formula of universal law’: ‘act only in accordance with that maxim (subjective rule) through which you can at the same

19

Salzberger and Elkin-Koren (2005), pp. 59 ff., provides a good overview of the connections between classical theories of the state, social philosophy and economic approaches to this topic. On the economics of constitutional democracy, see the introductory overview in Dylla (2008), pp. 30 ff. 20 Kant (2016), p. 79. 21 Vanberg (2020), pp. 359 ff.; regarding utilitarianism, see Sect. 1.2.1.3 above.

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time will that it become a universal law.’22 Modern contract theorists also view the ‘test of universalisability’ as a necessary condition for the general binding nature of rules. From an economic perspective, there is also evidence that, in large societies, it would be virtually impossible or too expensive or time-consuming to achieve actual consensus on rules under empirical conditions. The need for consensus would be detrimental to all because decisions would be made too slowly, and because any decisions reached could carry no more risks than the most risk-averse member of the society would accept. The central analytical tool for justifying a constitution is the ‘veil of ignorance’.23 This logical construct supposes that every single member of a collective is behind a veil of ignorance, knowing nothing of the society in which they will live at any time in the future or the position they will occupy within it. This assumption does not mean, however, that the framers of a constitution are not self-interested rational actors.24 Discussion: Discourse Theory of Law (Jürgen Habermas)

At its core, the discourse theory of law – which is closely associated with Jürgen Habermas and Robert Alexy, among others – is also a consensus theory. Like contract theory, discourse theory is concerned not with factual consensus, but with a potential universal discourse that all possible discourse participants have established and thus (ideally) achieved.25 Contract doctrine and discourse theory thus differ only in their specific methods of evaluating arguments.26 ◄

2.2.1.3 Related Considerations In an economic analysis, the rules of constitutional democracy are considered to be the result of weighing two factors: the democratic emphasis on providing every individual the opportunity to participate in state decision-making to the greatest possible extent is balanced against the guarantee of effective and efficient state institutions and decision-making structures. The starting point for every democracy is an initial consensus establishing that, under certain conditions, ‘later decisions’ will be made without consensus and nevertheless considered binding. This prospect of a departure from consensus would be regarded as advantageous to all and would thus likely be accepted by consensus. The principle of unanimity is undoubtedly impracticable in larger, heterogeneous groups, and there is a danger of strategic 22

Kant (1993), p. 30. Buchanan and Tullock (1962), p. 78; this discussion is further elaborated in Rawls (1972). Accordingly, Voigt (2017), pp. 205 ff., coined this approach ‘veilonomics’. 24 Ginsburg (2010), p. 264. 25 See, in particular, Habermas (2009). See also Maria Patrão Neves (2015), who situates Habermas’s theory within the broader context of consensus theories. 26 Both methods largely converge regarding results; Kirchgässner (2008), pp. 127 f. 23

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behaviour in such contexts. But majority decisions cannot be accepted without restrictions, because majorities can exploit and oppress minorities; majority decisions can be considered legitimate only under constitutional conditions. Such conditions are based on the principle that all individuals have a veto right for decisions that are particularly important to them. This is the concept of human or fundamental rights, which deprive the majority of certain options for action that may affect fundamental rights in order to protect the individual. The underlying assumption is that people will give up their (originally limitless) freedom for the benefit of the state only to the degree that doing so serves their interests. In all other cases, they will preserve their freedom as individuals in order to pursue their own interests through their own free will. One implication of this assumption is that state will-formation must take place under certain preconditions. This is reflected in concepts like the separation powers, the rule of law and, in particular, the democratic participation of individuals.27 Rational individuals will construct the state in such a way that negative consequences for individual freedom and individual well-being are minimised if the worst conceivable political circumstances arise (the ‘minimax’ rule).28 When creating a constitution, citizens face the ‘dilemma of the strong state’:29 effective protection of individual rights requires strong state institutions, but because state power can be abused, it is precisely this power that can be used to thwart individual freedom. As a result, ‘self-binding’ on the part of the state is necessary. This is more difficult to achieve than self-binding of private individuals, however, because the self-binding of individuals is regularly accomplished through neutral third parties, which are not available in the case of the state. The horizontal separation of powers can thus be viewed as a crucial mechanism for resolving the problem of self-binding.30 As the French Declaration on Human Rights rightly noted, there can be no constitution without a separation of powers.31 Following Montesquieu, modern constitutional states typically divide power between the legislature (the setting of abstract-general laws), the executive (state leadership and implementation of state power in certain cases) and the judiciary (control over particular decisions). Additional entities and further differentiations are possible, and these are realised to varying degrees in practice, such as in the division of the legislature into chambers or houses (Bundestag and Bundesrat in Germany; Senate and House of Representatives in the US; Upper and Lower House in the UK). From an economic perspective, these divisions become the basis for negotiation processes (‘bargaining’) within the state that result in reciprocal checks and balances. These negotiation processes carry (political) transaction costs, however,

27

Salzberger and Elkin-Koren (2005), pp. 79 ff., rightly considers whether the principles of directdemocratic participation will gain significance in the age of ‘cyberspace’. 28 Cooter (2000), pp. 11 f. 29 Cf. Voigt (2009), 4.2.5. 30 For an economic analysis of the separation of powers, see, e.g., Cooter (2000), chap. 9. 31 Martinez (2012), p. 551.

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as they can complicate and impede the decision-making process. Such concerns have given rise to discussions about the political roadblocks caused by excessive approval requirements for German laws in the Bundesrat32 and by the antagonistic relationship between Congress and the President in the United States.33 These examples illustrate the importance of considering how extensively power should be divided in order to avoid an abuse of power (or how many peripheral interests should be legitimised). This must be weighed against another factor, namely how necessary one considers an effective central decision-making process (including for purposes of securing individual freedom). In light of the above, it is easy to ‘construct’ the modern constitutional state as a rule-of-law state. It is much harder to derive from this the foundations of a welfare state.34 It is therefore not surprising that the assumptions of John Rawls (i.e. the ‘veil of ignorance’) faced considerable criticism with regard to this issue.35 In principle, social welfare can be considered justified because it provides opportunities to increase prosperity that would remain untapped by decentralised self-interested action. More specific conclusions regarding a constitutionally protected minimum standard are problematic, however: it will be difficult to identify appropriate criteria to quantify the extent of guaranteed social rights; governments have a limited capacity to realise social rights (e.g. regarding employment or housing); and, where guarantees of social rights are concerned, income redistribution will ultimately be decided not by parliament, but by judges (with relatively little democratic legitimation). These issues should therefore be considered in the democratic process rather than in the constitution. In Germany, this is accomplished by treating the principle of the welfare state as merely an abstract constitutional objective.36

2.2.2

Forms of Government as a Subject of Economic Theory

Beyond their key defining characteristics, constitutional states vary considerably, especially in the concrete design of their government systems. This opens the door for positive constitutional economics.37 There has always been significant scholarly interest in understanding and explaining the features of these various forms.

32

Cf. Lehmann-Brauns (2008), pp. 27 ff. See Fisher (2014). 34 See, e.g., Kliemt (1993). 35 In stark contrast to utilitarian theories, Rawls’s deductions are based on the well-being of the worst-off person in society; see, e.g., Sen (1977), pp. 283 ff. 36 Empirical analyses have shown that social rights in constitutions have only marginal effects on political outcomes. See, e.g., Ben-Bassat and Dahan (2008). 37 See, e.g., Voigt (2017), pp. 206 ff. 33

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Economics has also taken on this task, although the development of a generally applicable theory of transformation is still in its early stages.38 Several elements of a theory of transformation are already obvious, although they have not yet been applied specifically in the context of institution-building. These include recourse to the self-interest of the rulers and rule-setters as well as environmental factors in a broader sense, including the issue of population growth.39 The theory of ‘competition among institutions’ may offer the most important institutional approach.40 This theory is based on the simple reasoning that there is competition not only among suppliers of traditional goods, but also among suppliers of bundles of public goods. It was first developed in relation to federal states whose member states compete among themselves.41 Its application was later extended to nation states whose governments compete for (scarce) mobile resources.42 The focus is on attracting investments and the resulting tax revenue.43 Stefan Voigt has outlined key components of a general theory to explain the transformation of forms of government over time.44 The following are cited as essential factors: the limited rationality of the actors, the problem of collective action, the path dependence of institutional change and the related phenomenon of political transaction costs, the relative power of relevant actors, and the concept of justice. The concept of path dependence,45 developed by Douglass North, suggests that the inertia in institutional change is greater than in technological change, for example, and that the initial historical conditions thus play a significant role. This inertia is due to established networks as well as to the political transaction costs of institutional change. Another obvious aspect contributing to the inertia is the relative power of relevant actors, because any political structure will have specific distributional effects that the ‘profiteers’ will try to maintain. Public conceptions of justice and fairness, on the other hand, refer to the ‘demand side’ of bundles of collective goods. The question here is how greatly such conceptions are integrated into the political process through elections.

2.2.3

Economic Theory of Democracy

Like other fields, including political science and law, economics regards democracy as the basic feature of modern constitutions. As explained above, rational individuals

38

For an overview, see, e.g., Voigt (2009), 6.4. See Voigt (2009), 6.4.1 and further reference. 40 See, e.g., Marciano and Josselin (2003). 41 In this context, see Sect. 2.4.2.2.1 below. 42 Peters (2010), pp. 11 ff., is informative on the advantages and analytical utility of the competition paradigm regarding states, as well as on the objections against it. 43 In the context of tax competition, see Sect. 5.3.1.4.3.6 below. 44 Voigt (2009), 6.6. 45 North (1990); see also Sect. 6.1.3.1.4 below. 39

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will only consent to be governed if they maintain some influence over the governing power. Constitutional structures must therefore assure that collective (government) decisions can be perceived as an aggregation of individual preferences. Still, there are varying definitions of democracy.46 Many political scientists, for example, include the influence of interest groups on the government as an integral and justified part of democracy.

2.2.3.1 Basic Principles Modern theories of democracy address questions of the common good—such as how to define it and how to realise it in practice—with the individual as the reference point, rather than by invoking old conceptions of domination and democracy (see, e.g., Plato’s Republic and Rousseau). For example, in the democratic process, is it possible to arrive at an understanding of the common good that is at least consistent while taking into account the values and preferences of the citizens? The economic theory of democracy attempts to answer this question.47 It approaches the issue by analysing the behaviour of voters and governments based on the assumption that governing bodies, political parties and voters are all rational actors aiming to maximise utility. It is particularly challenging to understand the role of the ‘rational’ voter in a democracy; this is therefore a focal point of the analysis.48 2.2.3.2 The Political Process In addition to voters, politicians play a central role in the political process. This role will be discussed here in greater detail.49 Other key participants—specifically ‘bureaucrats’,50 political parties51 and interest groups52—will be discussed in a systemic context. In representative democracies, politicians typically organise themselves into parties so that they are able to achieve their goals effectively.53 From an economic perspective, parties are organisations that offer bundles of collective goods.54

46

See, e.g., Fuchs and Roller (2018), with empirical background. In this context, see the essential writings of Arrow (1951) and Downs (1957). For a good overview, see Kirchgässner (2008), 4.1. 48 See Sect. 2.2.3.3 below. 49 See, e.g., Kirchgässner (2013), 4.1.2. 50 See Sect. 4.1.2 below. 51 See Sect. 2.2.3.2.2 and 3.3.4 below. 52 See Sect. 2.2.3.2.2 and 3.3.2.2 below. 53 See Sect. 2.2.3.2.1 and 3.3.4.1 below. 54 See Sect. 2.2.3.2.2 below. 47

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2.2.3.2.1 The Role of Politicians in the Political Process Schumpeter’s characterisation of politicians as ‘political entrepreneurs’ was an important forerunner of modern theories of democracy.55 Anthony Downs further developed this concept in An Economic Theory of Democracy (1957), arguing that politicians have their own interests, and that the maximisation of their own benefits is foremost among these (e.g. the power, prestige and income tied to their political office).56 The New Political Economy developed this assertion—that both the voters and the politicians behave as utility-maximising, rational individuals—into one of the basic assumptions about the political process. Politicians are not ‘benevolent people’ who only want to maximise social welfare. They strive for the power, prestige and income associated with their political position and therefore seek to win re-election and maximise votes.57 The common good is not even the primary concern of voters themselves; instead, they base their decisions on the desire to maximise their own interests. 2.2.3.2.2 The Role of Parties in the Political Process It is striking that economics focuses extensively on the role of politicians, but little on the role of parties. In Western democracies, parties play the decisive role in the political will-formation of the people and in its subsequent ‘translation’ into the political choices of the state. Politicians without party affiliation have virtually no prospect of success. Many state constitutions, especially old ones, do not address political parties at all; the US Constitution is one example. These were designed to oppose the creation of factions in an effort to avoid the development of intermediary organisations.58 It is increasingly common for newer constitutions to devote at least one article to political parties.59 In abstract terms, parties can be redefined as organisations competing for governmental power.60 They perform the functions of aggregation and articulation:61 parties bundle social interests and present platforms that offer a (more or less comprehensive) impression of the packages of public goods that the state should provide (including decisions regarding financing). In effect, they develop plans for state will-formation. At the same time, however, parties are organisations that bring

55

See, e.g., Schumpeter (1946). On Schumpeter’s significance for the development of an economic theory of democracy, see Wohlgemuth (2005), pp. 21 ff. 56 These are frequently referred to as ‘Maslow’s needs’ in reference to the groundbreaking work by Maslow (1978), pp. 87 ff. 57 See Voigt (2019), pp. 83 ff. See also Sect. 4.1.1 below. 58 Pildes (2011), p. 255; Issacharoff and Miller (2010), p. 195. 59 See, e.g., Article 17 of the Constitution of Brazil, Article 4 of the Constitution of France, Article 21 of the Constitution of Germany, Article 49 of the Constitution of Italy, and Section 6 of the Constitution of Spain. 60 Stokes (1999), pp. 243 ff. 61 Stokes (1999), pp. 250 ff., with an emphasis on differences in the context of ideological parties.

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together ‘like-minded people’ with the goal of filling political offices with party members; insights from organisational economics thus apply to parties as well.62 The key challenge for parties is to persuade as many voters as possible to support their platform. In the past, ‘loyal voters’, or base voters, played an important role in the success of these efforts, but today their significance is dwindling.63 Problems with credibility and distance from voters have become increasingly significant.64 How can parties convince voters that they are genuinely committed to their publicised goals so that members of the electorate who would benefit most from the platform actually vote for it? This question raises the issues of informational problems and voter turnout. Parties are intermediary organisations of society that aggregate and define the political will of the people; as such, they must be independent of the state and especially of the majority or government. At the same time, once they gain power in parliament and government, parties will be the ones who define the will of the state. This position allows them to influence party regulation in order to stabilise power and distort competition between parties.65 The primary objective of a constitution is to ensure and guarantee strong and autonomous parties that are independent of the state. For this purpose, most modern constitutions guarantee an individual right to establish or join parties. But this rightsbased approach cannot do justice to the dual function of parties. Daniel Ortiz suggests that we must therefore take a more structural approach66 in order to shift our perspective ‘from rights to arrangements’.67 This enables constitutional courts (and constitutional lawyers) to develop an overarching theory of parties that integrates diverse fields (e.g. election law, parliamentary law or party organisation law). In some cases, this has resulted in the derivation of specific rights for parliamentary party groups from general constitutional rules; under the German Constitution, for example, rights of state organs (e.g. regarding standing in trials before the Constitutional Court) were extended to parties through teleological interpretation.68 In addition to the individual or collective-rights approach to parties, competition among parties must be ensured. From an economic perspective, politics can be viewed as markets, and competition among the participants can be distorted as in real markets. For parties, this threat is particularly severe, as some will gain power and thus be able to influence all laws that determine the parties’ chances of taking power (election law or party law, e.g. regarding financing). Existing parties have better prospects, because they have opportunities to influence norms relevant to party success (media law, election law, party finance) to their benefit in advance. 62

See Sect. 3.2 below. Cf. Fritsch (2018), 14.2.2. 64 Cf. Fritsch (2018), 14.2.2. 65 Issacharoff and Miller (2010), pp. 195 ff. 66 On this development, see Issacharoff and Miller (2010), pp. 182 ff. 67 Ortiz (1999). 68 See Pildes (2011), pp. 255 f. 63

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Election law is the primary source of preliminary decisions about the opportunities for parties to form and grow.69 It is clear that a majority voting system facilitates the existence of two large parties, while proportional representation promotes a multi-party system. In the latter, parties must organise themselves in a way that allows them to obtain the access to power that they seek. Defining the size and shape of electoral districts has proven to be another controversial point and has led to constitutional court decisions in several jurisdictions.70 Other important areas of legislative influence on party competition include party finance,71 state and party influence on media,72 electoral thresholds,73 and bans prohibiting political parties from competing politically.74 It is interesting to analyse which of these topics have been regulated at the constitutional level. The German Constitution has established strict rules on banning parties (Article 21(2)), for example, and the Constitution of Spain addresses the principle of proportional representation (Section 68(3)). The issue of ‘path dependence’ is relevant in this context:75 because many such aspects have been established constitutionally, they are difficult (for new parties) to change. 2.2.3.2.3 The Role of Information in the Political Process The self-interest of politicians could produce optimal results—if state organisation were ideal and voters perfectly informed. However, there are many barriers to securing these conditions in practice.76 One might suspect that, under such circumstances, self-interested politicians would align themselves with voter preferences, but there are obvious reasons why this is not the case. Because voters are often under-informed (high information costs are not considered worthwhile), politicians can systematically deceive voters. In his theory of political business cycles,77 William D. Nordhaus (1975) has demonstrated that politicians can specifically orient their economic policies towards election day, such as by ensuring that the unemployment rate decreases shortly before the election (at the cost of subsequent price increases).78 This phenomenon can also be applied to 69

Loomes (2012), pp. 43 ff. On the ‘redistricting’ problem in the US, see, e.g., Issacharoff and Miller (2010), pp. 173 f., 191 ff. 71 See, e.g., Corduwener (2020), pp. 51 ff. 72 See Sect. 3.3.3 below. 73 See Pildes (2011), 3.1.3 (259). 74 Ibid., Sect. 3.2 (259 ff.). 75 Aldrich (2011), pp. 56 ff.; Krouwel (2006), p. 250. 76 See Sect. 2.2.3.3 below. 77 See, e.g., Voigt (2009), 4.2.3. 78 This theory is based on the hypothesis that a vote-maximising government does not dampen economic cycles contrary to voters’ wishes, but rather demonstrates pro-cyclical behaviour. At the beginning of the legislative period, an attempt is made to reduce the rate of inflation through restrictive monetary and fiscal policy, which is carried out at the cost of an increase in the unemployment rate. Near the end of the legislative period, expansionary policies are adopted to 70

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other policy areas. In general, after an election, or when parties are certain of a majority, politicians have leeway to shape policy in their own interest or in the interest of their backers (the policy of ‘ideology maximisation’).79 Problems in the process of political will-formation are linked to asymmetrically distributed information in two respects.80 The arrangement between the relevant actors can be characterised as a two-tiered principal-agent relationship.81 Voters can be seen as principals of the politicians, who act as agents. But there is also a principal-agent relationship between the (elected) politicians (as principals) and the executive administration, the ‘bureaucrats’ (as agents); this relationship will be revisited later in connection with issues of administration.82 Given the central importance of information and information flows in democracies, a relevant question is: what has changed in the digital age?83 One especially significant change is the dramatic decrease in transaction costs incurred to obtain and process information. Among other things, opportunities for citizens to control politicians have increased. 2.2.3.2.4 The Role of Money in the Political Process (Party Finance) The probability of success in parties’ struggles for electoral victories and mandates also depends, of course, on the scale of the financial resources at their disposal.84 Party finance in a narrower sense will be addressed in Chap. 3, which analyses parties as organisations.85 It is important to note, however, that this issue is closely related to the financing of other institutions and offices affiliated with parties, such as party political foundations, parliamentary factions and delegates (i.e. party finance in a broader sense). The financial resources of parties are provided mainly by citizens (membership dues and donations) and by the state (election campaign reimbursements and other aid). Regulation of these two areas of party finance has long been controversial: given the close connection between parties and parliamentary factions, decisions on relevant issues can be referred to as making a ‘judgement in one’s own cause’—as when legislators determine legislative salaries. Today, parties continue to play their historical role as (private) intermediary organisations in society. They are therefore largely privately financed through membership dues and donations. The specific interests leading members to promote economic growth and reduce unemployment. Because the rate of inflation generally responds to such changes with a lag, it is possible to achieve a combination of relatively low unemployment (high economic growth) and relatively low inflation by election day. This approach was evident during the first Reagan Administration from 1981–1985. 79 On these phenomena, see Bischof and Wagner (2017). 80 Towfigh (2012), pp. 254 ff. 81 Lane (2013); on principal-agent theories, see Sect. 1.2.3.5 above. 82 See Sect. 4.1.2.3 below. 83 See, e.g., Salzberger and Elkin-Koren (2005), pp. 58 ff. 84 From a comparative perspective, Potter and Tavits (2013). Regarding US campaign financing, see Issacharoff and Miller (2010), pp. 188 ff.: only the size of the impact is disputed. 85 See Sect. 3.3.4.3 below.

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participate in parties will be discussed later;86 from an economic point of view, it seems reasonable to suppose that they act strategically, as is likely also the case with donors.87 A key risk in party finance is that parties will become overly dependent on large donations and, relatedly, that large donors will gain too much influence. For this reason, the German Federal Constitutional Court struck down provisions that made donations to political parties tax deductible (without limit);88 it later ruled that, based on the constitutional principle of equal opportunity for parties, perquisites (i.e. subsidies or tax benefits for donors) could be granted only up to an amount that the majority of citizens could afford.89 Legislators can provide state payments on top of private contributions only up to a fixed amount. Most countries have placed a general ban or limit on donations.90 Beginning in the 1970s, most democratic states began to provide public funding to political parties (e.g. in accordance with their share of votes, parliamentary representation or the amount of private funding received). State funding of political parties introduces a dilemma: the constitution presupposes that parties are capable of action and play a role in forming the political will of the people, but it also assumes that parties are the product of civic engagement (the principle of freedom from state interference). Based on these considerations, the Federal Constitutional Court concluded that parties should be funded primarily through self-financing and only partially by the state; under its ruling, state funding can cover no more than 50% of the party budget. The Court also prescribed an absolute upper limit as an additional safeguard to prevent parties from exploiting the state.91 Under the Political Parties Act (Parteiengesetz), payments are specifically apportioned based on the number of votes (generally at a fixed rate per vote) and the total revenue from third parties, including membership dues, donations and contributions from elected officials, with a fixed limit on donations allowable for each natural person. Economic concepts can be applied to justify these principles. From the perspective of public goods theory, public will-formation can be regarded as a public good that justifies state financing. At the same time, parties can be viewed as ‘interest groups’, as discussed in the work of Max Weber. Parties seek power and, in doing so, (also) indirectly produce private goods, essentially in the form of collective goods for group members. This implies private financing. It is not possible, however, to draw precise boundaries between public and private funding on this basis.92

86

See Sect. 3.3.4.1 below. Issacharoff and Miller (2010), pp. 188 ff. 88 On the development of this jurisprudence, see Pildes (2011), pp. 256 f. 89 These judgements are presented in Bumke and Voßkuhle (2019), annot. 1549 ff. 90 See Falguera et al. (2014). According to an overview by the International Institute for Democracy and Electoral Assistance (IDEA), this applies to 70% of countries worldwide. 91 These judgements are presented in Bumke and Voßkuhle (2019), annot. 1549 ff.; see also Pildes (2011), pp. 256 ff. 92 For further detail, see Sect. 3.3.4.3 below. 87

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2.2.3.3 Transforming Individual Decisions Into Collective Decisions: Problems of Social Choice The central challenge of democracy is to ‘translate’ the individual preferences of citizens into collective decisions. Economics has attempted to analyse this process of political decision-making, and the difficulties associated with it, using several theoretical models.93 The following pages introduce some of the most significant concepts. 2.2.3.3.1 Fundamental Problems with Majority Decisions and Arrow’s Paradox Independent of the presence of new, expanded opportunities for participation through the internet, the democratic voting process has always been the central focus of economic theories of democracy. The key challenge lies in how majority voting can be organised effectively, considering the vast heterogeneity of voter preference and the absence of transitive, ordinal or interpersonal comparability or consistency.94 In economic terms, this process is one in which individual ranked preferences are converted into one collective ordering. Social choice theory and collective-decision theory address this issue. As early as the eighteenth century, Marquis de Condorcet (1743–1794) offered an impressive description of the fundamental difficulties in establishing reliable and convincing majorities.95 According to the Condorcet paradox, transitivity— regarded as a core property of individual rationality—does not apply when groups of three or more individuals choose from among three or more alternatives in a system of unlimited majority rule. In a simple model, three actors (A, B and C) are presented with three options for a vote (I, II and III). The order of preferences is summarised in Fig. 2.1. If the alternatives are put to a vote successively and in pairs, the following outcomes are obtained: (1) a majority (consisting of A and C) for I > II (2) a majority (consisting of A and B) for II > III (3) a majority (consisting of B and C) for III > I. In other words, a vote between alternatives II and III results in a 2:1 majority for II. If III is eliminated and the vote is between I and II, the outcome is a 2:1 majority for I, and I appears to be the winner. If I and III are then directly compared, the outcome is a 2:1 majority for III. Changing the voting order produces a corresponding variation in outcome. This means, in effect, that either there is no outcome or there is an arbitrary outcome. The result I > II > III > I is contradictory in itself (a ‘cyclical

93

For an informative overview, Cooter (2000), chap. 2 (‘Voting’). On the topics discussed in the following paragraphs, see Kirchgässner (2008), 4.1.1; Issacharoff and Miller (2010), pp. 175 ff.; Hindriks and Myles (2013), chap. 11. 95 Condorcet (1785). 94

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Fig. 2.1 Condorcet paradox

majority’). The alternative is to make a determination (e.g. I > II > III) that disregards the preference of a majority (B and C). Based on this outcome, B might ask whether alternative III would be preferable in a direct comparison of III and I (which would in fact be the case). Nobel Laureate Kenneth J. Arrow took a more general approach to this question. The Arrow paradox96 demonstrates that any rule applied to solve the problem will either fail to produce rational, transitive outcomes or violate one of the basic criteria of fair and democratic decision-making.97 Arrow has used several examples 96 Arrow (1951). See also, e.g., Stiglitz and Rosengard (2015), pp. 236 ff.; Hindriks and Myles (2013), section 11.3 (347 ff.); Mashaw (2012), pp. 26 ff. 97 As reformulated by Stearns (2010), pp. 92 f., the fairness criteria are:

(1) Range: The collective decision-making rule must select its outcome in a manner that is consistent with the members’ selection from among all conceivable ordinal rankings over three available alternatives. (2) Interdependence of irrelevant alternatives: In choosing among paired alternatives, participants are assumed to decide solely based upon the merits of those options and without regard to how they would rank options that might be introduced later. (3) Unanimity: If a change from the status quo to an alternate state will improve the position of at least one participant without harming anyone else, the decision-making body must so move. (4) Non-dictatorship: The group cannot consistently vindicate the preferences of a group member against the contrary will of the group as a whole.

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(including a 1970 state senate election in New York State) to show that such situations indeed occur in practice.98 He inferred from the model that it is impossible to establish a rational process for collective decision-making in politics. Thus, institutions are inevitably forced to make trade-offs so that they can guarantee stable and reliable outcomes while realising the fairness criteria of democratic decisionmaking to the greatest possible extent.99 In different institutional settings, this may also lead to the development of different voting systems, such as a system based on a quantitative aggregation of voter preferences.100 Arrow thus set the course for normative approaches to the Condorcet or Arrow paradox that would search for good—instead of perfect—systems and institutions. Buchanan, too, argued that the possibility of cyclical majorities must be acknowledged and that, in democracies, the crucial issue is not to achieve consistent outcomes in every case (i.e. outcomes that meet logical conditions in an optimal way); institutional conditions should instead seek to ensure a relative optimisation. Buchanan maintained that, in reality, it is a matter not of individuals’ concrete choice of end results, but the coordination of the actions of different agents. It is also important to bear in mind that, in general, many decisions must be taken, not just one; this creates opportunities for strategic vote trading and bundling (e.g. through party platforms). Insights from these studies suggest that, even if stable results are observed in democracies, we should critically examine whether these results are fair.101 Ultimately, then, the process of reaching decisions comes to the forefront, while the outcome of those decisions recedes into the background (Buchanan: ‘that which emerges is that which emerges’). It is important to acknowledge that elections and votes can be manipulated and that parties can significantly influence the outcomes, especially through the process of ‘issue management’. This suggests the central importance of procedural law, including the concept of ‘legitimation through procedure’ developed by Luhmann. The outcome of procedures greatly depends on ‘agenda-setting’, for which effective regulations must be established.102 The basic decision for proportional representation or a majority voting system is of fundamental importance in this context.103 This was the background for the procedural theory of the common good developed by influential political scientist Ernst Fraenkel.104 Even if we concede some uncertainty about whether and to what extent elections produce accurate assessment of the future common good, they do result—at least in

98

For an example from Denmark, see Kurrild-Klitgaard (2001). For examples, see Stearns (2010), pp. 120 ff. 100 On associated methods (Borda count, runoff voting and others), see Hindriks and Myles (2013), 11.5. See Stearns (2010), pp. 99 ff., on the corresponding institutional voting procedures. 101 Mashaw (2012), p. 27. 102 On the significance of agenda setting, see, e.g., Hindriks and Myles (2013), 11.4.5; Cooter (2000), pp. 43 ff.; Mashow (2012), p. 27. 103 See, e.g., Cooter (2000), p. 28 ff. 104 Fraenkel (1991). 99

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one respect—in a very concrete expression of will, namely by voting out (or confirming) an existing government. Viewed in these terms, elections constitute the ‘most ingenious means of disempowerment in history’.105 The observation that voting systems can never be perfect is another argument for the importance of basic individual rights.106 2.2.3.3.2 Distortion of Collective Decisions Democracies aspire to translate the will of the voters into collective decisions as accurately as possible. In reality, however, there are many distortions, as individual preferences can be asserted to varying degrees. In addition, certain actors, especially politicians and parties, can influence and shape this process—and are of course interested in doing so. First, it is evident that certain preferences are given greater consideration than others in collective decisions, a phenomenon known as ‘mobilisation bias’.107 Some interests and preferences are more likely than others to be integrated into decisionmaking processes, especially if they can be considered (and ‘marketed’) in line with public interests (for example, teachers may argue that improving their working conditions will benefit schools and education). Other interests and preferences may be better suited to dominate public debate because they are relevant to a major topic of public debate; this is due, in part, to the difficulty that voters have in processing greater amounts of information and to their general orientation towards a limited number of key themes. Another obstacle to the transformation of individual preferences into collective decisions with as few distortions as possible is that voter needs are by no means fixed ex ante; they can be shaped by politicians, parties and other actors. While it may be an exaggeration to view voter preferences as the ‘creation of politicians’,108 we can assume that ‘party proposals’ (like the supply of goods) and ‘voter demand’ (like customer demand) are interdependent. Parties design political agenda to maximise votes and, in doing so, prioritise certain issues (‘issue management’), especially topics on which they are perceived as competent (‘issue ownership’). They define the criteria for their own evaluation (‘priming’), then attempt to contextualise issues in order to gain interpretive authority (‘framing’). The media then assist in appealing to the voters—which is, of course, particularly easy to do when issues are emotionally charged, affect many people or are very important.

105

Dylla (2008), section 2.8 (5) and further reference. Mashaw (2012), pp. 28 f. 107 Cf. McNollgast (2007), pp. 1670 f. 108 Herder-Dornreich (1979), p. 76: ‘The politician does not only take the orders dictated to him by the citizens; he also forms and shapes the will of the citizens. (. . .) The needs of the voters lie dormant. (. . .) They are only brought to life by the politician, who seizes them and transforms them into political raw materials. The politician sums up voters’ needs, finds the right words for them and condenses them into catchwords and agenda items. He organises them and enables them to become politically effective.’ (Translation by the author.) 106

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In 1976, political scientists Douglas Rae and Hans Daudt introduced a voting paradox, which they named after Russian party researcher Moissei Ostrogorski.109 This Ostrogorski paradox shows that strong distortions of the ‘will of the electorate’ can occur when entire party platforms, rather than individual issues, are put to a vote. Situations can thus be constructed in which a party (Y) wins in a vote en bloc, although another party (X) obtained a majority in a vote on the individual issues. This presents yet another challenge to the translation of individual preferences into a collective decision. 2.2.3.3.3 The Median Voter Model and Its Critics An influential paper by Anthony Downs developed the concept of a median voter theorem, which provided scientific support for the popular wisdom that elections are won in the middle.110 If two parties (one ‘left’ and one ‘right’) compete for votes, the competition plays out in the ‘centre’, effectively bringing the two party platforms closer together. This phenomenon has also been observed under Germany’s stable three-party system of the 1960s and 1970s, which consisted of conservatives, social democrats and liberals in the middle. In the following model, every point on the horizontal axis represents a voter’s possible ideological position on a left-right spectrum. Assuming that voters choose the party that is ‘closest’ to them, the party gains approval as its candidate’s platform approaches the middle of the probability distribution. This relationship holds for both unimodal (Fig. 2.2) and bimodal voter distributions (Fig. 2.3). The explanatory power of this model is extremely limited. This is partly because it is very much oriented towards two-party systems, which are more prominent in Anglo-American democracies. In addition, as has been shown, voter preferences are not fixed, but can be influenced by a variety of circumstances, especially by the ‘persuasive power’ of the parties and the voters’ (necessarily) incomplete information. Politicians can thus strive to ‘maximise’ ideology as well as votes. Thus, the median voter theorem is a supply-side model (aggregating voter preferences), which must be supplemented by supply-side considerations.111 The emergence of the environmental movement in particular has called into question whether a one-dimensional political spectrum (for example, a left-right spectrum) can be reconceptualised.112 For a realistic assessment, however, two dimensions are insufficient. A spatial model would need to be developed, in which case the outer borders would assume very irregular forms (see Fig. 2.4).

109

Rae and Daudt (1976), pp. 391 ff. For an introduction: Petersen and Towfigh (2015), IV. C. See Downs (1957). For a good introduction and overview, see Petersen and Towfigh (2015), III. A., and Hindriks and Myles (2013), 11.4.3. For further reading, Cooter (2000), pp. 25 ff. The median voter theorem can be traced back to a famous article on competition by American economist Harold Hotelling; see Hotelling (1929). 111 Holocombe (1989). 112 On the median voter theorem in a multidimensional space with mixed preferences, see Hindriks and Myles (2013), 11.4.4; Issacharoff and Miller (2010), pp. 178 f. 110

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Fig. 2.2 Median voter theorem (unimodal voter distribution)

Fig. 2.3 Median voter theorem (bimodal voter distribution)

Fig. 2.4 Median voter theorem in a multidimensional space (in the case of the German party system)

Overall, the median voter theorem can be seen as a pure (and perhaps theoretical) model that serves as a starting point for analysis, like market models with perfect competition. It is important to note that Downs based the model on the following five assumptions; in reality, deviations from each may appear: (1) Political space is one-dimensional and can be ordered from left to right. (2) Preferences are single-peaked and have a normal, bell-shaped distribution.

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(3) Voter preferences are not altered by historical, sociological or physiological factors. (4) Political parties can move within the spectrum (except beyond the nearest party). (5) Extremist voters may abstain if they perceive the two main parties as being too similar. It can be demonstrated that all five assumptions do not hold in the case of populist movements; nevertheless, it is interesting to analyse such movements on these grounds.113 2.2.3.3.4 Rational Voting Behaviour and the Theory of Low-Cost Situations The key question in an analysis of rational voting behaviour is, what do voters gain from their voting decision? Discussion: Low-Cost Situations

The theory of low-cost situations is most often applied in explanations of voter behaviour.114 In general, it refers to decisions that are without consequences for the decision-maker because they involve low costs for the individual.115 Under these circumstances, individual decisions cannot be analysed using a traditional cost-benefit scheme; additional assumptions are needed to explain the motivation. Because there are no hard (materialised) incentives (which are usually relevant in economics), soft incentives like those created by moral rules can exert a strong impact on these decisions. These decision situations are problematic, as they may have serious consequences for other individuals or for the general public. Kirchgässner and Pommerehne differentiate between two types of decisions: (1) Low-cost Decisions of Type I, in which an individual decision is irrelevant to the individual him- or herself, but the aggregate decision is relevant to all individuals, and (2) Low-cost Decisions of Type II, in which an individual’s decision is irrelevant to the individual him- or herself but highly relevant to others.116 The main example of Type II is judicial decisions, which will not be further discussed here in the context of democracy.117 Decisions of Type I are more relevant to this discussion, as their main field of application is voter decisions. In this context, low-cost situations are those in which the impact of decisions is different at an individual level than at a group level: the decision of a given individual has no effect on him- or herself or on any other individual, but the

113

See, e.g., Figueira (2018). For an introduction, see Kirchgässner (2008), chap. 5, and Cooter (2000), pp. 20 ff. 115 Kirchgässner and Pommerehne (1993). 116 Kirchgässner and Pommerehne (1993), pp. 108 f. 117 For these, see Kirchgässner and Pommerehne (1993), pp. 110 f. 114

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aggregate of these has consequences for all. The act of participating in an election provides no direct benefits to individuals, because an individual generally has no influence on the outcome. By contrast, the costs of participating in the election are relatively high. The theory of low-cost situations addresses the question: what (rational) reasons do individuals have for participating in an election (and for collecting necessary information beforehand)? The answer, in short, lies in the ‘consumer value’ (instead of ‘investment value’) of voter participation. An example of consumer value is a feeling of satisfaction for having fulfilled a civic duty. But here, too, there is a problem: the real costs of making an ‘incorrect’ choice when casting a vote are exceptionally low. One proposed explanation suggests that the motivating factor is the personal ‘psychological’ cost: individuals can avoid the psychological costs of ‘cognitive dissonance’ if their actual behaviour is consistent with their moral values. On the other hand, voting can confer psychological benefits if individuals perceive it as an act of expressing their opinion (‘expressive voting’).118 The ‘reward’ for participating in an election is thus derived from ‘participation value’.119 It is important to note that ‘psychological costs’ should only be taken into account in exceptional cases; otherwise, nearly any decision could be explained in this way.120 Low-cost situations are one such case because they lack the typical feature that decisions entail costs (for the decisionmaker and/or for third parties). ◄ The above considerations raise another question: what factors influence voter decisions? On the one hand, political issues are highly complex. On the other hand, an individual would incur enormous costs if they attempted to conform to the ideal of the fully informed citizen. As a result, it is entirely rational (and empirically substantiated) that voters are satisfied with a relatively low level of informedness. It may therefore be entirely logical for individuals to vote for the party that most closely approximates their general ideology, even without knowing the full details of the party platform. The same is true of the strategy to vote in accordance with the opinion of the social group to which individuals belong. Protest votes, on the other hand, are consistent with the general thinking behind ‘expressive voting’.121 2.2.3.3.5 Indirect vs Direct Democracy Issues like those raised above ultimately suggest reasons for a shift away from direct democracy and towards the forms of indirect democracy that are now the norm.122 The creation of a parliament as a reflection of society lowers the costs of decision-

118

See Brennan and Lomasky (1993). This assertion was made as early as Downs (1968), p. 265. 120 Kirchgässner (2008), p. 54. 121 Acacia and Cubel Sanchez (2014), with empirical data on ‘strategic voting and happiness’. 122 See, e.g., Cooter (2000), pp. 143 ff. 119

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making while simultaneously preserving preferences. The choice is therefore between party platforms, which establish the packages of public goods offered at a specific (tax) price. But there are also good arguments in favour of (elements of) direct democracy.123 Above all, feedback loops with citizens can induce politicians to move policy outcomes closer to the will of the majority and keep the influence of interest groups at bay. This happens in two ways. First, the decisions of unfaithful elected officials can be overridden via an initiative or a referendum (direct effect). Second, the threat of a ballot proposition can cause elected officials to choose different policies than they would have if direct democracy were unavailable (indirect effect).124 In indirect democracies, voters can only decide on politicians or parties representing issue packages. An initiative or a referendum gives citizens an opportunity to unbundle these issues.125 Evidence shows that voters in direct democracies take advantage of this option, e.g. to lower taxes and state spending or to make campaign finance laws more restrictive.126 As a consequence, this leads to less corruption as well as to higher productivity and per capita income.127 In addition to these advantages of direct democracies, there are arguments that do not favour one form of democracy clearly. These may concern voter competence, information asymmetries or the role of money in (and interests behind) the campaigns.128 Finally, direct democracy is associated with high decision-making costs. It is certainly debatable whether these costs will dramatically decline in the digital age,129 but even if this does prove to be the case, it would by no means solve all problems associated with direct democracy. Particularly in light of the above discussion, which highlighted potential barriers to rational majority decisions, it is important to consider how questions should be presented to the public; these questions must be answerable with a ‘yes’ or a ‘no’. After careful consideration of pros and cons, a ‘hybrid system’ can be designed to integrate the best of both worlds.130

2.3

Functions of the State

The functions of the state have always been a subject of great interest in the fields of political philosophy, state theory and constitutional law. In recent decades, economics has increasingly explored the justification for the state (typically based on a

123

See Voigt (2017), pp. 213 ff. (10.3.4.); Garrett (2010); Matsusaka (2005). Matsusaka (2005), pp. 192 f. 125 Ibid., 194 f. 126 Matsusaka (2005), pp. 195 f.; Voigt (2017), pp. 214 f. and further reference. 127 Voigt (2017), pp. 214 f. and further reference. 128 Matsusaka (2005), pp. 197 ff. 129 See, e.g., Salzberger and Elkin-Koren (2005), pp. 58 ff. 130 In this vein, Garrett (2010). 124

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critical, restrictive position on state functions), with a particular focus on identifying the specific fields of action in which the state has comparative advantages.131 The theory of market failure132 can merely identify problem areas in which it is possible for state dilemma structures, external effects, transaction costs, information failures and incomplete markets to constrain or prevent cooperation benefits. Economics searches for ways and means to remedy market failures.133 It is important to note here, too, that economic analysis does not presume markets to be fundamentally superior to state action;134 however, in view of the above discussion of ‘state failure’, the opposite cannot be assumed either. The theory of market failure can only indicate problem areas in which it is possible for state intervention to promote efficiency. This is the starting point for another function, which is no less challenging: namely, the use of this information to propose remedies for market failure and a tool adequate to do so.135 In positive terms, the function of the state is to build structures that can encourage cooperation, in particular by recognising property rights, creating markets and enabling competition. Facilitating cooperation is therefore one of the state’s central responsibilities.136 The following pages provide only a brief typological overview of possible approaches to such tasks.

2.3.1

Management of Institutions

The state is the agent that provides the structure for the rule-setting and institutionbuilding necessary for people to overcome dilemma structures and benefit from cooperation. In short, the state is an organisation that humans construct in order to realise cooperative gains. In a more abstract sense, economic theory describes the task of the state as the ‘management of institutions’137 to compensate for market failure and produce public (collective) goods. The primary function of the state is thus to organise itself and to draft and enforce a constitution.

131

For an introduction, see Homann and Suchanek (2005), chap. 3.2. For further reading, Blankart (2017), chap. 4. 132 See Sect. 1.2.3 above. 133 In this context, Behrens (2010), pp. 4 f., discusses ‘intervention rules’, which he contrasts with ‘transaction rules’. He describes the latter as ‘all legal norms (institutions) that are necessary to enable markets to function efficiently’ and uses the concept mainly in reference to the creation of private usage rights. The discussion above applies it to the state’s facilitation of advantages from cooperation, in the context of which both concepts are relevant. 134 Trachtman (2008), p. 2. 135 See Voigt (2009), chap. 9. 136 For a systematic analysis, see Sect. 2.3.2 below; for an overview, Homann and Suchanek (2005), 2.4. 137 Homann and Suchanek (2005), 3.2.1, is persuasive on this point.

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It is impossible to compile a definitive list of state functions in abstract terms, however; these functions can be better identified from concrete analyses of specific constellations of market failure. As a result, the following overview cannot be regarded as the only ‘correct’ approach to this issue.

2.3.2

Typological Overview of State and Government Functions (Fields of Action)

2.3.2.1 Provision of Pure Public Goods At a minimum, the state is assumed to be responsible for providing pure collective or public goods.138 These are goods that can be used by their beneficiaries simultaneously and without restrictions (within certain capacity limitations): it is either impossible or extremely difficult to restrict use of the good to individuals who have paid for it. Several examples are discussed below. The production and safeguarding of internal and external security are longestablished functions of the state.139 We have known since Thomas Hobbes that, without external and internal peace, there can be no institution-building and ultimately no acquisition of gains from cooperation. In this sense, the first and most crucial state function is peacekeeping, which can overcome the basic dilemma structure of the bellum omnium contra omnes.140 The same principle applies to the provision of a legal system.141 In constitutional states, the mutual limitation of freedom is conceivable only if these restrictions are subject to legal regulations. These must be established by state institutions. 2.3.2.2 Facilitation of Cooperation and Competition and Reduction of Transaction Costs States have always considered it important to expand opportunities for individuals to engage in cooperation and exchange.142 This was, after all, the underlying reason for the creation of a money economy, private property, contract law, entities for dispute resolution (courts) and other institutions. This is, of course, an ongoing responsibility. Slow and expensive court proceedings, for example, may hinder trade and cooperation.143 In this context, the recent liberalisation and re-regulation of former monopoly markets (e.g. for the energy supply, the postal service and telecommunications) have played a significant role.144 In an era of globalisation,

138

See Sect. 1.2.3.3 above. Kasper et al. (2012) on the internal security policy as the ‘protective function’ of the state (323 ff.) and defence policy as a ‘productive function’ of the state (328 ff.). 140 Cf. Homann and Suchanek (2005), 3.2.2.1. 141 See Kirchgässner (2008), p. 50, on legal security as a pure public good. 142 See also Homann and Suchanek (2005), 3.2.2.2. 143 Voigt (2009), 2.1. 144 See Sect. 6.3.3.2.2 below. 139

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attempts to broaden the field of transactions can naturally also play out at an international level. A significant example of this is the liberalisation of trade that has occurred under the General Agreement on Tariffs and Trade (GATT)/World Trade Organization (WTO).145 Later the state acquired another important function, the protection of competition.146 It should be noted again here that competition is not a means in itself. There is, however, broad consensus that (functional) competition is an indispensable instrument for an efficient supply of goods and services; it thus increases the welfare of society as a whole and that of producers and consumers as individuals.147 This function aims primarily to create a framework for fair competition. Another aspect is the prevention of structures that preclude or reduce competition, such as cartels and monopolies. Identifying how regulation can introduce competition into previously monopolistic network structures (e.g. railways, telecommunications and energy supply) is a current challenge.148 High transaction costs justify an intervention by the state to correct the resulting inefficiencies. The optimisation of transaction costs, which is carried out by public institutions, is an important legal-political goal.149 Current efforts at administrative reform150 are also oriented towards the optimisation of transaction costs because it is expected to reduce costs for both the state and the citizens, among other objectives.

2.3.2.3 Establishment and Recognition of Property Rights Secure rights of disposal over one’s own resources and assets is another important prerequisite for more complex forms of cooperation. The acknowledgement of property rights is one possible measure to enable the acquisition of benefits from cooperation.151 Assigning and protecting them is a central task of state and government.152 Civil law generally applies a narrower concept of property, defining it as the right to enjoy and dispose of things and rights in an absolute manner while excluding others from doing so. In this context, ‘property rights’ can be limited to individual rights of action and disposal, such as the right to use a good (usus), change a good (abusus) or enjoy the benefits arising from use of the good (usus fructus).153 These rights are valuable; therefore, there is a price for third-party intervention or for transfers to third parties. In general, the price increases with the exclusivity of the

145

See Sect. 6.4.2.2 below. See Homann and Suchanek (2005), 3.2.2.2; Behrens (2009), pp. 45 ff. (‘market-enabling law’). 147 Motta (2004), pp. 39 ff. 148 For further detail, see Sects. 6.2.1 and 6.3.3 below. 149 Voigt (2009), 2.4. 150 For more detail, see Sect. 4.1.2.3 below. 151 See, e.g., Richter and Furubotn (2014), Ch. III and IV. 152 Miceli (2017). 153 Voigt (2009), p. 54. 146

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right. At the same time, the principle holds that a clearer allocation of rights reduces the transaction costs. Recognition of property rights plays a central role in contemporary environmental policy. A current example is the creation of property rights for environmental resources that were previously free to use (emissions permits).154 Today, there is little debate that the creation of property rights is not a ‘silver bullet’ that can remedy market failure. The tragedy of the anti-commons, a concept developed by Michael Heller,155 describes a situation in which property rights are insufficiently used—a case of under-utilisation.156 This phenomenon is debated most intensively regarding the provision of patent rights.157 In light of such disputes, policymakers must perform a difficult balancing act to address how and to what extent the creation of property rights can remedy market failure.

2.3.2.4 Resolution of Information Asymmetries The market-failure typology outlined above also referred to the task of remedying information asymmetries.158 Particularly in light of the division of labour in modern society, the availability of information is becoming more important to people’s activities, both economically and socially, and the provision of information is increasingly viewed as an end in itself (e.g. through environmental information acts or general freedom of information acts). Measures to supply information include instruments of energy demand management, such as mandatory indications of products’ energy efficiency. 2.3.2.5 Elimination or Reduction of Externalities External effects prevent the efficient allocation of resources and thus represent a case of market failure.159 This is due to both negative and positive externalities. Many negative externalities arise in cases of environmentally damaging behaviour: there is no compensation for the costs involuntarily incurred by third parties as a result of the damage, resulting in inefficient production and decisions. Positive externalities exist when benefits received by third parties are not reflected in the calculation. These externalities will be illustrated using concrete examples. Education (in schools or universities) is not a pure public good. The additional costs of educating each additional child are far from zero, and it is not difficult to charge individuals for educational services. State activity in the field of education is therefore justified on the grounds of externalities.160 Even classical liberal economists like Milton Friedman and Gary S. Becker support publicly financing 154

For more detail, see Sect. 7.2.5 below. Heller (1998, 2013). 156 Cf. Colangelo (2012), pp. 15 f. 157 See Sect. 6.4.2.4.1 below. 158 See Sect. 1.2.3.5 above. 159 See Sect. 1.2.3.2 above. 160 See Stiglitz and Rosengard (2015), pp. 401 ff. 155

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education up to the university level, although they oppose the idea that the state itself should provide the education.161 This perspective has gained importance; today, ‘human capital’ (i.e. people’s acquired abilities and skills) has become a determinant of ‘prosperity’. Although education generally also provides individual benefits, demand for it would be too low without state support: education requires risky and long-term investments, and banks are generally reluctant to provide financing without full security. It is certainly debatable whether the actual production, or simply the guarantee, of education should fall to the state (Becker and Friedman favoured a ‘voucher’ system). Full public provision of educational services (as in many European countries) does not take individual returns into account.

2.3.2.6 Merit Goods The theory of merit goods can be traced back to Richard A. Musgrave.162 The availability of these goods fulfils the criteria for market supply (i.e. excludability and rivalry); but without intervention, the demand is either too low (as in the case of education and healthcare) or too high (as in the case of ‘demerit goods’, including addictive substances like alcohol, tobacco and narcotics). In other words: consumers may not act in their own best interest.163 The debate surrounding media consumption and media availability is interesting in this context: is high-quality media broadcasting a merit good, since demand for it is too low? Is television—which is often consumed in excess—a demerit good?164 One criticism of this perspective is that it can be very difficult to distinguish merit goods from public goods in individual cases.165 Another argument against the justification of state responsibility towards merit goods is that a state with responsibility in this area will determine whether the demand for a good on the market is too high or too low, and thus whether a market failure exists. This limits ‘consumer sovereignty’ and could be perceived as ‘paternalism’.166 The danger of paternalism should be pre-empted by establishing more individualised merit criteria that take individual meta-preferences into account.167 It is part of the phenomenon of bounded rationality that individuals have diverse preferences over time (problem of discounting) or meta-preferences. ‘Nudges’ may be an answer to individual biases;168 they can be applied, for example, to address the fact that most people do not adequately plan for old age.169 Demerit goods are generally accompanied by negative external effects, while merit goods are 161

Friedman (1962), pp. 85 ff.; Becker (1964). Musgrave (1957). 163 Stiglitz and Rosengard (2015), p. 96. 164 See Sect. 3.3.3.2 below. 165 For a good overview of critical arguments, see Desmarais-Tremblay (2019). 166 For an overview, see Stiglitz and Rosengard (2015), pp. 95 f. 167 Kirchgässner (2013), pp. 48 ff. 168 See Thaler and Sunstein (2008). 169 See Ulen (2014), pp. 103 ff. 162

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accompanied by positive ones; this is another way to integrate the merit-good argument into modern economic reasoning.

2.3.2.7 Redistribution and Distributive Goods Redistribution is an important policy field in Western democracies. This is not surprising, considering the preferences of the median voter. From a normative perspective, however, it is highly controversial whether and to what extent redistribution is a state responsibility.170 Leaving aside the issue of fairness171—a topic more in the realm of lawyers and political philosophers—there are strong arguments in favour of policies and measures that facilitate public redistribution. First, it is unlikely that (otherwise justified) state action is Pareto efficient (i.e. increasing welfare without making individuals worse off); thus, redistribution is a necessary companion to other policies. But redistribution also has an economic rationale of its own: redistribution serves as an insurance on income, which means that, if individuals are uncertain about their future income position, ‘income insurance’ is individually rational (Rawls’s theory). Finally, redistribution is a bargaining tool: it represents a reward for peace and security and pacifies potential agitators to such a degree that they adhere to the stipulations of the legal system in place. Redistribution is mainly carried out through tax and welfare policies (transfers). It can also be implemented through distributive goods; these are goods that the state makes more or less expensive to even out differences in ability, market power or income and achieve a more equitable distribution. Examples of distributive goods include reduced museum admission for students or seniors, rent subsidies and savings promotions. For these goods, redistribution is explicit, taking the form of transfer payments. The state’s provision of other goods is, in effect, also redistribution, unless these are financed based on the principle of equivalence. 2.3.2.8 Goods with Existence Value or Bequest Value Although there is no way to measure the utility of goods with existence value or bequest value, there is at least some public interest in preserving these goods and a willingness (to pay) to preserve them. Many environmental goods have an existence value (or option value or non-use value).172 Option value is the value individuals are willing to pay for the possibility of using a good, such as a city park or public transportation. Existence value reflects the benefit gained simply from the knowledge that a good exists; this applies to cultural assets, for example. Still, the general view that the state must make such goods available has not gone unchallenged.

170

Eaton and White (1991), pp. 336 ff. Kasper et al. (2012), p. 337, argues for the redistribution of property rights (income and wealth) based on the concept of social justice. In this view, market outcomes are based on luck; therefore, redistribution is necessary to create physical or intellectual capital that can guarantee fair participation in the market. 172 See, e.g., Attfield (1998); Binder (2020). 171

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2.3.2.9 Natural Monopolies A natural monopoly, which develops naturally through market forces, makes competition to provide certain services impossible or excessively costly.173 This occurs most often where services are provided within infrastructure networks, such as those for railway and telecommunications services or grid-based power supplies. This situation has already prompted the development of a new state function: establishing and enabling competition.174 2.3.2.10 Protection Against Individual Risks Markets involving risks, such as insurance and capital markets, tend to be incomplete.175 The protection of citizens against individual risks is a key focus of the measures designed to enable the realisation of gains from cooperation. Activity in this area can be justified by the fact that there is too little demand in such cases (merit goods). In addition, these markets are characterised by high transaction costs and information asymmetries, which typically result in high risk premiums. Finally, market forces will try to identify and isolate ‘good risks’, reducing the probability that ‘bad risks’ will be covered by insurance at all. This is clear, for example, in the case of legally required motor vehicle liability insurance. The state cannot restrict itself to the creation of a legal framework for insurance providers. People may not think far enough ahead, or they may make errors in planning that are absorbed by compulsory insurance. Demand for goods can be unpredictable (e.g. in the case of weather or the risk of accidents) and, when needs arise, it may be unreasonable to expect users to pay prices that would cover costs. For this reason, the organisation of civil (disaster) protection is considered the responsibility of the state.

2.4

State Structure (Specifically Federalism)

Once the functions of the state are defined, a new question arises: what institutional framework best allows the state to carry out these functions? In its theory of state failure, the New Political Economy (public-choice approach) applies models of individual-level rational behaviour at the state level. For example, diverging from Plato and Hobbes, this theory abandons the notion of a benevolent dictator who has only good intentions and strives to achieve the common good; it recognises that politicians and people in power instead seek to maximise their own interests. This effectively debunks the ‘myth of the benevolent state’.176 In addition, as discussed above in the context of decision-making, there is—by definition—no

173

See Joskow (2007), pp. 1229 ff.; see also Sect. 1.2.3.6 above. For further detail, see Sects. 6.2.1 and 6.3.3 below. 175 See Stiglitz and Rosengard (2015), pp. 88 ff. 176 Brennan and Buchanan (1993), chap. 3. 174

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such a thing as an optimal voting or election system that would lead to ‘perfect’ majority decisions.177

2.4.1

The Question of Who Should Control the State: Separation of Powers (Horizontal)

2.4.1.1 Initial Considerations The central question here is the classic focus of political science, state theory and constitutional law: how can the concentration and abuse of power be prevented? In abstract terms, economics provides an answer: through political competition. In this view, the organisation of the state must be based on a system of checks and balances.178 A corresponding distribution of power can occur between (1) parties and social forces (pluralism); (2) the central government and sub-state entities (as in the separation of powers under federalism, discussed below); and (3) the legislative, executive and judicial branches of government. This issue concerns the horizontal separation of powers, which was first outlined in detail by Montesquieu. The concentration of state power can lead to monopoly rents for political actors. If the concentration of power is regarded as a form of ‘monopoly’, the solution would be to ‘break up’ the monopoly and divide power among multiple actors who will monitor one another and restrict their exercise of power. This is the approach summarised in the famous quip by Martin M. Shapiro: ‘I would rather be governed by three crazy people than by one crazy person.’179 At the same time, however, establishing power restrictions and monitoring capabilities involves certain transaction costs, because it requires the various actors to engage in bargaining to reach official decisions. There is also a second factor to consider with regard to the rational distribution of state power among multiple actors, namely that dividing and distributing power makes it possible to transfer power to agents who are particularly well-equipped for it due to their institutional structure, knowledge and/or characteristics (‘specialisation’).180 2.4.1.2 Separation of Powers Between the Legislature, the Executive and the Judiciary Horizontal systems of checks and balances in a broad sense have been discussed ever since the work of Greek political philosophers, mainly in the context of ‘mixed governments’ that distribute competences to the monarch, the aristocrats and the

177

Ginsburg (2010), pp. 260 f. See also Sect. 2.2.3.3 above. On the general justification for a (horizontal and vertical) separation of powers, see Breton (1996), pp. 70 ff.; Posner (2014), § 23.2; and Cooter (2000), chap. 8. 179 Cooter (2000), p. 211. 180 See Cooter (2000), Part 3. 178

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people.181 Since John Locke and Montesquieu, the principal form of the (horizontal) separation of powers has been recognised in theoretical discussions as a division between legislative, administrative and jurisdictional functions.182 The success that this concept has enjoyed in modern constitutional states is founded on a basic principle that is as simple as it compelling. The parliament, which is composed of representatives of the public, defines general guidelines for state action in abstract terms (typically in the form of laws). Parliament is particularly well-suited to this task because it allows for a (transparent) dialogue between social groups (or their representatives). The executive branch (i.e. the government and administration), on the other hand, is responsible for the enforcement of laws in certain cases. These functions are assigned to the executive because the bureaucrats have the requisite expertise, and because it is possible for them to provide sufficient and differentiated specialised knowledge to ensure that the large number of necessary state decisions are reached. Binding action in individual cases clearly constitutes the most direct exercise of state power; however, such power is limited by the fact that it can only be deployed in accordance with law and is subject to judicial review. This is the responsibility of the courts (judiciary), which verify that the administration’s decisions comply with the law and the principle of justice and can overturn (‘nullify’) orders that violate the law. The power of the courts is particularly far-reaching when it also enables them to overturn legislative decisions, as is the case with Germany’s Federal Constitutional Court and the US Supreme Court. At the same time, judicial power is significantly restricted by the fact that courts can generally only rule on a case-by-case basis, with the effect of their decision limited to each individual case (this is fully valid for continental law, within which court rulings have limited binding effect beyond that). In addition, judicial review must be carried out at the request of authorised parties and in compliance with narrowly defined procedural requirements. Finally, the parliament has ‘power’ over the executive and judiciary, at least indirectly, through its ability to influence the personnel who serve in these capacities.

2.4.1.3 Mechanisms to Balance Power The basic principle of a power distribution between legislative, executive and judicial branches is still very crude. In the course of their evolution, modern constitutions have developed numerous mechanisms to make this balance more systematic. One important question related to the distribution of power between the legislature and judiciary relates to a feature of the system mentioned above: should courts have the authority to strike down laws? This ability can be limited by transferring the power of nullification only to certain courts, such as the Federal Constitutional Court in Germany and the Supreme Court in the US.183 181

See Martinez (2012), pp. 548 ff. Martinez (2012), pp. 548 ff. For an economic perspective, see Cooter (2000), chap. 9. 183 See Martinez (2012), pp. 567 ff. 182

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The relationship between the legislature and the executive can be influenced significantly by fundamental decisions, namely whether the administration is legitimised through direct democracy, as is the case in the presidential systems of France and the US.184 Such governments are stronger than those whose fate depends entirely on parliament. Another way to expand the power of the administration is to grant it a veto right185 or even authorise it to legislate in certain cases. The executive can be further strengthened if it is able to introduce bills that the parliament can only accept without modification (‘take it or leave it’).186 The many pros and cons regarding both archetypes of constitutional design cannot be elaborated here in detail.187 Presidential systems strengthen personal accountability and have a higher level of democratic legitimation, yet further differentiation in the separation of powers automatically results in more conflicts and thus transaction costs. A multicameral system, on the other hand, can restrict the power of the legislature.188 This structure can ensure that certain interests will be taken into account rather than ignored (e.g. protection of minorities). In the US, for example, it is this system that allows small states to exercise a disproportionately large influence in the Senate, where the principle of formal equality applies. At the same time, this system can also protect the majority from being overruled by a minority. It is precisely in majority-voting systems that a structural minority can win elections.

2.4.2

Federalism: Separation of Powers (Vertical)

Economics engages especially intensively (and controversially) with federalism, with regard to both its general advantages and disadvantages as a kind of vertical separation of powers and its optimal design more specifically.189

2.4.2.1 Basic Principles Federalism, a system whose primary feature is its vertical separation of power, has a long tradition, as the prominent example of James Madison and the Federalist Papers makes clear.190 The basis of (integrated) federalism, both historically and conceptually, is the idea of a contractual union of independent states (Latin: foedus, ‘treaty’). Switzerland, Germany, the US and (today also) Europe are leading examples of federalism in practice. More recently, however, the reverse of this

184

For an overview of different (also hybrid) systems, see Martinez (2012), pp. 563 ff. Cooter (2000), pp. 221 ff. 186 Ibid., 218 ff. 187 See Ginsburg (2010), pp. 270 ff. 188 Cooter (2000), pp. 212 ff. 189 For an introduction, see Stiglitz and Rosengard (2015), chap. 26; Hindriks and Myles (2013), chap. 19; Hills (2010); and Posner (2014), chap. 25. For further reading, see Kobayashi and Ribstein (2007) or (with a focus on law and politics) Halberstam (2012). 190 Madison ([1788] 2010). 185

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process—that is, devolutionary federalism—has also led to federal statehood through the decentralisation, or ‘federalisation’, of a formerly unitary state; this has been the case, for example, in India, Brazil, South Africa, Belgium, Great Britain and Spain.191 Around the world, there has been a general trend towards the development of federal structures.192 Individual federal states vary considerably in design. Still, transitions from federations to federal states, and from federal states to decentralised states, occur fluidly.193 There is no generally valid definition of the federal state—the suitability of the definition depends on the specific research question. Riker’s classic definition held that a ‘constitution is federal if (1) two levels of government rule the same land and people, (2) each level has at least one area of action in which it is autonomous, and (3) there is some guarantee (even though only a statement in the constitution) of the autonomy of each government in its own sphere.’194 Similarly, Halberstam recently defined federalism as ‘the coexistence within a compound polity of multiple levels of government each with constitutionally grounded claims to some degree of organizational autonomy and jurisdictional authority.’195 Thus, from an economic perspective, federalism should be seen as a principle and a yardstick for analyses of political institutions.196

2.4.2.2 Advantages and Disadvantages of Federalising State Decisions 2.4.2.2.1 The Justification for Federal Statehood The advantage of federalisation is that it allows member states to better respond to the particular needs of their citizens and allocate expenditures to offer specific bundles of public goods at certain ‘tax prices’ (i.e. in accordance with a specific revenue structure). This generates competition for the best solution. Federalism was therefore conceptualised as a system that could better satisfy decentralised needs.197 The supply of public goods198 can take regional preferences into account, and the location of collective problem-solving can be adapted to the location of the problems. It follows that a federal structure becomes more appropriate as regional preferences become more heterogeneous. Fiscally, i.e. on the revenue side, the principle of correspondence supplements this conclusion.199 Where there is fiscal equivalence (i.e. user fees and taxes are paid only by the inhabitants involved), different preferences can be taken into account

191

On these developments, see Boadway and Shah (2009), pp. 5 f.; Halberstam (2012), pp. 583 ff. Halberstam (2012), p. 577. 193 For differentiation and empirical data, see Blume and Voigt (2011). 194 Riker (1964), p. 11. 195 Halberstam (2012), p. 580. 196 In this sense, e.g., Keating (2017) and Kelemen (2003). 197 For further detail, see Boadway and Shah (2009), pp. 35 f., 69, 124 ff.; Hills (2010), pp. 214 ff. 198 For an overview of basic categories of public goods, see Cooter (2000), pp. 105 ff. 199 Oates (1972) (‘principle of correspondence’) and Olson (1969) (‘fiscal equivalence’). 192

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regarding the level of public goods supplied (e.g. road infrastructure or social benefits). Different bundles of public goods can be supplied at different ‘tax prices’. In light of these factors, economics interprets federalism as a competition between regional governments.200 This widely accepted assumption stems from a 1956 article in which Charles Tiebout201 examines relationships between municipalities in the US. He concludes that there is competition not only between suppliers of traditional goods, but also between suppliers of bundles of collective goods. This competition leads to specialisation and a division of labour with regard to the production of public goods and the development of a sense of the common good, as well as the associated ‘tax prices’. First, of course, the citizens must decide these issues through elections in individual regional governments. The theory of ‘exit’ and ‘voice’ (‘foot voting’), developed by Albert O. Hirschman, became particularly influential in this context.202 Discussion: The Theory of ‘Exit’ and ‘Voice’203

Hirschman developed the theory of exit and voice in his book Exit, Voice, and Loyalty: Responses to Decline in Firms, Organizations, and States,204 which examines, in general terms, the options available to members of organisations to respond to management decisions. Hirschmann’s reference to the state and its citizens is particularly relevant in the present context.205 The theory is based on the assumption that regional governments compete for the allocation of scarce mobile resources, with the goal of securing a net inflow. Citizens and businesses have the option to respond through withdrawal (‘exit’) or objection (‘voice’). They can raise their ‘voice’ by articulating preferences within the state – a tactic that is, of course, more realistic in democracies. When citizens respond by withdrawing, i.e. leaving (‘exit’), the state entity loses mobile resources. Citizens and businesses can influence the supply of bundles of collective goods even by merely threatening to leave – in other words, by communicating dissent (another case of ‘voice’). These threats become more credible as the costs of mobility decline (as is increasingly the case in the modern, globalised world). The transaction costs associated with moving to a new jurisdiction within a federal state are lower than those incurred from emigration to another country. It is therefore possible that people with the same preferences will come together, strengthening regional variation in preferences (‘clustering’).206 200

For theory and evidence, see Oates (2002). Tiebout (1956), pp. 416 ff.; for an introduction, Hindriks and Myles (2013), 19.2.2; Stiglitz and Rosengard (2015), pp. 810 ff. 202 Hirschman (1970). 203 For an introduction, see Hills (2010); for further reading, Hirschman (2004). 204 Hirschman (1970). 205 In an article well worth reading, Hirschman applies his theory to the collapse of the German Democratic Republic (GDR); see Hirschman (1992). 206 Cf. Cooter (2000), pp. 128 ff. 201

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One criticism of this model is that the mobility costs and transaction costs of emigration are frequently underestimated; individuals also have a variety of attachments unrelated to the economy, such as social or cultural ties. As a result, opportunities to ‘exit’ are unevenly distributed in practice. Because of their informational advantage, those who are better off are more mobile than others, because they have less difficulty covering the mobility costs. This disparity can hinder the implementation of redistributive policies. Because large businesses are particularly mobile, their interests carry more weight in political decisionmaking; they also win greater influence when they threaten to emigrate. These interests are also more easily organised and bundled, which means that, even initially, they have more ‘voice’. Critics also point out fundamental problems with the analogies used.207 First, the process of choice is considerably more complicated with regard to bundles of collective goods than individual goods. Bundles of collective goods are often intangible and therefore more difficult to evaluate; in addition, they can be identified as generally ‘good’ or ‘bad’ only in rare cases, since their individual components are frequently evaluated differently. This may also make the communication of preferences more difficult, however, because it is typically harder for the institutions to identify the specific reasons for emigration. ◄ As discussed above, federalism leads to a vertical form of the separation of powers (fragmentation hypothesis).208 The Leviathan model, formulated by Brennan and Buchanan,209 predicts that this will reduce the concentration of state power and thus the possibility of an unrestrained ‘turning of the screws’ in tax collection. At the core of the competition hypothesis is the assumption that ‘jurisdictional competition’ incentivises innovation and the discovery process (‘laboratory federalism’).210 The production of bundles of collective goods can stimulate the development and testing of innovative approaches that raise the quality of life (the mechanism of ‘selective retention’). In Germany, for example, it is conceivable that a state would use its cultural sovereignty to frame its own higher-education laws and to organise its institutions of higher education in a way that will be more successful on the ‘science market’. Federalism has also been defended as an antidote to the information asymmetries between citizens and state institutions and to the principal-agent problem211 that arises in these relationships.212 Under a decentralised government, citizens are more

207

Voigt (2009), 6.5, (1) and (2). For the roots in the development of US federalism, see Chafetz (2011). 209 See Sect. 5.3.1.4.2 below. 210 Hills (2010), pp. 221 f. 211 See Sect. 1.2.3.5 above. 212 Boadway and Shah (2009), pp. 127 ff. 208

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closely involved in decision-making, and the resulting decisions—and the costs associated with them—are more transparent. An additional advantage of federalism is its effectiveness in uniting formerly (more) independent entities. This consolidation typically entails the creation of a common market and can provide considerable economic benefits. Particularly in an era of globalisation, decentralised (economic) entities and stronger institutions can be expected to have competitive advantages at a global level. 2.4.2.2.2 Disadvantages of Federalism A major objection to federal structures is that the competition between individual units may be distorted because the consequences of their actions affect the other units as well as themselves (externality hypothesis). External effects (‘spillovers’) between local jurisdictions (spillover costs and benefits) can never be avoided entirely.213 Such effects may be of a positive nature; for example, if skilled graduates move from one German state to another, work there and boost its economic strength, that state has profited from the good higher-education policy of the other. External effects are often negative, however; such effects may have been approved or even inflicted deliberately. Under some conditions, decentralised units can create policies at the expense of others. A prime example of this is the ‘tragedy of the euro’.214 Due to the asymmetry of a common currency and the mainly national-level fiscal policy, Member State decisions, e.g. on debt, have severe negative effects. The premise of the Treaties, i.e. that these will be internalised via higher interest rates for state loans, has failed. If the EU will not find remedies to stop free riding on the ‘common good’ currency, the euro is in danger. This example provides a striking illustration of the undesirable overall outcome that can result from negative external effects. It is therefore unsurprising that the member states of a federation negotiate with one another to eliminate or minimise external effects. The central government also develops specific policy instruments to this end; for example, member states that create positive external effects (e.g. through proactive higher-education policies) can receive grants (e.g. the current Excellent Initiative in Germany). Still, an internalisation of this kind can only ever be partially successful.215 External effects pose specific risks to the common markets that are generally present in federal states.216 Although such markets vary on a case-by-case basis (e.g. free-trade area, customs union and economic union), they are generally characterised by the free movement of goods, services, capital and labour. Member states can influence and manipulate these traffic flows through different measures, such as subsidies or tax policies. Federal states must counteract such measures

213

Cooter (2000), pp. 108 f.; Boadway and Shah (2009), pp. 36 ff., 76 ff. Bagus (2011). 215 On the internalisation of external effects within federal states, see, e.g., Boadway and Shah (2009), pp. 36 ff., 76 ff. 216 Cf. Boadway and Shah (2009), pp. 30 ff., 97 ff. 214

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through regulations, such as the famous Interstate Commerce Clause217 in the US or the internal market regulations of the EU. Measures like these will never be entirely successful, however, because differences in policies will always have consequences. Another important problem directly linked to externalities is that member states may be tempted to design individual policies in a minimalist and cost-effective manner to reduce positive external effects.218 This can lead to negative competition (a ‘race to the bottom’) and to the implementation of policies that are suboptimal for society as a whole. Relevant policies may include those that are cultural, social or environmental in nature.219 Especially in the context of environmental policies, emprirical results are often ambivalent in practice, as evidenced by ‘clean air federalism’ in the US.220 Another important disadvantage of federalism is the potential lack of economies of scale.221 Even in the creation of public goods, marginal and average costs can decrease if production is expanded (increasing economies of scale in production); however, it is possible that average costs will rise again when the local administrative unit reaches a certain size.222 The loss of economies of scale can be considered a cost of federalism. It leads to a disadvantage often cited in connection with federalism, namely the increase in costs of administration and coordination.223 In a federal state, certain functions, such as budget creation and review, must be performed numerous times; every federal state sets up its own government and parliament. In addition, there are the costs associated with coordinating the production of public goods that cross jurisdictional boundaries, such as infrastructure. Finally, the crucial function of federalism—that is, to differentiate policy approaches and responsibilities—can become a major disadvantage and create inequalities that are undesirable for reasons of fairness.224 From this perspective, the decentralisation of redistributive and social policies, for example, can prove problematic. This does not only concern the equal treatment of individual citizens; inequality can also arise at an aggregate level if member states begin with unequal conditions, such as greater access to valuable resources and raw materials. (The natural wealth of regions is often the starting point for efforts to gain independence or to federalise.)

217

For an economic analysis see, e.g., Conant (2008). Hills (2010), pp. 209 ff. 219 On the latter, see, e.g., Dalmazzone (2006), chap. 18 (459 ff). 220 See Potoski (2001). 221 See, e.g., Boadway and Shah (2009), pp. 80 f. 222 This is known as ‘Brecht’s law’ in reference to the statistician (Brecht 1932). See, e.g., Blankart (2007), pp. 62 ff., with a graphical representation in Figure 3.2. 223 Voigt and Blume (2012), p. 232, 245, with empirical evidence. 224 See, e.g., Boadway and Shah (2009), pp. 54 ff., 83 ff., 95 ff. 218

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2.4.2.2.3 Empirical Results As in other areas of economic analysis, there have been numerous attempts to examine propositions about federalism by conducting empirical tests. Due to the heterogeneity of federal systems and other complex factors, it is virtually impossible for such efforts to succeed. In general, however, federal states tend to be more stable than others.225 Boadway and Shah provide an overview of studies that investigate the effects of decentralising state decisions (e.g. the impact on economic development or the quality of public goods). Based on their findings, they conclude that, despite the general heterogeneity, there is evidence of an overall positive trend.226 Still, critics have rightly questioned whether assertions of this sort can be made about federalism, since federal states can be highly centralised and unitary states can be decentralised.227

2.4.2.3 Economic Analysis of Select Federal Systems 2.4.2.3.1 Typology of Federal Systems To better classify and evaluate federal entities, it is useful to categorise them typologically. A fundamental distinction was introduced above—that is, the difference between decentralisation and a federal structure in a narrower sense, which is a system established as such under constitutional provisions. A federal state can also be distinguished from a federation of states. The primary distinction is, of course, the degree of decentralisation, which can vary considerably even within federations. A further distinction is based on the relationship between federal units. This relationship may be one of legal cooperation, as is the case in Germany; this is called cooperative federalism.228 Under treaty federalism, on the other hand, there can be many possible ways for member states to structure relationships with one another through agreements, as in the US.229 2.4.2.3.2 Germany The German Constitution is the only constitution in the world that prohibits the abolishment of the federal order. The trauma of the Nazi period led to the incorporation of a strict eternity clause (Art. 79(3) GG).230

225

See Halberstam (2012), pp. 597 ff. Boadway and Shah (2009), appendix to chap. 2, 119 ff. 227 Blume and Voigt (2011), pp. 238 ff. 228 For examples, see Hegele and Behnke (2017) on Germany and Schutze (2009) on the EU. 229 See, e.g., Spahn (2006), chap. 7 (182 ff.). 230 Article 79(3) GG: ‘Amendments to this Basic Law affecting the division of the Federation into Länder, their participation on principle in the legislative process, or the principles laid down in Articles 1 and 20 shall be inadmissible.’ Art. 1 GG expressly grants human dignity and binds all branches of the state to enforce basic rights. Art. 20 GG guarantees the basic principles of the state (democracy, federalism and the social state). See Hueglin and Fenna (2015), pp. 291 f. 226

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The GG is an example of highly centralised federalism. Since the foundation of a German state from many previously independent states in 1871, a clear centralisation process has led to a high degree of homogeneity (also with regard to the constitutions of the German states, or Länder; see Article 28(1) GG). In addition, the powers of the federal government are relatively strong; most of the legislative competences are assigned to the federal level. The Länder have remarkably little authority over fiscal matters, which makes tax competition virtually impossible. The correspondence principle is therefore not fully realised: the population of the member states can hardly vote for regional public goods at a specific ‘tax price’. Since the founding of the federation, the Länder (as former independent states) have been ‘compensated’ in two main ways: (1) they participate in federal decisionmaking and especially legislation in a Länder chamber, the Bundesrat, which functions as a ‘clearinghouse’ for intergovernmental coordination;231 and (2) the tasks of administration and implementation are largely assigned to them. This system leads to a specific feature of German federalism: powers are more interlocked than divided, which forces the federation and the Länder to engage in multiple forms of cooperation (‘cooperative federalism’). In economics, this institutional incongruence is regarded as a governance problem because it is accompanied by considerable transaction costs, spillover effects and thus undesirable external effects. Critics argue that it is a ‘decision trap’ for efficient policymaking.232 Although many constitutional reforms have been proposed (and some implemented) to resolve these issues, they have had little success.233 The financial provisions of the Basic Law grant the Länder limited financial selfsufficiency.234 Federal states are barred from generating even negligible income of their own. In addition, (horizontal) fiscal equalisation—which is once again the subject of intensive debate—ensures a significant levelling-off of spending power, which has prompted references to a ‘limited-liability federalism’.235 Länder insolvency is unthinkable under the German Constitution.236 In general, federalism in Germany is uncontroversial and functions quite well. The system of unitary and cooperative federalism enshrined in the Grundgesetz does not advance principles of strong federalism but emphasises the importance of homogeneous living conditions. As a result, there is little leeway for competition among the Länder, and the strength of the federal system lies in its vertical separation of powers.

231

Hueglin and Fenna (2015), p. 150. See, e.g., Scharpf (1988). 233 Hueglin and Fenna (2015), pp. 151 ff.; Benz and Sonnicksen (2018). 234 For an overview, see Hueglin and Fenna (2015), pp. 188 ff. 235 Blankart (2007), p. 149. 236 Cf. Blankart (2007), chap. 9. 232

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2.4.2.3.3 Switzerland One countermodel to German federalism is the system established under the Swiss Constitution, which, like the US Constitution, provides the framework for a confederation.237 The federation was created to pursue political integration goals, namely for the purposes of defence, a common market and national infrastructure. In all other respects, Switzerland has remained a highly federalised state with a weak central government. This system is evident in the strong tax competences of the states (accounting for more than 80% of the tax revenue), leading to tax (and other) competition among states (with differences in tax rates of up to 100%). Overall, Switzerland reflects a classic competitive approach to federalism. Centralisation has always been regarded as critical and has generally been restricted to areas that offer clear advantages in terms of scale and scope. 2.4.2.3.4 European Union From an economic perspective, the European Union (EU) is a particularly interesting subject of analysis because it represents a unique federal entity.238 The EU lacks statehood (and, in particular, competence-competence) and is therefore not a federal state. The German Federal Constitutional Court described its unique structure by coining a new term, Staatenverbund (‘association of states’). At the same time, in an economic sense, the Treaty on European Union (EUT) and the Treaty on the Functioning of the European Union (TFEU) clearly form a constitution.239 This Constitution is strongly based on the concept of federal consent, which explains why the amendment procedure is extremely difficult (see Art. 48 TFEU).240 Like German federalism, European federalism is a mixed system with a high degree of institutional incongruence. In contrast to German federalism, the EU central government is relatively weak, although its powers have increased continuously over the past fifty years. The principles of conferral and subsidiarity have had a ‘restraining effect’; this approach is compelling from an economic perspective, as very different preferences lead to high decision-making costs at the central level.241 Still, the functional approach to unification (e.g. coal and steel, nuclear power, the common market principle and the monetary union) and the doctrine of ‘implied powers’ have proved to be a considerable centripetal force. From an economic perspective, the functional approach has two clear advantages (which have made the EU model a success). On the one hand, heterogeneity costs in these fields are much lower (compared to more ‘political’ fields like defence or fiscal policy). On the other hand, it was clear from the beginning that the functional approach to unification would reveal integration deficits and necessitate further (political)

237

See Hueglin and Fenna (2015), pp. 121 ff. For further detail, see Voigt (2012) and the articles in Barber et al. (2019). 239 Voigt (2012), pp. 11 ff. 240 See Voigt (2012), pp. 22 f.; Hueglin and Fenna (2015), pp. 296 ff. 241 Voigt (2012), pp. 13 ff. 238

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integration.242 This trend towards greater centralisation has been strengthened substantially by the EU-friendly jurisprudence of the European Court of Justice, which, as the court of final instance, has the ultimate jurisdiction on such matters and can protect the allocation of European competences. EU legislation requires the participation of central bodies (Commission and Parliament) and a federal body (Council). The latter plays a central role (unlike the Bundesrat in Germany, for example) and serves as a de facto barrier against further centralisation (especially, of course, where the principle of unanimity and the principle of qualified majorities are concerned). The preservation of federal consent enshrined in the European constitution is necessary to avoid excluding structural minorities from the decision-making process.243 The EU can ultimately be characterised by its vast range of ‘veto players’ that must agree to any proposed changes in the legislative status quo.244 This structure leads to an extreme separation of powers, with provisions that grant national parliaments the right to exercise veto power (Art. 12 TFEU) in accordance with the subsidiarity principle (Art. 5 TFEU). The ultimate veto right is the right to exit from the Union.245 The other side of the coin is the relative weakness of the parliament. Individual rights and the cooperation of national states serve as structural compensation for the lack of democratic participation by the citizens.246 The extremely weak role of the EU in fiscal and tax matters is striking and stands in direct contrast to the role of the federal government in Germany’s federal structure. The EU is still largely dependent on financial contributions from Member States; it has only marginal competence to levy its own taxes (with regard to its civil servants).247 The significant dependence on funding from Member States has thus served as a stronger brake on further centralisation than has the limited allocation of competences. An intriguing question is whether the EU exemplifies ‘limited-liability federalism’. In principle, the ‘no-bailout’ clause applies, and Member States are capable of insolvency; however, this policy has proved impracticable for the eurozone states. As expected, functional integration in fiscal matters and the incomplete fiscal union have considerable centralising effects (e.g. the banking union or budgetary rules).248

242

Spolaore (2015), pp. 438 ff. Voigt (2012), p. 18; for a detailed analysis, see Tschebelis (2012). 244 Tschebelis (2012). 245 Voigt (2012), p. 22. 246 Ibid., 21. 247 Blankart (2007), chap. 6. 248 Hueglin and Fenna (2015), pp. 193 ff. 243

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Open Statehood

When studying the modern state, it is impossible to avoid the realisation that ‘closed nation-states’ no longer exist—and in fact can no longer exist. In the age of globalisation, statehood necessarily means ‘open statehood’: it is based on the concept that a state is embedded in a global network of states which cooperate with one another. Economic analysis also provides a useful toolkit for analysing open statehood.249 The same basic principles apply in this context, with the special feature that independent actors and organisations are studied in conjunction with states, which mediate the interests of the individuals and companies belonging to them. State preferences that appear to reflect state or national interests are therefore no less stable than individual ones, even though changes at the state level may be motivated by different factors (e.g. a change of government or a new constitution).250 It is, of course, also important to consider the insights of the New Political Economy,251 which assert that individuals (can) pursue their own interests while acting on behalf of states. The movement towards greater and stronger international cooperation is often described as global governance.252 This concept accurately reflects the growing importance in international relations of actors other than states, such as international organisations, non-governmental organisations (NGOs), private companies and sub-state actors. Today, however, states remain the central agents, especially regarding the development of international law.

2.5.1

The Need to Open Up the State to the Outside World

An entirely autarkic state with no external contact or cooperation has long been inconceivable (and may have always been so). The validity of this observation has become even clearer in the era of globalisation, which has seen international trade flourish and innovations revolutionise communications and transport technologies.253 International cooperation has proved to be an economic necessity, especially due to the phenomenon of global public goods and the external effects of state actions. Cooperation has thus become essential in order to prevent a ‘world order failure’.254

249

For an introduction, see Richter and Furubotn (2014), IX.4; for greater depth, see Trachtman (2008) and Morgan and Yeung (2007), chap. 6. 250 Cf. Sykes (2007), pp. 762 f. 251 See Sect. 1.2.3.7 above. 252 See Breton (1996), 10.2; Dingwerth and Plattberg (2006); with a focus on climate-change governance, Hickmann (2016). 253 Cf. Van Meerhaeghe (2012), pp. 239 ff. 254 Breton (1996), pp. 264 f.

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Global environmental goods, like the ozone layer and the climate, illustrate the danger of ‘underproduction’ (in the sense of inadequate protection) that would arise if all states only acted in accordance with their ‘individual’ interests. At the same time, no state can be excluded from the advantages that result from actions taken by other states to mitigate climate change. The same principle applies in the context of global trade and international security and peacekeeping operations. State action thus has (positive or negative) external effects.255 If State B is affected by environmental pollution emitted from State A, for example, it may be cheaper for State B to convince State A to agree to environmental protection measures (with payments, if necessary) than to bear the consequences or make its own adjustments. This conclusion follows from a simple application of the Coase Theorem to the relationship between states.256 Growing competition between states and legal systems is the second driving force behind state decisions to participate in greater international cooperation.257 Competition of this kind is possible only if it is defined as ‘the striving of individuals or groups of individuals to improve their position relative to other individuals or groups through deliberate, targeted action’ (a modification of its traditional definition: ‘the striving of rivals to provide a certain service to a third party and thereby secure advantages for themselves’).258 Such competition is not only conceivable between private actors (especially companies), but also as a result of governmental measures.259 For instance, states can compete to attract mobile factors of production, mobile finance capital and business functions, as well as residents, who boost productivity and tax revenue. Although economists generally characterise such competition as positive,260 this assessment has also been criticised.261 It is clear, however, that like any other form of competition, international competition among states requires a regulatory framework in order to prevent abuse. A framework of this kind can only be achieved through international cooperation between states.

2.5.2

Principles of International Cooperation Between States

Although the concept of global governance encompasses the interactions of non-state actors, international cooperation is mainly carried out as cooperation between sovereign states.262 States have ownership of territorial jurisdictions. If

255

Posner and Sykes (2013), pp. 17 ff. For a discussion of the Coase Theorem, see Sect. 7.1.2 below. 257 Cf. Gerken (1999), pp. 1 ff. 258 Gerken (1999), pp. 5 f. 259 Ibid., 8 f. 260 Breton (1996), 10.1. 261 See, e.g., Trachtman (2000). 262 For the attributes of statehood and sovereignty, see Posner and Sykes (2013), pp. 5 ff., 15 ff., 39 ff. 256

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international cooperation is interpreted in market terms—that is, as an exchange of sovereign rights—then state interaction of this sort can be considered analogous to an exchange of property rights between private parties.263 This ‘market’ among nations has several unique characteristics, however; transaction costs, in particular, are difficult to determine. It is ultimately impossible to ignore the existence of specific state interests and preferences that may be independent of the ‘private’ interests of the citizens.264 Typically, it is in the interest of each state to generalise its own rules or legal structures to an international context because doing so provides distinct advantages, such as a decrease in its transaction costs. There are clear differences between cooperation among individuals and cooperation among states. It is particularly important to note that states cannot be equated to ordinary organisations.265 States, and their relationship to their citizens, are essentially ‘set’: they are neither voluntarily chosen nor easily changed. This has significant repercussions for state action, which can only be understood by taking into account the specific feedback mechanisms between the state and the citizens. Such mechanisms are important to consider, for example, in predicting how closely states will abide by the rules of international law.266 On the other hand, state leaders or other actors representing the state can use constraints from international cooperation or international obligations as an instrument in the debate with internal stakeholders.267 A state may initiate a de facto attempt to extend its jurisdiction. Such attempts frequently end in a hegemonic balance of power.268 The actions that follow are generally consistent with tactics like the well-known ‘tit-for-tat’ strategy.269 Both sides often perceive the result as unsatisfactory, which leads them to enter into informal agreements that include elements of reciprocity. This process is evident, for example, in competition policy, as when the European Commission objected to the merger of Boeing and McDonnell Douglas because it violated competition law.270 Like individuals, states strive for reliable forms of cooperation and thus for constitutional rules, which can eliminate uncertainty and lower transaction costs.271 These rules may develop as a result of informal cooperation or through a legal process. The legal rules for international cooperation—international law—will be considered in greater detail below.272 The provisions of international law are

263

For an economic analysis of organisations see, e.g., Trachtman (2008), pp. 19 ff. Trachtman (2008), pp. 34 ff. 265 See Sect. 3.1 below. 266 See also Trachtman (2008), pp. 19 ff. 267 Posner and Sykes (2013), p. 20. 268 See also Richter and Furubotn (2014), XI.4.(9) and (10). 269 Richter and Furubotn (2014), IX.4.(8). 270 See also Trachtman (2008), pp. 63 ff. 271 On the economic justification for international regimes, see Richter and Furubotn (2014), IX.4. 272 On the economic analysis of international law, see Sykes (2007) and Posner and Sykes (2013). 264

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rooted in implicit consent (customary international law) or explicit consent (international treaties).273

2.5.2.1 Customary International Law The development of customary international law (Art. 38(1)(b) of the Statute of the International Court of Justice) is particularly interesting from an economic perspective.274 This law emerges from the general and consistent practices that states follow out of a sense of legal obligation.275 It can be divided into two basic categories: peremptory norms (Latin: jus cogens, meaning ‘compelling law’) and rules that can be superseded by subsequent special rules.276 Only relatively general legal rules can become customary law; the establishment of specific legal rules is usually only possible on the basis of treaties. In the absence of explicit agreements, customary international law ‘runs wild’. It likely originates when individual states act first in the hope that other states will follow their lead, thereby establishing common legal convictions. By steadfastly opposing the practice, states can skirt the commitment; from an economic point of view, ‘persistent objectors’, as these states are known, are thus able to assert their individual preferences.277 The preconditions for customary international law remain the subject of considerable controversy. This applies, in particular, to the question of how broadly to define the content of state practice—a question requiring a determination of which, and how many, states must engage in a practice for it to be considered ‘general’. The answer depends on specific circumstances; actions are more likely to be recognised as components of customary international law if they are supported by states that carry greater influence in international relations, represent different groups of states in a cultural or ideological respect or are specifically affected by the rule in question.278 These legal principles also reflect economic considerations, which could provide further criteria to distinguish the legal principles of customary international law that are expected to be ‘socially optimal’ from those that are not.279

273

For an overview of the sources of international law, see Posner and Sykes (2013), pp. 8 ff. Cf. Parisi and Fon (2009), chap. 11 and 12; Trachtman (2008), chap. 3 (72 ff.); Sykes (2007), p. 763 ff.; Posner and Sykes (2013), chap. 5 (50 ff.). 275 Posner and Sykes (2013), p. 50, with reference to the definition of the Restatement of Foreign Relations Law of the United States. 276 On these categories, see Posner and Sykes (2013), pp. 57 ff.; De Wet (2012), pp. 1213 ff., on the hierarchy of norms in international law. 277 For an economic treatment and evaluation of the ‘persistent objector’ doctrine, see Parisi and Fon (2009), pp. 183 ff. 278 Draft conclusions on identification of customary international law, with commentaries 2018, adopted by the International Law Commission at its seventieth session, in 2018, and submitted to the General Assembly as a part of the Commission’s report covering the work of that session (A/73/ 10) (Yearbook of the International Law Commission, 2018, vol. II), commentaries 3 and 4 to Conclusion 8 (The practice must be general). 279 See Petersen (2011). 274

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Still, customary international law faces fundamental criticism as a legal concept. Jack A. Goldsmith and Eric A. Posner have attempted to show, on the basis of several examples, that what is considered customary international law is in fact little more than consistent regularities in self-interested behaviour; accordingly, these patterns of behaviour are ‘broken’ when it is in states’ self-interest to do so.280 In many situations, such as those concerning global public goods, the emergence of customary international law can be explained using the principles of the prisoner’s dilemma, although these situations often unfold as a series of games, which allows parties to exchange information and form agreements.281 States will only engage in these interactions if they expect to benefit from doing so, taking into account the transaction costs and the possibility of other states’ non-cooperation. There is therefore an assumption that the outcome reflects a ‘fair exchange’. Game theory can be used to explain other situations differently, such as cases of coordination in which a balance of interests simply must be found (for example, in cases involving the right to diplomatic missions or in territorial disputes related to issues like the partitioning of the continental shelf).282 Once customary international law is established, methods to ensure state compliance with its provisions become a central concern.283 The most obvious approach is for states to threaten not to adhere to the commitment in the future or to retaliate against any violation. An offending state can also suffer from damage to its reputation, which in some circumstances may prevent future (beneficial) cooperation with other states. There is generally broad support for principles of international customary law that serve as the foundation for international law. This applies first to the territoriality principle, which designates what is, in essence, a ‘first allocation’ of sovereign rights; this initial allocation becomes the basis for the subsequent ‘exchange’ of sovereign rights. Pacta sunt servanda is a fundamental principle of international treaty law and also applies to the formation of international organisations.

2.5.2.2 International Treaties International treaty law arises as a result of efforts to define more specific rules.284 The nature of cooperation as an ‘exchange’ is particularly clear in this context. A contractual obligation compels states to mutually renounce the exercise of aspects of their sovereignty; the reciprocal nature of this action indicates the existence of an exchange relationship. This is especially evident in double-taxation agreements. When transactions cross state borders, the taxpayer’s state of residence and the state in which the taxable activity is carried out both have a claim to income tax;

280

Goldsmith and Posner (1999, 2005); see also the critique in Sykes (2007), pp. 763 ff. Trachtman (2008), pp. 80 ff. 282 Cf. Petersen (2011), pp. 9 ff. 283 Cf. Trachtman (2008), pp. 98 f. 284 For an economic perspective, see Trachtman (2008), chap. 4 (119 ff.); Parisi and Fon (2009), part IV; Sykes (2007), 3.3; Posner and Sykes (2013), pp. 24 ff., 63 ff. 281

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to avoid double taxation, one of the two states in the treaty forgoes its right of taxation. Legal economics is particularly interested in the factors that motivate states to enter into agreements and thus to create international treaty law.285 According to the rational behaviour model, this decision results from the determination that entering into the agreement provides more advantages than forgoing it (the ‘payoff’); this concept is often referred to as a ‘participation constraint’.286 In abstract terms, a treaty is formed if it improves the welfare of the participating states by eliminating externalities; this can be facilitated with instruments like side payments and issue linking.287 At the same time, entering into the contract entails significant transaction costs, such as those associated with holding negotiations, establishing a regime for implementation, preparing documents and transposing provisions into domestic law.288 The benefits of this process are relatively easy to determine if the effects of the treaty impact only the contracting parties (as is the case, for example, in the doubletaxation treaties described above). It is more problematic if the treaty produces positive externalities that create or enhance public goods or benefits for third parties, an outcome that is particularly common in cases of climate change agreements; this presents a prisoner’s dilemma. The interactions between states often represent a repeated game situation (‘iterated prisoner’s dilemma’), however; this allows each state to threaten not to cooperate in the future if the opposite party ‘defects’.289 But the prisoner’s dilemma is not the only possible jumping-off point: Trachtman shows, for example, that international counter-terrorism treaties parallel the ‘stag hunt’ situation in game theory.290 The stag hunt game is derived from Rousseau’s fable about cooperation among hunters: if everyone works together, they can kill a stag. The hunters may be tempted to hunt a smaller animal (a hare) along the way, thereby deviating from the larger objective; however, the hare will provide fewer benefits than will a portion of a slain deer. When applied to counter-terrorism efforts, the ‘hare’ represents domestic counter-terrorism activities: it would be more advantageous to organise a common, effective counter-terrorism strategy. Another motivation to enter into an agreement a contract may also lie in the fact that, by doing so, there is clear, visible, and public documentation of the seriousness of the commitments, which is not present in cases of customary international law. This documentation makes it possible for any party violating the treaty to be ‘pilloried’ before an international audience.291

285

For further detail, see Trachtman (2008), pp. 130 ff.; Parisi and Fon (2009), pp. 220 ff. See, e.g., Posner and Sykes (2013), p. 21. 287 Posner and Sykes (2013), pp. 21 f.; on the concept of issue linking, see also Sect. 7.4.4.5 below (in the context of international climate law). 288 Posner and Sykes (2013), pp. 22 ff. 289 Cf. Sykes (2007), pp. 774 ff. 290 Trachtman (2008), p. 135 ff., and Sect. 1.2.3.1 above. 291 Sykes (2007), pp. 766 f.; Posner and Sykes (2013), pp. 26 ff. 286

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The second focus of legal economics in the context of international treaties is the execution and, in particular, the mechanisms to ensure that contracting parties comply with the agreement (‘enforcement’).292 The central question is whether the treaty regime supplies sufficient (positive or negative) incentives to prevent the subsequent withdrawal of contracting parties (for example, through termination of the treaty) or breach of contract.293 There may be situations in which the advantages of a breach of contract exceed the disadvantages (a ‘rational’ or ‘efficient’ breach).294 Of course, in weighing these alternatives, states must take into account the loss of prestige associated with a breach.295 The design of measures to sanction states for noncompliance is especially important; in particular, states must determine whether the sanctions are severe and whether there is a credible threat that they will be imposed.296 In this respect, it is important to realise that establishing and using enforcement mechanisms (‘punishing’) is itself associated with considerable transaction costs.297 Finally, the relationship between international and national law—and thus the implementation of international treaties within national legal systems—is a crucial consideration in international treaties.298 National systems of separation of powers frequently cause treaty ratifications to fail. This has occurred in the US (for example, US ratification of the Kyoto Protocol failed because of the country’s systems of checks and balances, even though the Protocol itself had been shaped significantly by US negotiators).299 Contracting states have initial influence over the domestic effects of treaties: they can design a treaty to be ‘self-executing’, in which case the rights and obligations laid out in the treaty’s provisions are directly applicable. National law is significant because it specifies whether the provisions of international agreements become ‘automatically’ effective in the national legal system (‘monist’ systems) or require implementation by national bodies (‘dualist’ systems). The existence of these two categories raises a related question: why do ‘monist states’ relinquish sovereign rights so extensively? The most obvious answer is that, by doing so, they spare the transaction costs associated with transposition. A more important motivation may be the desire to establish a record of openness to international treaties and thus gain credibility in negotiations. A problem with ‘dualist systems’ is that, after international treaty has been incorporated into national

292

Cf. Sykes (2007), pp. 773 ff. On the sanctions regime under the Kyoto Protocol, see Sect. 7.4.4.3 below. 294 Trachtman (2008), pp. 142 ff.; Posner and Sykes (2013), pp. 25 f. 295 Trachtman (2008), pp. 140 ff.; Sykes (2007), p. 777. 296 For an overview of the extensive arsenal of possible contractual sanctions, see Sykes (2007), pp. 773 ff. 297 Sykes (2007), p. 770; Posner and Sykes (2013), p. 23. 298 Cf. Posner and Sykes (2013), chap. 10 (139 ff.). 299 Cf. Sykes (2007), pp. 778 f. 293

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legislation, the state legislature can simply modify the domestic law retroactively (‘treaty override’).300

2.5.2.3 International Institutions and Organisations The economic analysis of business organisations can be applied in many ways to explain the formation of international organisations. States, too, can seek to gain certain advantages through institutionalised cooperation.301 The controversy over whether states can have their own interests or should only be regarded as representatives of their citizens’ interests is irrelevant in this context.302 The enormous boom in the creation of international organisations since the Second World War303 is largely due to the advantages of mutual support in acquiring and processing relevant information.304 This development represents a partial constitutionalisation of the international legal order through international organisations.305 On the other hand, considerable transaction costs are associated with these activities.306 In deciding whether to join an international organisation, a state must also consider the alternatives (such as international agreements) as opportunity costs. Needless to say, these advantages and ‘costs’ are highly variable and therefore difficult to assess.307 As in the analysis of organisations,308 modern economics does not regard international organisations as a ‘black box’ but uses their internal structures as the basis for evaluation. It may well be that, at its core, an organisation reveals little more than ‘intergovernmentalism’ obscured by rules of consensus or unanimity.309 Departure from the principle of consensus in the dispute-settlement procedure of the World Trade Organization (WTO) has been an important turning point in this regard.310 Even more dramatic in this respect were conflicts during the European integration process and the bitter disputes over the ‘Luxembourg Compromise’.311 French President Charles de Gaulle had difficulty accepting majority voting on specific Commission proposals and boycotted European institutions (the ‘empty chair crisis’). In the end, a compromise was reached, giving Member States a de facto veto

300

Cf. Sykes (2007), p. 780. For an economic analysis of international organisations, see Posner and Sykes (2013), chap. 7 (79 ff.); Trachtman (2008), chap. 5 (150 ff.). 302 Trachtman (2008), pp. 150 ff.; see also Sect. 2.5.2 above. 303 Homann and Suchanek (2005), 5.4.3. 304 Ibid. 305 De Wet (2012), pp. 1219 ff. 306 Trachtman (2008), pp. 157 ff. 307 Ibid., 164. 308 See Chap. 3 below. 309 On this principle, see Trachtman (2008), pp. 176 ff. 310 Trachtman (2008), pp. 190 ff. 311 Trachtman (2008), pp. 189 ff.; Teasdale (1993). 301

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right on topics deemed to be ‘very important to national interests’. With this qualification, majority voting was finally accepted.

2.5.3

Questions on the Content of International Law

Economics also considers individual issues associated with the structure of international treaty law in order to identify effective and efficient rules.

2.5.3.1 Formal Aspects The most critical formal question is how competences are allocated between international legal regimes and the national sphere.312 The choice of types of rules is an essential preliminary decision. In national legal discourse, it is common knowledge that the choice of standards for discretionary powers delegates decision-making authority to the administration, while the choice of more indeterminate legal terms delegates this authority to the judiciary.313 In international law, this transfer of decision-making authority results from the choice of specific rules (as in the ‘most-favoured-nation’ clause) or of principles or general objectives (such as the climate change target in Article 2 of the Convention on Climate Change). Provisions of international law tend to be vaguer and more abstract than those of national law. This may be because no broader consensus could be reached in individual cases. At times, vague formulations may conceal political dissent.314 The establishment of general rules often serves to maintain broad initial consensus at a relatively abstract level. Efforts to define more concrete terms for the consensus often require subsequent agreements (generally known as ‘protocols’). One such agreement is the Kyoto Protocol, which is based on the Framework Convention on Climate Change.315 The effectiveness of international law is limited by weaknesses in its implementation and enforcement.316 In contrast to national law, international law seldom establishes decision-making bodies or mechanisms authorised to make legally binding resolutions. National entities generally do not fulfil this function because, as a rule, provisions are not directly applicable at a domestic level.317 In addition, the transposition of international law into national legislation often faces barriers. If treaties are only granted the status of statutory law, as in Germany (Article 59(2) GG), then there is a greater likelihood that subsequent legislation will deviate from it

312

On the formal aspects of international treaty law, see Trachtman (2008), chap. 7 (208 ff). See Sect. 4.1.2.3 below. 314 Morgan and Yeung (2007), 6.4.1. 315 See Sect. 7.4.4.3 below. 316 Cf. Morgan and Yeung (2007), 6.4.2. 317 On the controversies over the violation European banana market’s violation of world trade policy, see, e.g., Breuss et al. (2003). 313

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(treaty override).318 At the international level, decision-making bodies are rarely established or authorised; this helps explain the weaknesses of the global regime to mitigate climate change, among others. The creation of a mechanism to settle disputes in international trade law was thus considered a significant step towards a greater juridification of international law.319 Largely for this reason, informal instruments, or ‘soft law’, continue to play a major role in international cooperation.320 The compelling power of uniform international standards has a positive effect, for example, and may also motivate private actors to take part in the domestic implementation of international law.321 On the other hand, the ‘pillory effect’ that follows from violations of international law has a negative impact on the affected states.

2.5.3.2 Material Aspects Material questions concerning the design of international law regimes are also important topics within economics.322 Perhaps the greatest difference between the international and national legal systems is the fact that the former has a very weak ‘central power’, the United Nations (UN). Material international law generally develops from specific legal regimes based on international law. These regimes are established through the cooperation of specialised governmental and administrative representatives. As a result, specific areas of public international law are isolated from one another, and international law is ‘fragmented’ accordingly.323 This does not mean, however, that specific fields of law are not politically interrelated. States make extensive use of the ability to couple concessions in one area with demands in other areas (‘linking of issues’). For example, industrialised countries, above all the US, have made concessions in trade liberalisation dependent on concessions in intellectual property protection. This is reflected in law: international trade law was amended to include intellectual property provisions, a topic that, on its own, is irrelevant to global trade (Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS)).324 Linking issues improves the probability of achieving ‘win-win situations’ but can also lead to significantly higher transaction costs.325 Today, the juridification of linkages between material areas of international law is likely the greatest challenge for the science and practice of international law. The

318

Regarding double taxation, see, e.g., Gosch (2008). Cf. Morgan and Yeung (2007), 6.4.1. 320 See also Morgan and Yeung (2007), 6.4.2.; on the meaning of ‘soft law’, Sykes (2007), pp. 765 f. 321 Cf. Morgan and Yeung (2007), 6.4.3. 322 For an overview, see Trachtman (2008), chap. 6, 196 ff. 323 See, e.g., Van Asselt et al. (2008). 324 See also Trachtman (2008), pp. 198 ff. 325 For an economic assessment of ‘issue linking’, see Sykes (2007), pp. 768 ff. See also Sect. 2.5.2.2 above and Sect. 7.4.4.5 below (on ‘issue linking’ in the context of international climate law). 319

2.6 Summary

111

relationship between international trade law and climate change legislation,326 for instance, can be studied as one example of the many areas of law that are often in conflict with one another. Overarching balancing mechanisms are generally absent. In this example, the decision falls—largely by chance—to one of the two legal regimes due to its familiarity with decision-making bodies and processes (i.e. the dispute-settlement procedure established under international trade law). In theory, balancing is based on a comprehensive cost-benefit analysis. Even if we assume that it is possible to monetise individual costs and benefits, however, the obstacles to balancing are virtually insurmountable.327 Under the exceptions clause in Article XX GATT, a proportionality test is necessary in order to consider international trade law in relation to other public interests. From an economic perspective, of course, it would be preferable to regulate the issue of balancing between the objectives of different legal regimes; in practice, however, this proves very difficult.

2.6

Summary

This chapter analyses the state and its constitution from the perspective of institutional economics. The constitution is reconceptualised in terms of a hypothetical consensus and informed by the principles of methodological individualism; this creates overlap with contract theories originating in political philosophy, such as those of John Rawls. From these concepts, we can abstract the rational basis and limits of majority decisions and of basic rights as ‘individual veto rights’. With regard to the democratic process, this chapter interprets voters, politicians and parties as fundamentally rational and utility-maximising actors and considers the particular role of information and money (‘party finance’) in this context. The Arrow Paradox illustrates that majority decisions cannot be determined logically but will always depend on the design of voting procedures. The theory of low-cost situations can be applied to explain why voters participate in elections even though individual votes almost never influence the outcome in practice. In addition to the justification for the state as a whole, the justification for—and criticism of—state functions are considered here from an economic perspective. Theories of market failure can be used to identify areas in which the state has comparative advantages. The state has major advantages in terms of the provision of pure public goods, such as the legal system, internal and external security, and the safeguarding of competition. Structural elements include the creation of property rights, the alleviation of information asymmetries and the elimination of externalities. It is clear that a list of state functions can never be conclusive or definite, since additional approaches to legitimise them—e.g. the theories of merit,

326 327

See Sect. 7.4.4.5 below. See Trachtman (2008), pp. 226 ff.

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optional or distributive goods or the theory of natural monopoly—have only limited explanatory power. Two topics related to state structure are of particular interest in economics: the (horizontal) separation of powers and federalism. Advantages of the separation of powers (e.g. control over the exercise of power or protection of minorities) must be weighed against the transaction costs associated with it. An evaluation of the vertical separation of powers is more difficult. Positive aspects of federalism include federal competition (the theory of ‘exit’ and ‘voice’) and, in particular, the ability to offer more specific bundles of public goods at specific tax prices. On the other hand, federalisation may prevent economies of scale and cause undesirable externalities across the borders of individual federal states; the competition can also have negative consequences (‘race to the bottom’). Finally, the modern state cannot be viewed independently of its involvement in a network of international relationships (‘open statehood’). These interactions are also subject to an economic analysis that perceives states as additional rational and utility-maximising actors. The emergence of customary international law and international treaty law, as well as the formation of international organisations, can be explained and evaluated in this context. The material aspects of international law explain the fragmentation of the contemporary international legal structure and the opportunities associated with combining interests (‘linking of issues’).

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Morgan B, Yeung K (2007) An introduction to law and regulation. Text and materials. Cambridge University Press, Cambridge Motta M (2004) Competition policy. Theory and practice. Cambridge University Press, Cambridge Musgrave RA (1957) A multiple theory of budget determination. Finanzarchiv 17:333–343 Neves PM (2015) Consensus. In: Encyclopedia of global bioethics. Science+Business Springer, Dordrecht North DC (1990) Institutions, institutional change and economic performance. Cambridge University Press, Cambridge Oates WE (1972) Fiscal federalism. Harcourt, New York Oates WE (2002) Fiscal and regulatory competition: theory and evidence. Perspektiven der Wirtschaftspolitik 3:377–390 Olson M (1969) Strategic theory and its applications. Am Econ Rev 59:479–503 Ortiz DR (1999) From rights to arrangements. Loyola Los Angeles Law Rev 32:1217–1226 Parisi F, Fon V (2009) The economics of lawmaking. Oxford University Press, Oxford Peters A (2010) Wettbewerb von Rechtsordnungen. VVDStRL 69:7–53 Petersen N (2011) The role of consent and uncertainty in the formation of customary international law, Bonn (Reprints of the Max Planck Institute for Research on Collective Goods 2011/4) Petersen N, Towfigh EV (2015) Economic methods and legal reasoning. In: Towfigh EV, Petersen N (eds) Economic methods for lawyers. Edward Elgar Publishing, Cheltenham, pp 1–17 Pildes RA (2011) Political parties and constitutionalism. In: Ginsburg T, Dixon R (eds) Comparative constitutional law. Edward Elgar Publishing, Cheltenham, pp 254–264 Posner AR (2014) Economic analysis of law. Wolters Kluwer, Alphen aan den Rijn Posner EA, Sykes AO (2013) Economic foundations of international law. The Belknap Press of Harvard University Press, Cambridge Potoski M (2001) Clean air federalism: do states race to the bottom? Public Adm Rev 61:335–342 Potter JD, Tavits M (2013) The impact of campaign finance laws on party competition. Br J Polit Sci 45:73–95 Rae D, Daudt H (1976) The Ostrogorski Paradox: a peculiarity of compound majority decision. Eur J Polit Res 4:391–398 Rawls J (1972) A theory of justice. Oxford University Press, Oxford (German: Eine Theorie der Gerechtigkeit, Frankfurt a.M. (Suhrkamp) 1975) Richter R, Furubotn EG (2014) Institutions & economic theory. The contribution of the new institutional economics, 2nd edn. The University of Michigan Press, Ann Arbor Riker WH (1964) Federalism: origin, operation, significance. Little Brown, Boston et al Rowley CK (2005) An intellectual history of law and economics: 1739–2003. In: Parisi F, Rowley CK (eds) The origins of law and economics. Essays by the founding Fathers. Edward Elgar Publishing, Cheltenham etc, pp 3–32 Salzberger EB, Elkin-Koren N (2005) The effects of cyberspace on the economic theory of the state. In: Marciano A, Josselin JM (eds) Law and the state. A political economy approach. Edward Elgar Publishing, Cheltenham, pp 58–99 Scharpf FW (1988) Th joint-decision trap: lessons from German federalism and European integration. Public Adm Int Quart 66:239–278 Schumpeter JA (1946) Kapitalismus, Sozialismus und Demokratie. Francke, Bern Schutze R (2009) From dual to cooperative federalism: the changing structure of European law. Oxford University Press, Oxford Sen AK (1977) Rawls versus Bentham: Eine axiomatische Untersuchung des reinen Verteilungsproblems. In: Höffe O (ed) Über John Rawlś Theorie der Gerechtigkeit. Suhrkamp, Frankfurt a.M., pp 283–295 Spahn PB (2006) Contract federalism. In: Ahmad E, Brosio G (eds) Handbook of fiscal federalism. Edward Elgar, pp 182–197 Spolaore E (2015) The political economy of European integration. In: Badinger H, Nitsch V (2015) Routledge handbook of the economics of the European integration, Chapter 26. Routledge, London

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Stearns ML (2010) An introduction to social choice. In: Farber DA, Joseph O’Connel A (eds) Research handbook on public choice and public law. Edward Elgar Publishing, Cheltenham, pp 88–136 Stiglitz JE, Rosengard JK (2015) Economics of the public sector, 4th edn. W.W. Norton, New York Stokes SC (1999) Political parties and democracy. Ann Rev Polit Sci 2:243–267 Sykes AO (2007) International law. In: Polinsky AM, Shavell S (eds) Handbook of law and economics, vol 1. North Holland, Amsterdam et al., pp 757–826 Teasdale A (1993) The life and death of the Luxembourg compromise. J Common Mark Stud 31: 567–579 Thaler RH Sunstein CR (2008) Nudge: improving decisions about health, wealth and happiness. Yale University Press, New Haven, p 293 Tiebout CM (1956) A pure theory of local expenditures. J Polit Econ 64:416–424. University of Chicago Press, Chicago, Ill Towfigh EV (2012) Old Weimar meets new political economy: democratic representation in the party state. German Law J 13:238–258 Trachtman JP (2000) Regulatory competition and regulatory jurisdiction. J Int Econ Law 3:331– 348 Trachtman JP (2008) The economic structure of international law. Harvard University Press, Cambridge Tschebelis G (2012) The rules of decisionmaking in EU institutions. In: Research handbook on the economics of European Union law, Chapter 2. Edward Elgar Publishing, Northhampton, pp 29–51 Tushnet M (2014) Advanced introduction to comparative constitutional law. Edward Elgar Publishing Cheltenham Ulen TS (2014) The importance of behavioral law. In: Zamir E, Teichman D (eds) The Oxford handbook of behavioral economics and the law. Oxford University Press, Oxford, pp 93–124 Van Asselt H, Sindico F, Mehling MA (2008) Global climate change and the fragmentation of international law. Law Policy 30:423–449 Van den Hauwe L (2005) Constitutional economics II. In: Backhaus JG (ed) The Elgar companion to law and economics. Edward Elgar Publishing, Cheltenham, pp 223–238 Van Meerhaeghe MAG (2012) Globalization: concept, outcome, future - a continental view. Eur J Law Econ 33:239–306 Vanberg VJ (2020) J.M. Buchanan’s contractarian constitutionalism: political economy for democratic society. Public Choice, pp 339–370 Voigt S (2009) Institutionenökonomik, 2nd edn. Fink, Paderborn Voigt S (2012) A constitution like any other? Comparing the European constitution with nation state constitutions. In: Eger T, Schäfer HB (eds) Research Handbook on the economics of European Union law. Edward Elgar Publishing, Cheltenham, pp 11–28 Voigt S (2017) Constitutional economics and the law. In: Parisi F (ed) Methodology and concepts. The Oxford handbook of law and economics, vol 1. Oxford University Press, Oxford, pp 202–221 Voigt S (2019) Institutional economics. An introduction, Cambridge University Press, Cambridge Voigt S (2020) Constitutional economics: a primer. Cambridge University Press, Cambridge Voigt S, Blume L (2012) The economic effects of federalism and decentralization – a cross-country assessment. Public Choice 151:229–254 Wicksell K (1986) Finanztheoretische Untersuchungen. Jena, Gustav Fischer Wohlgemuth M (2005) Schumpeterian political economy and Downsian public choice: alternative economic theories of democracy. In: Marciano A, Josselin JM (eds) Law and the state. A political economy approach. Edward Elgar Publishing, Cheltenham, pp 21–57

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Economic Theory of Institutions and Organisations

3.1

Basic Principles

The study of companies and other organisations is a classic component of economics. Today, it is an important focus area in the field of institutional economics as well.1

3.1.1

The Importance of Organisations

Thus far, we have assumed that individuals act and interact in markets to achieve gains from cooperation. Modern society, however, is fundamentally shaped by the action of organisations as ‘corporate actors’. It is therefore often aptly referred to as an ‘organisational society’.2 Institutional economics takes this significance into account and recognises the unique features of organisations, which ‘act’ as entities capable of decisionmaking—that is, as ‘corporate actors’—in markets or in politics. Despite their many manifestations (e.g. as businesses, interest groups, media companies and international organisations), all organisations have at least one characteristic in common: they operate as ‘networks of contracts’ with an institutional structure that grants them agency in their relations with the outside world and enables them to pursue their own interests. Organisations serve to obtain additional gains from cooperation that would otherwise be acquired less readily or not at all. As Herbert Simon pointed out as early as 1945,3 the problems associated with ‘bounded rationality’ are particularly clear in the context of organisations and their members.4

1

For an introduction, see Barney and Hesterly (2006); Crespo (2017), chap. 7; Voigt (2019). Coleman (1992). Original title: Foundations of Social Theory, 1990. 3 Simon (1945/1981), chap. V, 115 ff. 4 See, e.g., Ørsted Nielsen (2012), pp. 446 f. 2

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Approaches in Organisational Theory

The field of organisational economics has developed a variety of explanatory approaches. These generally consist less of independent theories than of lines of reasoning that are elaborated as part of more complex theories. The purpose of the following discussion is to distinguish between classical concepts, action concepts based on the New Institutional Economics and system-oriented network approaches.

3.1.2.1 Classical Organisational Economics Classical organisational economists (e.g. Hayek) interpret the organisation as a social entity that pursues a single uniform goal and purpose. The standard model of the organisation is the firm,5 which, with its orientation towards production and the related goal of maximising profit, is the theoretical reference point and the starting point for analysis.6 This perspective is still relevant today and represents a basic assumption of organisational economics. Attempts to establish the existence of an independent actor focus heavily, of course, on interactions between organisations and external parties. In their analysis of internal relationships, classical approaches still largely ignore the interests and motivations of different groups of members within the organisation. These approaches are still based primarily on the principles of a hierarchical legal entity: the employment contract, as a form of governance, establishes the archetypal organisation as a structure for hierarchical interaction regulated by a set of rules. 3.1.2.2 Action Concepts Based on the New Institutional Economics A good starting point for analysis is the contractual theory of organisations.7 This is most compatible with the perspective presented here, which is based on the principles of interaction economics. According to this interpretation, an organisation is an institutional arrangement of individual actors (i.e. a network of contracts); this assemblage of individuals takes the form of a discrete ‘corporate actor’, which itself functions as an interaction partner. The approach thus considers the mutually advantageous cooperation that arises in both internal and external relationships. This interpretation provides the foundation for the organisational equilibrium theory, which examines the role of the members of the organisation.8 Specifically, the theory attempts to explain why individuals become members of organisations (incentives) and how they behave as members (in the pursuit of individual advantages). It suggests that the expectation of reaping personal advantages incentivises individuals to become members; in return, they are willing to contribute by fulfilling the entry requirements or performing duties on an ongoing basis. This consideration only captures one aspect of an organisation, however, because it does

5

This insight was introduced by Coase (1937), pp. 386 ff. See, e.g., Richter and Furubotn (2014), chap. 8 (361 ff.). 7 See, e.g., Richter and Furubotn (2014), chap. 5 (199 ff.). 8 See the fundamental insight formulated in, e.g., Simon (1945/1981), pp. 145 ff. 6

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not account for the unity of the organisation or for other relevant actors, such as the customers or suppliers of a company or the donors of an interest group. The constitution of the organisation is thus an issue of central importance in organisational economics.9 Such constitutions are not only relevant to studies of the organisational capacity to act, but also establish a system of highly coordinated and jointly exercised property rights and thus have a value in their own right. In addition, organisational constitutions shape the development of an organisational culture10 and the attitude of internal and external actors towards the organisation.11 Organisational culture, in turn, serves as the foundation for a ‘corporate identity’, which is closely linked to organisational reputation and accountability.

3.1.2.3 Network Approaches from a Systems Perspective These concepts eliminate the strict distinction between internal and external relationships; the organisation is intepreted as a system. As analytical tools, systems-oriented network approaches can focus attention on the functional relationships of organisations and thus bring systems theory (as a grand theory of society) into a productive symbiosis with economics (based on methodological individualism). This connection is logical because organisations were the initial basis for the development of systems theory.12 In this context, Luhmann rejects the application of the ‘purpose-oriented hierarchical model’,13 arguing that the primary consideration should be the distinction between the system and its environment.14 This view is consistent with more recent currents in the economic theory of organisations that emphasise the importance of interdependent internal and external relations in organisational analyses. In accordance with these approaches, organisations are significant not only in their functions for members, but also— from a societal perspective—as fixed points of attribution for the consequences of interaction. With greater differentiation in the social division of labour, accountability for corresponding interactions can be specified more precisely. Because of their capacity to facilitate self-binding, organisations can establish a basis for trust (both internally and externally).15 As a result, it may be difficult for multinational companies to evade responsibility that is attributed to them. This is interesting in light of the increasing complexity of organisational structures and the crucial role of external perception: the controversy over the sinking of the Brent Spar oil platform

9

Cf. Mills and Ungson (2003). Kreps (1999), pp. 90 ff. 11 See, e.g., Richter and Furubotn (2014), 4.4.3 (‘relational contract theory’). 12 Luhmann (1999). For an overview of recent literature on this topic, see Weber and Waeger (2017). 13 Luhmann (2011), p. 426. On purpose orientation and the hierarchical paradigm of organisational theory, see Luhmann (1999), chap. 2. 14 On Luhmann’s theory of organisations, see Seidl and Mormann (2014). 15 On this perspective, see, e.g., Dirks and Ferrin (2001). 10

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focused on Shell, for instance, even though Esso was a 50% shareholder in the company. (Shell operated the platform.)16 In such situations, a ‘concealment of structures’ may backfire, forcing organisations to invest in their ‘reputation capital’.

3.2

Key Topics in Organisational Economics

Organisational economics has offered many useful insights, only a few of which can be covered in the following pages. The perspectives discussed here are also relevant in the context of public law.17

3.2.1

Freedom and Restrictions in the Formation of Organisations

Modern society would be unthinkable without a differentiated system of organisations. Organisations reduce uncertainty in the interactions of individuals, compensate for the loss of traditional authorities, function as integrating elements in society and serve as reference points for the exercise of trust. Thus, from an economic perspective, any differentiated interaction or cooperation of individuals would be impossible without organisations. Legislation plays a crucial role in determining the possibilities for forming and structuring organisations. In this process, the legislature is guided by the freedom of association incorporated into modern constitutions, which marks the twentiethcentury shift from the liberal ‘society of individuals’ to the ‘society of organisations’.18 This constitutional right not only prevents the state from intervening, but also imposes a constitutional mandate on the government, which is responsible for designing effective laws related to companies and associations as well as to collective bargaining. The ‘invention’ of the entity of the legal person in jurisprudence was highly significant in this context.19 This concept allowed a group of individuals to achieve the legal status of a single, autonomous actor for the first time. The German Basic Law incorporates this legal concept by entitling legal persons to basic rights, to the extent that such rights are applicable to that entity (Article 19(3) GG).

16

On the Brent Spar controversy, see Jordan (2001). For an overview, see Homann and Suchanek (2005), 5.2.2. 18 For a comparative law perspective, see Preuß (2012), pp. 953 ff. 19 See also Beaud (2012), pp. 278 ff., on slight distinctions between Continental European and Anglo-American perceptions. For a historical perspective on the emergence of the corporate form of organisation, see Dari-Mattiacci et al. (2017), pp. 193 ff. 17

3.2 Key Topics in Organisational Economics

3.2.2

123

Decision-Making, Distribution and Control Problems in Organisations

The concept of legal personality enables organisations to act as a unit in their external relationships and to make legally relevant decisions. This does not mean, however, that in its internal interactions an organisation can be considered a single entity that aims to maximise benefits on the basis of a common preference structure. Instead, the (varied) interests of the individual members assert themselves, resulting in problems for decision-making, distribution and control. As a basic principle, organisations must reach collective decisions—that is, they must create a unified ‘organisational will’ from the heterogeneous will of the members. This will-formation process is primarily relevant to decisions regarding external relationships and thus to the question of maximising gains from cooperation. The use of member-contributed resources and the distribution of revenue are matters for internal decisions. Bodies within the organisation (e.g. acting executive bodies like the executive board or decision-making bodies like general meetings) fulfil this function, as prescribed by the legal system and in the articles of association. As a result, principal-agent relationships20 and related control problems play a particular role in organisations. Members often have limited opportunities to control or influence leadership decisions. The theory of ‘exit and voice’21 was developed in this context. Especially in large companies, there is little chance of exerting influence (‘voice’) due to the mediating role of decision-making structures. Leaving the organisation (‘exit’) is therefore often the only possible response.22

3.2.3

External Relationships

In their external relationships, organisations can act in a legally binding way as corporate actors. As a result, they, too, function as persons seeking advantages through cooperation. In principle, the general assumptions of the rational-behaviour model also apply to these actions; however, the differences between individuals and organisations should not be overlooked. For example, relative to individuals, corporate actors tend to be much more focused on the performance of specific tasks; their success greatly depends on the reputation they develop in these areas. Depending on the magnitude of their personal and financial resources, organisations can be extremely powerful, with the ability to influence politics through lobbying activities or damage third parties.

20

See Sect. 1.2.3.5 above on market failure resulting from incomplete information. See Sect. 2.4.2.2.1 above in connection with federalism. 22 Cf. Dehling and Schubert (2011), p. 7.2. 21

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Regulatory Challenges Related to Internal and External Relationships

In order to limit such negative effects, there must be regulations on the amount of leeway provided for organisations to operate. It is a challenge for the legislature to decide on the breadth and depth of regulation; in doing so, legislators must weigh the positive effects of organisations on society against the negative external effects of organisational practices. There are three main facets to this regulatory challenge. First, the legislator must decide on the tax treatment of organisations and above all must determine the preferential tax treatment that organisations will receive for acting in the public interest. The second legal policy question refers to whether the internal (democratic) structure of organisations should be regulated. In Germany, organisations have considerable leeway to determine their internal structure, depending on the organisational form they choose. Because of ‘deficits in democracy’, demands for laws governing associations became more strident in the 1970s;23 however, the German legislature has taken no such action. It is interesting to note the wide variation in the regulation of NGOs, even among OECD countries.24 The third important challenge for legislators refers to the question of whether organisations can be held liable under criminal law. There is a clear trend towards greater criminal liability in countries around the world, although expanding the concept of criminal liability from individuals to organisations leads to dogmatic problems (and, accordingly, to different models to address them).25 For this reason, some countries, such as Italy and Germany, have maintained traditional sanctions for organisations, such as administrative fines. The majority of countries, however, have recognised the need to apply basic functions of criminal law at the corporate level, including deterrence, stigma and rehabilitation, and public demands for vengeance.26 Corporate criminal liability is currently the topic of vigorous legal policy debate, including in Germany.27

23

See, e.g., Behrends (2001), pp. 234 ff.; Bolleyer (2018), p. 21 and further reference. See, e.g., Bloodgood et al. (2013), pp. 1 ff., for a contrast between more pluralistic countries with looser regulations (main example: US) and more corporatist countries that tend towards stricter regulation (main example: Japan). 25 For a thorough overview, see De Maglie (2005). 26 De Maglie (2005), pp. 563 ff. 27 On this debate, see, e.g., Laue (2010), pp. 339 ff. 24

3.3 Types of Organisations

3.3

Types of Organisations

3.3.1

The Firm

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3.3.1.1 Basic Principles The study of institutional economics has always focused on the role of firms as corporate actors.28 The concept of a ‘legal entity’ recognises the company or firm as a (legal) person with its own preferences and the capacity to act (strategically).29 Profit maximisation remains one of the firm’s primary objectives; firms that do not generate profits over a long period of time will disappear from the market. Today, profit maximisation is understood in more nuanced terms than in neoclassical theory:30 alongside current profits, company value plays an important role. The importance of company reputation (which is based on elements like company culture, ethics and social responsibility) is related to, but still distinct from, this value. Reputation is the foundation for the company’s internal integration and external approval. Both aspects can enhance company value.31 The theory of the firm has advanced the study of organisations by opening up the ‘black box’ of company operations, allowing for a closer examination of internal processes and interactions. Applying the principal-agent theory to relationships in the firm offers new insight. The shareholder primacy model, introduced in the 1930s,32 compares shareholders to traditional owners of a firm who strive to control the managers. Control problems that arise between the owners and managers are those of a typical principal-agent relationship.33 Today, however, it is clear that the internal structure of a firm is much more complex. In the nineteenth century, the influential German law historian Otto von Gierke theorised that corporations can be seen as a ‘living organism’.34 From a modern economic perspective, this reveals the firm’s internal structure to be a network of interests and contracts. A firm is thus interpreted as both a bundle of contractual arrangements and a collection of human and non-human assets.35 This is the basis for a ‘pluralistic stakeholder approach’: anyone whose interests are affected by the firm is a ‘stakeholder’, and the factors of production—‘capital’ and ‘work’—are central to these interests. Shareholders are particularly concerned with ‘shareholder value’, while employees are most interested in (secure) income opportunities. Customers, suppliers, competitors, state entities and other associations also have a variety of interests.

28 For an introduction, see Richter and Furubotn (2014), chap. VIII; on the economic nature of the corporation, Stout (2017). 29 Magnier (2015), pp. 22 ff. 30 Magnier (2015), pp. 29 f., refers to this as the ‘enlightened shareholder value’. 31 Richter and Furubotn (2014), VIII.2. 32 Magnier (2015), pp. 18 ff. 33 See, e.g., Richter and Furubotn (2014), VIII.4. 34 See, e.g., Magnier (2015), pp. 24 f. 35 Chassagnon (2011), pp. 27 ff.

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Three central problems emerge in the relationships between the most important internal ‘stakeholders’ (capital/owner, leadership/management and employees). The question of co-determination36 arises in the relationship between employees and management; this issue ‘dilutes’ the owner/management relationship (rights of disposal). Finally, there is an important control relationship—and thus a principalagent relationship—between leadership and employees. Today, this is no longer seen merely as a problem of effective monitoring, but also as a problem of motivation.37 Today’s perspective on the external relationships of the firm is more nuanced as well. In particular, relationships with individual stakeholders such as customers, suppliers, government agencies and non-governmental organisations are considered in greater detail. The size and limits of the firm are also important issues in this context38 because these factors have consequences for the organisation of the firm, as well as its network of contracts and relationships. These two factors are significant, for example, with regard to mergers, horizontal and vertical integrations and the much-discussed phenomenon of ‘outsourcing’.

3.3.1.2 Company Law and Business Organisation If firms are considered networks of contracts, they could theoretically be founded on freedom of contract and general contract law. For good reason, however, the law took a different course, and company law was developed as a specific form of commercial law. Company law imposes significant limitations on businesses with regard to their organisation (e.g. compulsory legal forms and co-determination), but also grants important privileges (e.g. limited liability).39 Although these issues fall within the scope of civil law, the following discussion briefly outlines some of these regulatory areas, as they serve specific public interests. 3.3.1.2.1 Limitation of Liability From an economic point of view, limitation of liability is one of the most interesting and significant privileges granted to companies that are organised as legal persons.40 If the business fails, only the capital contributions of the owners can be seized to repay creditors or satisfy obligations; partners and shareholders are not personally liable. As a result, the consequences of poor business decisions are largely externalised to third parties that have varying degrees of involvement. There is no question that limited liability of this kind has been a cornerstone of Western economic development since the Industrial Revolution. It would have been impossible, for example, to acquire the capital needed for large companies (such as

36

See Sect. 3.3.1.2.2 below. Richter and Furubotn (2014), VIII.1. 38 Ibid., VIII.3. 39 For an overview of the economic analysis of corporate law, see Gindis and Petrin (2019). 40 See, e.g., Halpern et al. (1980). 37

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railroads) in the capital market.41 Information costs would simply be too high for potential investors under such conditions (with unlimited joint and several liability): investors would have to perform a detailed evaluation of the company’s financial soundness and the creditworthiness of other shareholders. In addition, the interest rates on loans would be prohibitively high. Finally, the free transferability of shares, which is required for a functioning capital market, would be unimaginable without limited liability: only with such provisions in place can the value of shares be determined with any reliability, because this value is not determined by the personal assets of the shareholders. The legislature can control the extent of external effects attributable to limited liability without having to call the entire principle into question. As the financial crisis of the past decades has shown, lawmakers can raise capital requirements. They can also prevent externalised costs on a selective basis, primarily by mandating liability insurance coverage. Such measures are especially relevant in the case of ‘involuntary creditors’, since contract creditors can protect themselves (e.g. through real securities). This applies to consumers, for example, with regard to their warranty claims for defective products (e.g. under the EU Product Liability Directive). There is ongoing debate about whether employees should be protected as involuntary creditors with respect to outstanding wage payments.42 3.3.1.2.2 Co-determination Co-determination is a form of corporate governance that grants workers a right of control and co-decision in a company. There are different models to implement this concept: voluntary or obligatory co-determination, parity or partial participation, employee shareholding, or representation on a supervisory board (‘board of directors’).43 Economic assessments of this practice vary considerably44 due to significant differences between the models of co-determination selected for analysis.45 General company co-determination is different from sector co-determination and primarily refers to issues of personnel management by work councils. There is also a distinction between voluntary and legally mandated co-determination. Finally, equitable co-determination (‘parity co-determination’) can be distinguished from forms with lower levels of participation. The German system is a model of extensive obligatory worker representation on Under the German Co-determination Act supervisory boards.46 (Mitbestimmungsgesetz) of 1976, companies with more than 2000 employees must form a board of directors (if not otherwise required) filled with an equal number of employee representatives and shareholders. In the event of a split vote, the

41

See, e.g., Halpern et al. (1980), pp. 117 ff., for a comprehensive discussion of this issue. Cf. Adams (2004), pp. 255 f. 43 For a country overview, see Addison (2009), pp. 5 ff.; Magnier (2015), pp. 43, 167 ff. 44 On the economics of co-determination, see Richter and Furubotn (2014), VIII.8. 45 Richter and Furubotn (2014), VIII.8. 46 For an overview of the history and characteristics of this system, see Addison (2009), pp. 5 ff. 42

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chairperson of the supervisory board has two votes. The chairperson is elected by a two-thirds majority; if no member receives two thirds of the votes, shareholder representatives elect the chairperson of the supervisory board and employee representatives elect the vice-chairperson. This arrangement thus does not constitute parity co-determination, as shareholder representatives prevail in the case of a stalemate. The overall effects of these policies have been positive.47 Participation rights are one of the main sources of worker satisfaction and a primary reason for the low number of lost working days due to strikes. From an economic perspective, workers embody ‘human capital’ and are therefore owners of one factor of production; as a result, they hold company-specific capital and bear the risk of uncompensated losses.48 Worker participation ensures that employees invest their human capital and are protected from being ‘disposed of’ later if shareholders develop myopic strategies to maximise profit by reducing the workforce.49 This system is especially useful in preventing wage disputes and the associated transaction costs, which would otherwise result from worker demands to be compensated for risks. The question, then, is why employers remain reluctant to introduce co-determination on a voluntary basis. Proposed explanations refer to a prisoner’s dilemma as well as to positive external effects, which emerge because co-determination is useful for the whole economy, not just the firm that introduces it. There is also an agency problem, as managers tend to see more disadvantages than do shareholders.50 One criticism of this system is that, as is the case in Germany, the core economic idea behind parity co-determination is typically not realised in practice.51 A primary objection to the co-determination concept presented here is that the model reduces interests in the company to employees and shareholders. The model does not accommodate the more recent view of ‘corporate governance’, which accounts for competing interests among portfolio managers, blockholders and company management. It is therefore not entirely surprising that this specific approach to corporate governance has not gained traction outside Germany. 3.3.1.2.3 Executive Compensation In recent decades, executive compensation has risen tremendously.52 This has sparked heated debate on the need for stricter legislation to regulate the astronomical increases in executive salaries at large companies.53 From an economic perspective, this increase raises questions about whether and to what extent such payments can be

47

Wagner (2011). For a meta-study, see Addison (2009), pp. 108 ff. Chassagnon (2011), pp. 34 ff. 49 See Becht et al. (2007), pp. 865 ff., with reference to relevant studies. 50 For an overview of different studies, see Addison (2009), pp. 105 ff. 51 Cf. Richter and Furubotn (2014), VIII.8.1. 52 Keller and Olney (2017), pp. 2 ff. 53 For an overview of the literature on theories of high manager compensation, see Manuere and Hove (2018). 48

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justified (e.g. under functioning market rules) or instead represent a case of market failure. ‘Economic superstar theory’, particularly as developed by Sherwin Rosen,54 proposes one explanation for high executive compensation.55 According to this theory, ‘superstars’ like professional athletes or classical music soloists achieve incredible success because very few suppliers encounter markets that can be expanded almost indefinitely without significant additional costs (e.g. through television). This theory likely cannot be applied to business executives, however, as it fails to explain the large income gap between the CEO and other executive board members who are responsible for important activities. It is also striking that familyowned businesses offer significantly lower compensation, even though these businesses look for managers in the same market.56 In a market society, there is a general assumption that high compensation is an efficient tool to motivate company executives to act in the interest of the company (or its shareholders).57 ‘Efficient contract theory’ suggests possible incentives for instituting the ‘pay-for-performance’ principle.58 At the same time, however, today it is widely accepted that the relationship between shareholders and executives constitutes a typical principal-agent relationship.59 The obvious information asymmetry makes it difficult for shareholders to reach informed decisions on compensation-related issues. In addition, shareholders generally demonstrate ‘rational apathy’ and thus expend little effort to monitor management.60 At the same time, managers have significant interest in obtaining higher salaries—and, with limited oversight, they have considerable leeway to do so. There is thus substantial evidence to support the ‘plunder hypothesis’,61 such as a correlation between positions of greater power and (even) higher compensation among American business leaders. Empirical evidence indicates that the level of compensation is rarely based on measurable performance criteria, which is consistent with the hypothesis. If high executive compensation is considered a consequence of market failure, the focus turns to the types of regulatory instruments that could address it. Companies have typically responded to agency problems by using incentive contracts, which are a key area of interest in the field of institutional economics.62 In practice, however, managers often succeed in decoupling a large percentage of their own compensation

54

Rosen (1981), pp. 845 ff. Cf. Malmendies and Tate (2009). 56 For a summary of critical arguments, see Bebchuk and Fried (2004), pp. 20 ff. 57 Cf. Becht et al. (2007), pp. 900 ff. 58 For references, see, e.g., Bebchuk and Fried (2004), pp. 15 ff. 59 See, e.g., Bebchuk and Fried (2003). 60 Adams (2004), D.I. 61 See Adams (2004), D.III, 313 ff. For a fuller presentation of the results of empirical studies, see Becht et al. (2007), pp. 903 ff. 62 Magnier (2015), pp. 175 f. and further reference. 55

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from company performance. They also effectively sidestep certain elements of incentive-based payment systems: for example, executives often neutralise risks associated with stock-option plans through offsetting transactions (e.g. hedging or equity swaps), thereby counteracting incentives. One way out of this dilemma is to create (material) legislative rules aimed at regulating executive compensation. Strictly capping it (e.g. with some ratio of managerial compensation to median employee pay)63 risks jeopardising companies’ decision-making autonomy. Thus, legislators often take a less interventionist approach by implementing general rules, as in Section 87(1) of the German Stock Corporation Act (AktG): In establishing the overall emoluments of the individual member of the management board (salary, profit-sharing, expense allowances, insurance premiums, commissions, incentivebased remuneration commitments such as, for example, stock options and collateral performance of any kind), the supervisory board is to ensure that they are appropriate in relation to the tasks and performance of the member of the management board and to the economic situation of the company and that, unless particular reasons so require, the customary remuneration is not exceeded. For companies listed on the stock exchange, the remuneration structure is to be oriented towards the promotion of a sustainable development of the enterprise. . .

The problem with such rules is that they are generally too vague to serve as a basis for court decisions. Decisions on executive renumeration are typically made by the (general) board of directors. In practice, there have been attempts to tackle the problem by instituting special supervisory bodies to oversee executive remuneration; thus far, however, these bodies have not produced the desired result64 and are therefore not considered an effective measure for general legislation. Reinforced transparency rules appear to be the most promising legislative option.65 These could lead to stricter shareholder control. There are various types of disclosure rules (e.g. full disclosure of the top five or 10 earners in a company or pay ratios, such as the mean ratio of executive compensation to average employee pay66).67 The drawback to all such rules is that the information disclosed will always be selective and incomplete. Paradoxically, disclosure requirements can even have the opposite of their intended effect: because a ‘transparent scorecard’ enable managers to compare their income with that of their peers, lower payments are often adjusted to align with higher ones.68 Overall, reinforced transparency has had

63 For a discussion of the executive-pay debate in the US Congress, see, e.g., Shorter (2013), pp. 11 f. 64 Cf. Becht et al. (2007), pp. 904 f. 65 Magnier (2015), pp. 176 ff. 66 Ibid., 184 ff. 67 Sheehan (2012); Magnier (2015), pp. 176 ff. 68 Magnier (2015), pp. 180 f.

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positive results, but it is still far from a ‘silver bullet’.69 Its effects vary considerably depending on the specific details of the regulation; whether such requirements are combined with an advisory or binding shareholder vote has proved to be an especially important factor. The debate on excessive executive compensation will surely continue, but it is unlikely that perfect responses to market failure will be found.

3.3.2

Interest Groups

In today’s pluralistic society, interest groups (i.e. non-governmental or non-profit organisations) play a central role in the political will-formation of both the people and the state. These groups are therefore of great interest from the perspective of institutional economics.70 Interest groups are associations of citizens with a common goal other than that of generating profit. In some countries, a subset of interest groups is subject to a certain legal regime reserved for designated public-benefit organisations.71

3.3.2.1 Reasons for the Formation of Non-Economic Organisations That Influence Social and Political Processes An interest group can be defined as an organised, multi-member entity through which its members pursue a shared political objective.72 Unification behind a common goal requires some homogeneity of preferences among the members. In order for an interest group to form, a fundamental dilemma must be overcome: non-members will also benefit from the group’s successful advocacy of certain interests (the free-rider problem). Mancur Olson developed the key principles of this argument in The Logic of Collective Action, published in 1965:73 if interest groups produced a public good only in pursuit of the general welfare, there would be no incentive to pay membership costs. To counter this problem, most organisations also produce a private good that is only available to their members. In doing so, they provide ‘selective incentives’ (Olson) that influence the cost-benefit calculations of individuals. Positive selective incentives (rewards) increase the benefits of participation (e.g. services for members of automobile associations or strike pay for workers in trade unions). Negative selective incentives (sanctions) increase the cost of non-participation and generally represent the reverse of a positive incentive, such

69

Ibid., 182 ff. For an introduction, see Kirchgässner (2008), 4.1.3; Croley (2010); Stearns et al. (2018), pp. 419 ff. 71 Cf. Bolleyer (2018), pp. 107 ff. 72 Croley (2010), p. 50. 73 Olson (1965). For an assessment of this study, see, e.g., Pecorino (2015); for critical perspectives on empiricism, see, e.g., Wiener and Richman (2010), pp. 374 ff. 70

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as the disadvantage of not being able to benefit the career-enhancing network available through an organisation. The accumulation of private goods is not the only motivation to join an interest group, however; members may experience satisfaction simply from participating in a collective endeavour and experiencing group solidarity. Moral considerations can also motivate contributions to interest groups.74 In certain cases, the free-rider problem is resolved through legislation, such as laws imposing compulsory membership (as in some professional associations).75 This eliminates the possibility of free riding.

3.3.2.2 Impact of Interest Group Activity on the Political Process In economics, the influence of interest groups on the political process has been the subject of extensive critical analysis. Interest groups generally aim to acquire benefits for individuals or groups; in doing so, they generally disrupt the allocation of resources that would be most efficient for the society as a whole. This effect is reinforced by the fact that politicians and bureaucrats also seek advantages for themselves when cooperating with interest groups. In economic theory, this practice is referred to as rent seeking. Discussion: The economic theory of rent seeking76

The concept of ‘rent seeking’ was developed by Gordon Tullock,77 although the term itself was later introduced by Anne Krueger.78 The concept explains in broad terms (including with regard to companies) why, in a society, it would be worthwhile to use resources to achieve special benefits at the expense of the general public rather than to face the uncertainty of competition. In such cases, the aim is to gain income or other benefits through political influence rather than through purely economic activities (profit-seeking). This practice is most successful when policymakers are motivated by self-interest to support the rentseeking behaviour of interest groups or individual business owners because they reap certain rewards in return (e.g. votes).79 Such actions lead governments to make inefficient decisions and deprive society of resources that could be used more efficiently elsewhere, resulting in a welfare loss. In Germany, this practice was especially visible in 2009, when the value-added tax (VAT) rate for hotel accommodation was reduced from 19% to 7%. This adjustment enabled the hospitality sector to realise a price increase of 12% at the expense of the taxpayer.

74

See Hardin (1982), chap. 7 (101 ff.), regarding environmental and consumer groups. Kirchgässner (2008), p. 111. 76 For an introduction, see Hindriks and Myles (2013), chap. 12; for further reading, Congleton and Hillman (2015). 77 Tullock (1974), pp. 39 ff. 78 Krueger (1974), pp. 291 ff. 79 Cf. Behrends (2001), pp. 68 ff. 75

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The governing party that implemented this policy then profited considerably from the party donations of hoteliers.80 ◄ The central question, of course, is how influence over the legislature or administration can be acquired and what factors determine the success of such attempts.81 These factors can be measured empirically, although doing so presents multiple methodological challenges.82 In general, the better able interest groups are to organise and to manage conflicts, the more opportunities such groups will have to exert political influence. Conflict readiness refers to an organisation’s ability to collectively threaten to deny some service that is vital to society (e.g. strike threats by certain occupational groups). Unions are therefore clearly more conflict-ready than student groups. The ability of an interest group to gain influence increases if the group can portray its particular interests as being in the public good (e.g. demands from doctors or teachers for better pay). The individual influence of an organisation is also dependent on the number of resources the group can invest in certain methods to gain influence. Financial resources, for example, play a role in enabling groups to acquire influence directly (e.g. through party donations) or indirectly (e.g. by financing media articles). Economic power can shore up the credibility of potential threats, such as the threat to relocate production facilities. Membership size can be used as a tool to influence elections through voting recommendations (membershipspecific resources); this has traditionally played a role in churches and trade unions. The specialised knowledge and information advantage that interest groups can provide is particularly valuable in this context. As the ‘real world’ grows more complex and the regulatory tasks associated with it become more difficult, politics becomes increasingly dependent on the knowledge of organisations, which serve as ‘input’ suppliers for the political system. In return, organisations demand influence on regulation or hold such influence, at least in practice. Regulation of energy industry law, for example, would be virtually unthinkable without insider knowledge, such as that of network operators and their associations.83 The structure of the vertical or horizontal separation of powers is, of course, also important in this context.84 It is interesting to compare the opportunities for influence that interest groups have at European and national levels. As the EU’s legislative power expands, associations can increasingly assert their interests at the European level and are thus better able to pool resources with others across Europe.85

Cf. Towfigh and Petersen (2010), § 6 III.2. See, e.g., Croley (2010), pp. 72 ff. 82 Cf. Croley (2010), pp. 74 ff. 83 On the various interests and actors involved in regulating the energy economy, see, e.g., Holzer (2007), 4.3. See Rudolph (2005), 4.4.2, on the influence of interest groups on individual policy instruments related to energy and the environment. 84 See, e.g., Cooter (2000), pp. 65 f. 85 Cf. Greenwood (2017). 80 81

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3.3.2.3 Impact of Political System Structure on Interest Group Activity Due to the importance of interest groups in the democratic process and in state decision-making, democratic states usually have detailed regulations on interestgroup activity. Regulatory approaches vary considerably, with some legal environments more permissive and others more restrictive for organised civil society.86 In light of provisions guaranteeing freedom of association, regulations on the formation of interest groups—especially bans on certain activities—are topics of considerable debate.87 In recent years, there has been a clear trend towards expanding regulations on lobbying, such as through the introduction of a lobbyist registry.88 Financial benefits in the operational stage, especially tax benefits, are also a target of regulations, and many legal regimes include special rules for public interest organisations in this area (often combined with stricter transparency and monitoring regimes).89 Countries with a more corporatist tradition also try to solve the free-rider problem through compulsory membership in specific groups, like professional associations.90 3.3.2.4 The Example of Trade Unions Trade unions are a particularly important form of interest group with a long history.91 Unions serve the economic interests of their members by improving wages and other terms and conditions of employment, as well as by lowering transaction costs of market exchange. They also advance the political interests of workers by promoting political reforms and reforms of firm-level governance systems.92 Over the past several decades, trade union activity has declined worldwide.93 In this context, it is interesting to examine the factors that incentivise workers to join unions. One of the main benefits, of course, is participation in the central goal of trade union activity: the improvement of working conditions. In pursuing this objective, unions have always been confronted with the free-rider problem: improvements in working conditions are often later adopted as standard policies that apply to all workers. If not already required to do so by law, employers can act on their own initiative to make these their standard policies and thus reduce incentives for union membership. Partly for this reason, unions have also always provided their members with private goods, such as legal advice. ‘Strike funds’, a

86

Cf. Bolleyer (2018), pp. 167 ff. and 192 ff. Ibid., 111 ff. 88 Ibid., 124 ff. 89 Ibid., 142 ff. 90 See Kirchgässner (2008), p. 111. 91 For an introduction, see Cole (1924/2019), pp. 1 ff. See Homann and Suchanek (2005), 5.4.2, for an introduction to the economic analysis of labour unions. 92 Kaufman (2012), p. 455 and further reference. 93 Cf. Doucouliagos et al. (2017), pp. 1 ff. 87

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form of insurance for income lost due to labour conflicts, play an especially important role in this respect. In trade unions, there is a clear principal-agent problem in the relationship between the ‘functionaries’ and the ‘rank-and-file’ workers. Union officials, as agents, have specific interests (e.g. as members of supervisory boards) and wield considerable influence, while average workers have very little opportunity to exert control. From a public choice perspective, trade unions serve important functions in modern societies. They counterbalance incomplete labour contracts,94 provide an important conduit of information between firms and employees, offer a collective voice for workers and strengthen the weak bargaining position of employees.95 Overall, unions have positive effects on growth and other macroeconomic indicators.96 For good reason, most modern constitutions provide strong protection for trade unions (including their formation and activities, like collective bargaining). For example, Article 9(3) of the German Basic Law guarantees the ‘right to form associations to safeguard and improve working and economic conditions. . .to every individual and to every occupation or profession’. According to consented legal dogmatics, this includes the right to form trade unions as associations. The freedom of association represents a specific right to form social partnerships. It protects not only the employees, but also the unions themselves, including their existence, organisation, will-formation process, and management of their own affairs—and, of course, their collective-bargaining autonomy and their right to take industrial action. At the same time, jurisprudence arising in connection with Article 9(3) GG has concluded that unions must satisfy certain requirements; for example, they must be freely formed and independent.97 This limits the discretion of the legislature, for example in the context of collective bargaining law; it is essentially restricted to resolving conflicts related to the freedom of association of various social partners.

3.3.3

The Media

In democracies, media organisations are particularly important.98 They enable the creation of an effective political public sphere and thus contribute significantly to public will-formation. The phenomenon of ‘media democracy’ is reinforced by the expanded possibilities of ‘new media’. Economics has been interested in the media

94

Cf. Addison (2009), pp. 27 ff. Ibid., 30 ff. 96 Cf. Doucouliagos et al. (2017), pp. 40 ff. 97 For the case law of the German Constitutional Court, see Bumke and Voßkuhle (2019), annot. 916 ff. 98 For an overview of media economics, see Ballon (2014). 95

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since the early works of Ronald Coase, prompting it to develop ‘media economics’, its own field of research on the topic.99 As used in this discussion, media are narrowly defined as mass media and institutions that disseminate information and ideas to a mass audience periodically and at a distance. The internet is integrated into the analysis to the extent that it serves a journalistic function.100 Media economics is significantly different from other organisational economics. This is not only because the economic analysis of firms and interest groups has a much longer tradition in the field, but also because studies of the media introduce technical complexities. The media also plays a very specific role in the political process.101

3.3.3.1 The Interests of Stakeholders Politicians have long recognised the importance of the media and are using it as an increasingly systematic part of their vote-maximisation strategy.102 The risk of media abuse for political purposes is obvious,103 particularly in light of wellknown historical (e.g. the radio propaganda of Nazi Germany) and contemporary examples (e.g. Berlusconi’s Italian media empire). A related problem is the excessive influence of private parties on politics. The media generates a great deal of money; the concentration of this capital, and the large impact of media on public opinion, makes it possible to acquire significant political influence.104 In more concrete terms, this influence is exercised by private media owners on the one hand, and by companies that finance media through advertisements on the other.105 In this discussion, only the press is excluded, because it follows special rules and generally involves fewer market failures. The relationship between the media and politics is one of mutual dependence. For example, journalists need specific and (where possible) exclusive access to politicians to raise their own profiles. Politicians, in turn, rely on journalists to gain media attention for their positions. This leads to an exchange of ‘information for publicity’. The crucial question is who dominates this exchange. There are good reasons to suspect that politicians are more likely to play the dominant role.106 In the face of increasingly scarce resources for research, political journalists, in particular, have demonstrated a growing and increasingly one-sided dependence on access to politicians. If this is in fact the case, the exchange has become asymmetrical and

99

Cf. Anderson et al. (2016), Cunningham et al. (2015), Picard and Wildman (2015). See Oster (2015), pp. 75 ff. 101 Cf. Oster (2015), pp. 28 ff., 84 ff., 256 ff. 102 On the (self-)medialisation of politics, see Dylla (2008), 7.1. 103 On the risks that media can pose for democracy, see, e.g., Oster (2015), pp. 33 ff. 104 On the danger of media commercialisation, Kirsch (2004), 2.11.3. 105 Cf. Sobbrio (2014), pp. 296 ff. 106 Cf. Dylla (2008), 7.4.2. 100

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discourages journalists from providing ‘critical journalism’ so that they will not lose their political access. It is important, of course, not to overlook the interest of media consumers in content that suits their preferences.107 Debate over the rationality of media consumers’ behaviour has focused on the issue of ‘consumer sovereignty’.108 Despite criticism of this approach, it is appropriate to examine consumer behaviour in terms of individual preferences and methodological individualism, and to reject more paternalistic perspectives. To do so, however, it is essential to modify the rational-behaviour approach to reflect a ‘bounded rationality’109 and to consider the possibility of a ranked preference order. Thus, a television viewer who has a firstorder preference for extensive television consumption can develop a metapreference for moderate television consumption with more sophisticated programming.110

3.3.3.2 Market Failure in the Media Sector The media market is characterised by several forms of market failure, although the details of each are controversial.111 The generally accepted categories of market failure can only be applied to the media sector with limitations and modifications. As a result, problems arise when media economists base their recommendations for appropriate media regulations on these categories. One form of market failure results from the existence of information asymmetries in relationships between the various actors in media markets.112 Consumer uncertainty about the quality of the media is examined in this context. The relationship between media consumer and media producer can be conceptualised as a principalagent situation in which the provider, as the agent, enjoys a significant informational advantage.113 This asymmetry can be mitigated very imperfectly through ‘screening’ (information acquired by the user, as the principal) or ‘signalling’ (incentives to provide information, e.g. prizes awarded to ‘good’ media).114 A second principalagent relationship exists between politicians and the media companies regulated and overseen by them. The theory of natural monopolies provides another basis for identifying market failure.115 Production costs for media—such as television programming—are largely fixed, which are ‘sunk’ after production. Existing media providers can

107

Cf. Sobbrio (2014), pp. 299 ff. Schröder (2008), pp. 20 ff. and further reference; see also Sect. 2.3.2.6 above. 109 See Sect. 1.2.2.2.3.2 above. 110 Schröder (2008), pp. 37 ff. 111 Ibid., 82 ff. 112 Ibid., 89 ff. 113 Cf. Radke and Then Bergh (2004), pp. 146 ff. 114 Cf. Schröder (2008), pp. 99 ff. 115 Schröder (2008), pp. 117 ff. 108

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therefore hinder or even prevent new providers from entering the market by reducing the prices of content to the (low) marginal costs. The media is ultimately a public good.116 It is generally impossible (or at least uneconomical) to prevent individuals from consuming media. Media is also non-rivalrous (i.e. an additional viewer does not diminish the supply of the good). High-quality media programming can even be considered a merit good; from a societal perspective, demand for it tends to be too low.117 On the other hand, advertisements—especially those on television—can be seen as a form of ‘pollution’ and are sometimes referred to as a public ‘bad’.118 The media market clearly has many external effects.119 These may be positive (such as cultural or political education of the general public)120 or negative (such as the coarsening of society through depictions of violence or pornography). The importance of media effects research is therefore indisputable.121 Applying the theory of external effects introduces significant problems, however; for example, it is often unclear to what extent external effects are caused by production and supply rather than by consumption and demand. It is also problematic to describe effects as ‘external’ in the narrower sense, since they frequently emerge in our social environment. In addition, the social effects of media are regularly associated with problems in society as a whole; this, too, obscures the relationship between cause and effect. Finally, it is generally extremely difficult to ‘translate’ media effects into third-party costs.

3.3.3.3 Media Regulation in the Public Interest From the above analysis of market failure, it is clear that regulating media in the public interest presents legislators with an enormous challenge. On the one hand, media must be protected against the state, including the legislature itself. This is the classic rationale for constitutional guarantees of media freedom.122 Thus, state ownership alone cannot be the solution to market failures.123 On the other hand, the legislature must protect society and democracy by preventing the concentration of private power and influence, which can lead to an abuse of power. Finally, for the sake of a functioning democracy, media as an institution must be safeguarded and media pluralism guaranteed.124

116

Cf. Schröder (2008), pp. 145 ff. For a critical discussion of the theory of merit goods, see Schröder (2008), pp. 28 ff. 118 Schröder (2008), p. 195, 200. 119 Cf. Schröder (2008), pp. 273 ff. 120 See Sobbrio (2014), pp. 292 ff., on the positive effects of news media. 121 Cf. Schröder (2008), pp. 321 ff. 122 Although the text of most constitutions is limited to freedom of expression and freedom of the press, media freedom is generally protected through a combination of certain guaranteed basic rights; see Oster (2015), pp. 24 ff., 48 ff. 123 Cf. Sobbrio (2014), pp. 308 ff. 124 Oster (2015), pp. 84 ff., 256 ff. 117

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To the extent that media freedom is understood in terms of freedom of expression—the position taken by the US Supreme Court125—it is difficult to find solutions outlined in the US Constitution. In the German Basic Law and the jurisprudence of the German Constitutional Court, the issue is approached differently. Media freedom is derived from Article 5(1) GG.126 Legal dogmatics interprets this freedom as encompassing not only a classic individual right (status negativus), but also a guarantee of positive state action to protect the media as a vital democratic institution (status positivus). A ‘dual system’ of public and private broadcasters has developed as a result of the interaction between the jurisprudence of the German Federal Constitutional Court and the Länder legislatures, which are responsible for broadcast regulation.127 The Interstate Broadcasting Treaty (Rundfunkstaatsvertrag) outlines the regulatory framework established by the Länder. Broadcast stations that are funded publicly or through licensing fees are required to provide ‘basic services’. Private broadcast stations are permitted to be more market-oriented and are not subject to restrictions on advertising, for example, but they, too, are required to ensure balanced programming (although the requirement for private broadcasters is less strict than that for public broadcasters). Pluralistic supervisory media authorities are responsible for monitoring broadcaster compliance. This system has been relatively successful in balancing (mediatised) state support and control, on the one hand, with non-intervention from the state and the political sphere (prevention of misuse) on the other. Nevertheless, significant problems remain: public broadcasters, in particular, are comparable to government agencies that aim to maximise their budget and exploit their relative independence to do so, even though this independence was granted to them for different purposes.128 In addition, due to the strong representation of political parties on the Broadcasting Board, efforts to prevent political interference are not always successful.129 Overall, however, these ‘dualistic approaches’ are highly effective in coping with the various market failures discussed above.130 In addition to the organisation of the media, sources of media financing are important from an economic perspective and are also discussed here in the context of television and radio. One focus of economic research on the subject is the negative impact of media reliance on advertising.131 Because ad-based funding frees consumers from the financial costs of media consumption, it tends to result in excess 125

Ibid., 24 f., 37. Article 5(1) GG reads: ‘Every person shall have the right freely to express and disseminate his opinions in speech, writing and pictures, and to inform himself without hindrance from generally accessible sources. Freedom of the press and freedom of reporting by means of broadcasts and films shall be guaranteed. There shall be no censorship.’ 127 For an overview, see Poth and Ferrau (2011); on the jurisprudence of the Federal Constitutional Court, see Bumke and Voßkuhle (2019), annotation 633 ff. 128 Cf. Schröder (2008), pp. 252 ff. 129 Schröder (2008), pp. 242 ff. 130 For additional examples, see Oster (2015), pp. 256 ff. 131 Cf. Schröder (2008), pp. 192 ff. 126

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demand.132 Orientation toward viewing figures leads to a dominance of the mass market and a corresponding ‘dumbing down’ of content.133 The merits of tax-based financing—defended most prominently by Paul A. Samuelson—have been the subject of much debate.134 Even if tax funding could alleviate the problems associated with ad-based financing, this approach would increase the risk of political influence on media content.135 From an economic point of view, the German system has produced the same structural outcome as a result of its transition from device-dependent fees to broadcast fees for households and businesses; the only difference is in the distributional effects (all users are charged the same amount, independent of their ability to pay). The prevailing opinion is that tax-based financing would not be permissible in Germany because it violates the financial provisions of the constitution.136

3.3.4

Parties

Western democracies—including Germany under the Basic Law—view political parties as a cornerstone of democracy.137 Good regulation of the party system is thus vital to modern democracy. For legislators, it is at least as challenging to regulate political parties as it is to regulate the media. Parties can be defined as organisations competing for power.138 They are durable associations of citizens whose objective is to influence the decision-making processes in the political sphere (and therefore those of the state itself) and to fill offices with party members.139

3.3.4.1 Interests of the Involved Actors Economic research into the the ‘black box’ of party operations often characterises parties as coalitions.140 But this description does not adequately convey the ‘bundle’ of human, material and financial human resources that make up the entity of the ‘party-as-organisation’; the synergy of these factors makes the party greater than the sum of its members. Inside the party-as-organisation, there is a dynamic interaction of personal commitment and financial contributions, and routines and expert knowledge gradually emerge. This significantly lowers transaction costs for political

132

Schröder (2008), pp. 207 ff. Ibid., 212. 134 Cf. Schröder (2008), pp. 158 ff. 135 Cf. Schröder (2008), pp. 229 ff. 136 See, e.g., Wagner (2011). See also Schneider (2013), on rejected alternatives to the broadcasting fees. 137 Pildes (2011), pp. 254 f. 138 See Sect. 2.2.3.2.2 above. 139 Issacharoff and Miller (2010), pp. 179 f., regarding Downs. 140 Aldrich (2011), p. 33 and further reference. 133

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candidates, who can refer to familiar positions and invoke the reputation of the party rather than beginning their campaigns ‘from scratch’. In this respect, parties serve as points of reference that signify confidence in the seriousness, sustainability and credibility of the pursuit of power.141 Political parties are thus necessary for politicians to achieve their objective of sharing in the power of the state. To achieve this goal, politicians are generally reliant on party infrastructure, which provides them with a kind of ‘brand’.142 From the perspective of economics, it is perhaps more interesting to consider how other citizens can be motivated to support parties and party membership. The same basic question applies to parties as to other organisations that work to create public goods143—that is, what can these groups offer their members? First, they can reward members with official party positions that provide income, power and influence; the distribution of government positions (where possible) to members at various political levels is a key feature of the party system. In addition, parties can tailor the content of their policies to ‘serve’ the tangible and intangible interests of their members.144 The relationship between parties and voters has been characterised as a typical principal-agent situation.145

3.3.4.2 Constitutional Foundations Political parties were long ignored by constitutions. The framers of the US Constitution even expressed explicit opposition to the formations of both factions and parties.146 This changed in the second half of the twentieth century, when the constitutionalisation of parties became more widespread. Today, more than 80% of constitutions contain specific rules for political parties.147 It is striking that economics engages so extensively with the role of politicians, but little with that of parties. In Western democracies, parties play a decisive role in the political will-formation of the people and in translating this will into the political will-formation of the state. Politicians without party affiliation have virtually no prospect of success. Many state constitutions, especially older ones like the US Constitution, do not address political parties at all. Such constitutions were in fact designed to oppose the development of factions in an effort to prevent the emergence of intermediary organisations.148

141

Hershey (2006), p. 80. On the interest of politicians in party membership, see Aldrich (2011), pp. 46 ff. 143 See Sect. 3.1.2.2 above. 144 Cf. Aldrich (2011), pp. 50 ff. 145 See Sects. 1.2.3.5 and 2.2.3.2.3 above. 146 See Issacharoff and Miller (2010), p. 195. 147 See, e.g., Article 17 of the Constitution of Brazil, Article 4 of the Constitution of France, Article 21 of the Constitution of Germany, Article 49 of the Constitution of Italy, and Section 6 of the Constitution of Spain. 148 Pildes (2011), p. 255; Issacharoff and Miller (2010), p. 195. 142

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Constitutions are primarily concerned with ensuring and guaranteeing strong and autonomous parties that are independent of the state. To this end, most modern constitutions guarantee an individual right to establish or join parties. This rightsbased approach does not reflect the dual function of parties, however, which has led Daniel Ortiz to advocate a shift in perspective ‘from rights to arrangements’149 to a more structural approach.150 This enables constitutional courts (as well as constitutional lawyers) to develop an overarching theory of parties that integrates diverse fields (e.g. election law, parliamentary law and party organisation law). As a result, in some cases, specific rights have been derived from general constitutional rules for parliamentary party groups. Under the German Constitution, for example, rights of state organs (e.g. regarding standing in trials before the Constitutional Court) were extended to parties through teleological interpretation.151 It is interesting to examine which of these issues have been regulated at the constitutional level. The German Constitution, for example, has established strict rules banning parties (Article 21(2)), while the Spanish Constitution addresses the principle of proportional representation (Section 68(3)). The topic of ‘path dependency’ is relevant in this context.152 Because many such aspects have been established constitutionally, it is difficult (for new parties) to change them.

3.3.4.3 State Regulation The discussion in Chap. 2 focused on the challenges associated with regulating fair competition between parties,153 given that parties with majorities in parliament and the administration can influence party competition by regulating electoral or media law. This chapter focuses specifically on organisational considerations, such as (1) which organisations are eligible to participate in the political process (including any party bans), (2) how stringently the legislature regulates the interior (democratic) structure and processes of parties as organisations and (3) to what extent parties are financed by the state. Parties are distinct from other kinds of organisations: they aim to influence political (and state) decision-making processes and thus compete for power. Any legal or constitutional provisions granting parties specific rights must define the minimum requirements that qualify an association as a party. More drastic decisions—particularly regarding party bans—must also be framed in legal terms: can political parties be banned from the political process because their positions conflict with basic features of the constitution (e.g. by embracing anti-democratic, separatist or religious principles)?154 There is historical precedent for such bans. For 149

Ortiz (1999). On this development, see Issacharoff and Miller (2010), pp. 182 ff. 151 See Pildes (2011), pp. 255 f. 152 Aldrich (2011), pp. 56 ff.; Krouwel (2006), p. 250. 153 See Sect. 2.2.3.2 above. 154 See also Pildes (2011), 3.2; Bolleyer (2018), pp. 98 ff. 150

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example, in the 1950s, Germany banned a Nazi and a Communist party. In 1988 Turkey has banned a mass-based Islamist party for violating the country’s constitutional commitment to a secular state. This points to the obvious risk that established parties will abuse this competence. In extreme cases, constitutions can define parties so narrowly that many political movements are excluded, as has occurred in Iran;155 whether such countries still qualify as democracies is open to debate. In Germany, on the other hand, the Constitution restricts the practice of banning parties (Article 21(2) GG). Political parties are also active in the social sphere, where they help to organise the political will of the people; they also serve an important state purpose by helping to organise a consistent will of the state. This dual role creates a potential conflict: party rights to autonomy must be balanced against the preservation of democratic standards in parties as organisations. In contrast to its treatment of associations,156 the German Basic Law attaches great importance to democratic will-formation within parties (Article 21(1)(2) GG); this is significant, as holding a party office is de facto an essential precondition for holding state office. At the other end of the spectrum, US constitutional doctrine places a greater emphasis on the concept of party autonomy.157 Of course, the probability of a party’s success in winning electoral victories and mandates also depends on the scale of the financial resources at its disposal.158 It is important to note, however, that the issue of party financing is closely related to the financing of other institutions and offices affiliated with parties, such as party political foundations, parliamentary factions and delegates (i.e. party financing in a broader sense).159 Parties acquire their financial resources primarily from the citizens (e.g. from membership dues and donations) and from the state (e.g. election campaign reimbursements and other aid). The regulation of these two areas of party financing160 has long been controversial: given the close connection between parties and parliamentary factions, determinations made in this context can be considered ‘decisions on one’s own behalf’, nearly on a par with the power of legislators to set their own salaries. Avoiding this problem is difficult; possible measures include the creation of an independent commission. It is also challenging to determine who should be in charge of implementing and controlling financial regulations. Few states entrust the administration (ministries) with this task, as it could affect the constitutional right to party autonomy; to avoid this risk, other national laws assign

155

See Article 1 of Iran’s Party Law. See Sect. 3.2.2 above. 157 See also Pildes (2011), 3.2.1. 158 Regarding US campaign financing, see Issacharoff and Miller (2010), pp. 188 ff.; only the size of the impact is disputed. 159 See Kohler (2010), pp. 33 ff. 160 See Sect. 2.2.3.2.4 above. 156

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this responsibility to the court of audit (or audit offices), parliamentary actors or bodies, or independent specialist agencies.161 Today, parties continue to play their traditional role as (private) intermediary organisations in society. They are therefore largely financed privately through membership dues and donations. From an economic point of view, it seems reasonable to assume that they act strategically, as is likely also the case with donors.162 A central problem in regulating party financing is the risk that parties will become overly dependent on large donations or that large donors will gain too much influence. Many countries have instituted a general ban or limit on donations.163 Beginning in the 1970s, most democratic states began to provide public funding to political parties (e.g. in accordance with their share of the vote, parliamentary representation or amount of private funding). The state’s funding of political parties introduces a dilemma. On the one hand, the constitution presupposes that parties are capable of action and that they play a role in forming the political will of the people; on the other hand, it also assumes that parties are the product of civic engagement (the principle of freedom from state interference). Based on these considerations, Federal Constitutional Court has concluded that party funding should come primarily from internal financing and only partially from the state. The Court thus ruled that state funding can cover no more than 50% of the party budget.164 It also prescribed an absolute upper limit as an additional safeguard to prevent parties from exploiting the state.165 Under the German Political Parties Act (ParteienG), payments are specifically apportioned based on the number of votes (generally at a fixed rate per vote) and total revenue from third parties, such as membership dues, donations and contributions from elected officials (with fixed limits for each natural person). In principle, such rules are justified from an economic point of view. Participation in public will-formation can be seen as a public good that warrants state financing.166 At the same time, parties can be viewed, in the terminology of Max Weber, as ‘interest groups’: they seek power and, in doing so, (also) indirectly produce private goods, essentially in the form of group collective goods.167 This can also refer to private financing. It is impossible, however, to draw precise boundaries between public and private funding on this basis.

161

Bolleyer (2018), pp. 92 ff. Issacharoff and Miller (2010), pp. 188 ff. 163 Falguera et al. (2014): 40% of the countries analysed; for the US, see Stearns et al. (2018), pp. 442 ff. 164 See Pildes (2011), pp. 256 ff. 165 Regarding the case law of the German Constitutional Court, see Bumke and Voßkuhle (2019), annotation 1549 ff. 166 Kohler (2010), p. 85. 167 Ibid., 90 ff. 162

References

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145

Summary

In the context of organisations, both corporate and individual actors function as independent decision-makers with autonomous preference systems. Members of organisations expect to gain specific advantages from the organisation (incentivecontribution theory). The state protects organisations and lays the legal foundation for their operation to increase opportunities for greater cooperation among those involved. The firm is an organisation that primarily integrates the factors of production ‘capital’ and ‘labour’ and strives continuously to maximise profits in the market. The state provides companies with legal structures for this purpose and facilitates operations by limiting liability. It has intervened significantly in the internal autonomy of organisations by instituting the right to co-determination and the more recent regulations limiting executive compensation. Interest groups are organisations that play an important role in political willformation. They supply government bodies with information, expertise and resources; ‘in exchange’, they seek special advantages (‘rent seeking’) for themselves and their members. Their success in securing advantages varies based on the organisation and conflict-readiness of the parties involved. Media regulation in the public interest appears necessary to ensure pluralistic participation, independence from the state, and a suitable media programme. There are serious problems, however, in clearly identifying cases of market failure in the media sector. Thus, in practice it is quite challenging for legislatures (and constitutions) to balance the media’s freedom of organisation, the consumer sovereignty of media users with state interventions to cure market failures. Because of their special significance in political and state decision-making, parties enjoy more and more often special protections under constitutions. They use their protected status to produce public goods, but also seek to secure individual advantages (‘ideology maximisation’, ‘gains in power’, etc.). As a result, strict requirements have been established to govern their internal organisation (internal democratisation) and (proportional) state financing.

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4

Theory of State Decision-Making

Public law primarily concerns state decisions, including the legislative decisions of the administration and the rulings by the relevant courts. Questions about how state decisions are made (positive analysis) and how they should be made (normative analysis) are, of course, some of the main topics explored within the New Political Economy. In this context, the key focus is not on the state decision-making system as such, but on the actions of individual actors (politicians, bureaucrats, or those subject to state decisions). Insight from institutional economics applies here insofar as parties, government bodies or the bureaucracy can be regarded as organisations; the principal-agent problem, for example, is significant. The economic theory of interest groups also has considerable influence on theories of state decision-making.1 The analysis in this field considers not only the decision-makers, but also the decision-making process itself.2 This refers to the entire political cycle, or ‘policy cycle’, from the identification of the need for regulation to the definition of regulatory objectives, the establishment of a legal framework for regulation and, finally, implementation and oversight.3

4.1

Decision-Makers

The following pages provide a brief overview of the decision-makers involved in regulation.4

1

On these issues, see Sect. 3.3.2 above. See Sect. 2.2.3.2 above. 3 Cf. Lyon (2007), pp. 1 ff. 4 For an overview, see Kirchgässner (2013), 4.1.2. 2

# Springer-Verlag GmbH Germany, part of Springer Nature 2022 M. Rodi, Economic Analysis of Public Law, Springer Textbooks in Law, https://doi.org/10.1007/978-3-662-66089-8_4

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4 Theory of State Decision-Making

Politicians

Analyses of this topic can examine the rationality of voter decisions as well as the rationality of decision-makers, elected officials and politicians in general.5 Of course, if the state were organised in an ideal manner and voters had complete information, self-interested actions by politicians could lead to optimal outcomes. However, earlier sections in this book have already discussed the practical obstacles to achieving such outcomes in the context of democratic systems and voting behaviour.6 Anthony Downs has characterised the objective of political decision-makers in striking terms, arguing that their goal is less to implement their political ideology and programmes than to gain votes and thus political office:7 ‘Parties formulate policies in order to win elections, rather than win elections in order to formulate policies.’8 However, while vote-maximisation is certainly a dominant strategy,9 it does not preclude political decision-makers from pursuing other goals as well. For most of these other objectives (e.g. prestige, income, implementation of ideology), an electoral victory is a means to an end—in other words, a primary goal that motivates courses of action. The goal of ideology maximisation illustrates this particularly clearly. Empirical studies have shown that unpopular measures are taken after an electoral victory.10 The theory of the ‘political business cycle’, developed by William D. Nordhaus, has become especially prominent in this context.11 This theory suggests that the political business cycle can vary as a result of real restrictions (electoral terms are a concrete example). The foundation of the theory is the hypothesis that administrations attempt to maximise votes by promoting pro-cyclical policies rather than by tempering business cycles that are contrary to voter preferences. At the beginning of a legislative term, the administration makes an effort to reduce inflation through restrictive monetary and fiscal policies, an objective achieved at the cost of increased unemployment. Towards the end of the legislative term, restrictive policies are replaced with expansionary policies to boost economic growth and lower the unemployment rate. Because such measures generally have a delayed impact on the inflation rate, it is possible to achieve a combination of relatively low unemployment (strong economic growth) and relatively low inflation in time for the election. The first Reagan Administration (1981–1985) provides empirical evidence of this strategy. This process also applies to legislation as a whole if legislative measures reallocate

5

See Sects. 1.2.3.7 (on state failure) and 4.1.2 (on bureaucrats). See Sect. 2.2.3.3 above. 7 Downs (1968), p. 402. 8 Ibid., 27 f. 9 Dylla (2008), Sect. 4.1.3.3 (113 ff). 10 Ibid., Sect. 4.1.3.5 (119 ff). 11 Nordhaus (1975), pp. 169 ff. For a discussion of the underlying theory of the business cycle, see Sect. 6.3.2.2 below. 6

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property rights through redistributive policies; in this case, it is referred to as a ‘political legislation cycle’.12 Of course, in pursuing their preferences, politicians, like other actors, encounter a variety of restrictions.13 Chief among these are constitutional requirements: although politicians may attempt to modify these provisions, the constitution can be amended only under certain conditions. In addition to the constraints within the political system, politicians are also increasingly subject to external restrictions due to the effects of globalisation.14 The extent of such restrictions is especially clear in light of the recent financial crisis (including the eurozone crisis).

4.1.2

The Administration (Bureaucratic Theory)

The economic theory of bureaucracy15 applies the rational behaviour model of individual conduct to state administration, breaking with the idealistic view of state bureaucracy developed by theorists including Max Weber.16 This approach, which is based on the groundbreaking work of Anthony Downs17 and William D. Niskanen,18 rests on the premise that the actions of bureaucrats are also motivated by self-interest (Downs uses the neutral term ‘officials’). In Downs’s theory, utilitymaximising bureaucrats pursue a complex set of goals, including ‘power, income, prestige, security, convenience, loyalty (to an idea, an institution, or the nation), pride in excellent work, and desire to serve the public interest (as the individual official conceives of it).’19 In keeping with this argument, it is well established that agencies seek to avoid lawsuits, as these are inconvenient and burdensome and may have negative outcomes.20 Downs creates a typology of officials based on their primary goals and distinguishes pure self-interest from mixed-motivation structures. The discussion below addresses only a few of the many topics in the economic theory of bureaucracy, including (1) why certain tasks are entrusted to officials at all (and not, for example, provided as services on the market), (2) conflict minimisation and budget maximisation as dominant strategies of the administration, and (3) the hierarchical structure of bureaucracies and the principal-agent problem.

12

Kirchgässner (2008), pp. 103 ff.; for a theoretical and empirical test of this theory using the example of Italian legislation, see Lagona and Padovano (2008), pp. 201 ff. 13 Dylla (2008), 4.2. 14 See Sects. 2.5.1 and 2.5.2 above. 15 For an introduction, see Carnis (2009); for greater depth, McNollgast (2007), pp. 1697 ff. 16 For an introduction, see Serpa and Ferreira (2019). 17 Downs (1965), pp. 439 ff.; Downs (1994/1967). 18 Niskanen (1968); Niskanen (1974). For an overview of later approaches, see Behrends (2001). 19 Downs (1994/1967), p. 201. 20 Rose-Ackerman (2012), p. V.

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4.1.2.1 Performance of State Tasks by Officials It is theoretically possible for a state to exist without an administration (or at least with a much smaller administration). This raises two questions: (1) why are certain state tasks carried out by officials instead of being offered as goods and services on the market? and (2) why do officials make binding decisions on legal issues when they could instead simply establish legal statutes and leave the courts to assess whether actions comply with these rules? 4.1.2.1.1 Fulfilment of State Tasks by an Administration in an Institutional Sense or Through Privatisation The question of why the state should maintain an administration in an institutional sense, and why it should assign tasks to this administration, can be compared to the question of why the state performs certain tasks.21 Given that modern states generally have an extensive administrative apparatus at their disposal, analysis of this topic serves above all to develop justifications for this apparatus and formulate criticism of ‘excessive’ administration. Guy Kirsch—following on Coase, Williamson and North—has presented persuasive economic arguments for maintaining an administration in an institutional sense.22 According to these arguments, a state is logically more likely to provide goods and services through its own administration when it needs them regularly and at short intervals: ‘A state that celebrates the anniversary of its founding by putting on a fireworks display every 100 years will hardly maintain a federal office for fireworks; it will instead hire a company to manage the fireworks display as needed – every 100 years.’ A state will also be less likely to solicit goods and services on the market if it is less certain to acquire these in the desired quality, in the required quantity and at the right times. As an example, Kirsch cites the provision of a counterterrorism unit in the event of a terrorist attack. The greater the negative effects of not obtaining goods and services in the right quantity and quality, the less the state will rely on the market to fulfil a task when needed. Kirsch illustrates this using his earlier example: if the fireworks display at a centennial celebration were cancelled because organisers could not find a company to carry it out properly, the loss would be bearable, but the same would not be true if there were not enough qualified personnel on hand to guarantee adequate disaster management after a nuclear meltdown. Of course, a legislator may also decide to establish an administrative unit and transfer tasks to it for reasons of self-interest. It may be convenient to claim credit for solving a problem (area), even though an agency will be responsible for taking the hard decisions later. The legislator may also be aware that certain agencies are susceptible to being captured by interest groups (more so than are judges). The responsibility for related issues thus tends to fall to the executive (this is of course

21 22

See Sect. 2.3 above. Kirsch (2004), 2.10.2 (346 ff.).

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especially interesting in presidential systems, where this task is the responsibility of the president).23 Economic analysis of law focuses in particular on the significance of constitutional provisions and the rationale behind them. In Germany, for example, Article 33(4) GG states that the ‘exercise of sovereign authority on a regular basis shall, as a rule, be entrusted to members of the public service who stand in a relationship of service and loyalty defined by public law’. Tasks are reserved for the civil service in order to guarantee the fulfilment of responsibilities essential for citizens to enjoy freedom and social security, as well as to ensure that laws are implemented in accordance with the Constitution. Such tasks are especially relevant in cases where executive management interferes with individual liberties. Law and economics is critical of the tendency among Länder to partially privatise penal systems (as in the United States model).24 4.1.2.1.2 Regulation by Private or Public Law But the options for fulfilling state tasks are not limited to the market or the administration. Legislators can also implement law simply by establishing legal statutes and delegating to the court the responsibility of ascertaining whether these laws are upheld in practice; this is an alternative to state action by the administration. There is much more vigorous debate in the Anglo-American sphere than in Europe about whether regulation should be governed by private or public law (‘administrative takeover’ by state officials).25 In Anglo-American terminology, this can be described as a debate over ‘ex-ante’ or ‘ex-post’ regulation.26 This alternative can be illustrated using the example of competition law in Germany. General competition law (based on the Act Against Unfair Competition (UWG)) has traditionally been regulated by establishing private rights and obligations that can be enforced in court in the event of a dispute. Antitrust law, however, assigned binding decision-making powers to authorities.27 A second example is the German Renewable Energy Sources Act (EEG). Initially, the law was limited to the regulation of rights and obligations. Once it became clear that long-standing court proceedings could thwart an effective provision of rights for renewable energy producers (against large energy suppliers), however, the legislators became more reliant on a system of decision-making by government agencies. Still, there are good reasons to implement regulation by private law in certain cases. Posner,28 in particular, has suggested that courts are have greater independence from the influence of interest groups. In addition, a private-law approach may

23

For additional constellations, see Rose-Ackerman (2012), p. II. Cf. Bonk (2000). 25 See, e.g., Posner (2011), § 22. 26 See, e.g., Ulen (2007), p. 33; Kolstad et al. (1990). 27 Practices related to this topic are extremely heterogenous; see Dabbah (2010), pp. 18 f. 28 Posner (1974), p. 351. 24

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ultimately be more economical for the state. On the other hand, parliament may choose regulation by public law for precisely this reason if it expects the administration to implement the law in line with the ideas of the legislating body (‘ally hopothesis’).29 There are good reasons for the administration to do so: it is not only threatened by ‘statutory override’ (a concept that applies to courts as well), but also more directly dependent on the ‘goodwill’ of the legislators, who can easily alter its financial resources or competences.30

4.1.2.2 Conflict Minimisation and Budget Maximisation as Dominant Strategies of the Administration If we assume that the self-interest of bureaucrats is primarily oriented towards gaining power and influence, it follows that the employees—and in particular the directors of the authorities—will have an interest in securing for their respective agencies as many financial and personal resources as possible. This goal can explain the tendency for administrations to grow—a phenomenon that has been known as Parkinson’s Law ever since it was described by the sociologist and historian Cyril Northcote Parkinson.31 Parkinson used the example of the British Navy to show that bureaucracies continue to expand in size even if their tasks do not increase. Based on this observation, Niskanen developed the ‘law of budget maximisation’ to describe the primary motivation for bureaucrats’ behaviour.32 Under this model, bureaucracies expand in small, inconspicuous steps according to the annualised budget and try to push through more extensive budget requests every year. Time constraints (and power structures), coupled with the information asymmetry that favours the administrative bodies in charge of drafting the assessments, prevents the previous year’s expenditure level from being called into question and used as a ‘basis’; instead, it is used as a starting point. As a result, budgetary expansion exhibits an irreversible ‘staircase effect’. The intensity of this effect is reinforced by the fact that, as the bureaucracy grows, control over it declines.33 It thus becomes even more capable of pushing through its requests, and control costs continue to rise. Other grounds for the ‘law of increasing administration’ essentially correspond to those for the ‘law of increasing state expenditure’.34 Both phenomena appear to have lost their empirical basis in recent years, however, as the growth of administration and the growth of state activities have slowed (and partly reversed). This is probably due to pressure on the income side of the budget, which results in a shift towards a ‘lean state’.

29

Stephenson (2010), pp. 292 ff., with examples from US legislation. Cf. Stephenson (2010), pp. 294 ff. 31 Parkinson (1957). 32 For an overview and a critique, see Blais and Dion (1990). 33 Mueller (2003). 34 See Sect. 5.2.2.1 below. 30

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4.1.2.3 The Hierarchical Structure of Bureaucracies and the Principal-Agent Problem The external relationship between bureaucrats and politicians and ultimately voters can be characterised as a multi-level principal-agent relationship.35 The voter is the (original) principal the politician is Agent I (and Principal II); the senior bureaucrat is Agent II (and Principal III); and the executive bureaucrat is Agent III. In certain cases, a bureaucrat may be the agent to multiple principals, such as a superior, the parliament (legislature) and a court.36 In the relationship between the legislature and the executive, the legislature, like any other principal, must decide (1) how extensively to delegate decisions to the administration or make these decisions itself and (2) how intensively—and by what means—to monitor the loyalty displayed by the administration. The first question concerns why and how the legislature delegates decisionmaking authority to the administration.37 This delegation can be explicit or implicit. It is explicit when legal statutes merely set out general objectives and authorise the government, a ministry or an agency to legislate more precise rules and regulations to achieve the purpose of the statute (‘delegated legislation’). It is implicit when the statutes contain gaps and ambiguities that must be filled in before the statute is implemented in concrete decisions (‘delegation through statutory imprecision’ or ‘interpretive delegation’).38 There are good reasons for the legislature to delegate a large portion of its decision-making authority to the administration. Explicit delegation of legislative power is necessary to a certain extent because the legislators in parliament lack specific expertise; in addition, regulating all details at this level in advance would be costly and time-consuming, because it is difficult for the parliamentary legislature (as a collective body) to anticipate and resolve all possible questions regarding the proper scope and application of a statute.39 Constitutions typically make generous allowance for explicit delegation (the non-delegation doctrine derived from Article 1 of the US Constitution provides one example).40 In Germany, Article 80 GG sets out strict conditions for the delegation of decision-making powers to avoid repeating the problems of past eras (the Ermächtigungsgesetz delegated nearly unlimited legislative power to the Nazi government at the end of the Weimar Republic). Implicit delegation is (also) necessary because of the extreme complexity of economic and social systems. Appropriate decisions in individual cases can only be made by a functionally differentiated administration, which has better information

35

See, e.g., Cooter (2000), pp. 80 ff., and McNollgast (2007), pp. 1703 ff.; see also Sect. 1.2.3.5 above. 36 On this aspect, see Cooter (2000), pp. 158 ff. 37 See Cooter (2000), chap. 4, and McNollgast (2007), pp. 1698 ff. In Parisi and Fon (2009), pp. 9 ff., this issue is discussed in the context of ‘standards vs rules’. 38 Cf. Stephenson (2010), pp. 286 ff. 39 Stephenson (2010), p. 287. 40 See Stephenson (2010), pp. 291 ff.; Gersen (2010), pp. 344 ff.

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about the link between policy choices and actual outcomes.41 In addition, the separation of powers established by the constitution permits the legislature to take administrative decisions only in exceptional cases. The question of delegation is therefore more relevant in a qualitative sense, particularly with regard to techniques for regulating the tension between the obligations of the administration and its decision-making authority. Thus, the legislature can make a binding decision to restrict the administration’s decision-making powers or expand the scope of its authority by granting margins of appreciation and room for manoeuvre in taking decisions.42 Ultimately, the details of creating public goods can only be specified on-site. It is therefore not desirable to completely limit opportunities for action of the ‘agent’ (i.e. the administration). On the other hand, more specific legal parameters ensure greater legal certainty. In addition to these constitutional aspects, there are of course arguments for and against delegation that are rooted in the preferences of the legislature. For example, the legislature may consider that agencies are (more) insulated from political influence (‘policy insulation hypothesis’) or may wish to take credit for handling a problem (in general) while shifting the blame to the administration for burdensome decisions on the details (‘credible-commitment hypothesis’ or ‘blame-shifting hypothesis’).43 The second question is particularly significant in this context: how can the legislature ensure that the administration will be loyal to the law when reaching its decisions (a classic agency problem)? It would be insufficient to point out that, in a parliamentary system, attention focuses mainly on the conflict between the government and the opposition, even though (as under the German Basic Law) the government is dependent on the majority’s confidence in parliament. It would also be an oversimplification, of course, to refer only briefly here to the binding force of law and statute (guaranteed in Germany, for example, under Article 20(3) GG). One of the tasks of administrative law is to realise this principle in practice; the function of administrative law is not only to secure individual freedoms from state power, but also to enforce legislative political control of the bureaucracy.44 Through the design of administrative law, the legislator is able to influence implementation with regard to the organisation and process (‘structure and process theory’).45 It is important to note that the legislature must define the basic principles of administrative organisation. The administration has traditionally had a hierarchical structure that relies on a system of direct, vertical orders and supervision; irregularities can be identified and corrected through statutory supervision. Alternatively, the legal system can grant greater independence or rights to

41

Stephenson (2010), pp. 287 ff. See Cooter (2000), pp. 90 ff., on the economic criteria for this decision. D’Alberti (2010), pp. 68 ff., observes a recent trend towards less administrative discretion. 43 See the detailed discussion in Stephenson (2010), pp. 288 ff. and further reference. 44 Mashaw (2012), p. 36. 45 For further detail, see Gersen (2010), pp. 339 ff. and further reference. 42

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self-administration and compensate for the relaxed control with other guarantee mechanisms (for the correctness of the decision), such as referral to interested parties (chamber system) or stakeholders (e.g. media companies). Independent agencies represent a special case: their relative independence from government is only justified by expert knowledge, which greatly conflicts with principles of democratic legitimation. Still, their field of application is growing, especially in the context of central banks and (above all) in the administration of monopolistic infrastructure.46 Finally, in the relationship between the legislature and the administration, mechanisms of control and monitoring have also been further developed and refined. The main focus is on mechanisms of control that ensure the large-scale realisation of legal objectives while taking into account the interests of the administration. In this respect, Niskanen has reconceptualised the relationship between policy and administration as a system of exchange that provides a reciprocal flow of favours and rewards.47 Here, as in large commercial enterprises, a central question is how to create a positive ‘corporate identity’ in the adminstration. In Europe—unlike in the US, for example—loyalty is sought to a lesser extent through an exchange of employees for others loyal to the government. Instead, the dominant approach in Europe, especially in Germany, is to confer privileges (permanent civil-servant status or privileges derived from the ‘traditional principles of the professional civil service’, according to Article 33(5) GG). Another approach to improve control of the administration is the concept of New Public Management. This combines leeway and official accountability with sanctions and rewards in order to persuade the administration to instrumentalise its decision-making authority in the interest of the ‘principal’. Increases in efficiency, for example, are to be achieved through the introduction of global budgets and costperformance analyses. Traditionally, the ‘output’ of the administration, which is oriented towards the common good, has been viewed as incapable of being measured or monetised; ‘benchmarking’, or market-like categorisation of the output into ‘products’ or ‘product groups’, is intended to create incentives and enable comparison.48 Finally, legislators can greatly influence the implementation of statutes by regulating administrative procedure. This can be done by providing targeted access to interest groups, prescribing more or less transparency, expanding or limiting the administration’s access to information, expanding or limiting access to courts, or introducing formal procedures of another kind.49

46

Cf. Rose-Ackerman (2012), chap. 31, III (679 ff.); Halberstam (2010); Shapiro (2010), for a comparison of independent agencies in the US and Europe. 47 Niskanen (1975). 48 Eriksson (2016), pp. 332 ff. 49 Cf. Gersen (2010), pp. 339 ff.; McNollGast (2007), p. 1687 and 1689 (participation of interest groups); Barnes (2010) regarding recent tendencies in administrative procedures.

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Regulation

Regulation is central to theories of state decision-making.50 Here, regulation is used in a narrower sense to denote targeted state influence on individual behaviour.51 Regulation has been explored within different branches of science and on various conceptual bases. In economics, regulation is understood to mean state intervention to limit market mechanisms or take over market functions in the absence of a market. This ‘economic regulation’ is often contrasted with ‘social regulation’, which refers to state control by law in the common good.52 But regardless of the specific basis for analysis, the issue of regulation can only be addressed satisfactorily with an interdisciplinary approach; thus, the economic theory of regulation does not preclude a complementary application of other approaches in individual cases.53 All of these theories of regulation have a common characteristic: they do not describe regulation only in terms of the regulator and the regulated, as is evident on a conceptual level from the interdisciplinary approach of governance research.54 This area of analysis, which originated within economics and was primarily developed by Williamson,55 recognises the central role of networks of actors and (collective and bounded-autonomy) organisations in implementing regulation. Market failure is addressed less by unilaterally setting norms than by managing interdependencies, which necessitates increasingly differentiated forms of regulation. The emphasis is on the coordinated interactions of actors in markets and in various state, social and supranational organisations.56 But even in these multipolar governance approaches, and in corresponding concepts of jurisprudence based on control theory, modern economics continues to view law as a control resource for remedying market and state failure.57 Economic decision theory, which has a long history,58 still plays a key role in this context, but it must be adapted to increasingly complex network structures. Especially in the context of regulatory issues, it seems important to distinguish between positive and normative approaches. The positive analysis of regulation is used to analyse why and in what form regulations are implemented and what effects this has in practice.59 The normative analysis of regulation examines what constitutes ‘good

50

On this point, see Morgan and Yeung (2007); Baldwin et al. (2011). On different definitions of regulation, see Morgan and Yeung (2007), pp. 3 ff. 52 On this distinction, see, e.g., Windholz and Hodge (2013). 53 For a good overview, see Morgan and Yeung (2007), Ch. 2. 54 See the articles in Ansell and Torfing (eds) (2016). 55 Williamson (1996), Williamson (1984). 56 Cf. Ansell and Torfing (eds) (2016). 57 See, e.g., Hussein et al. (2019). 58 See, e.g., Gilboa (2010). 59 See Sects. 4.2.1–4.2.3 below. 51

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governance’.60 Cooperation between various disciplines is also an element of the normative perspective.

4.2.1

Key Concepts

4.2.1.1 Regulation as a Public Good Since the publication of a landmark article by George J. Stigler,61 interaction between the regulator and the regulated has been analysed specifically from the perspective of the New Political Economy. Regulation is intended to eliminate market failures and thus contributes to the production of public goods. Regulation itself can also be seen as a public good, because no one can be excluded from the positive effects of regulation in a constitutional state.62 Traditional theory contends that this good is offered to citizens and voters at a certain price (mainly taxes). The phenomenon of state failure,63 which is particularly relevant in this area, can offer more specific insight into how the ‘supply’ of regulation as a public good is balanced with ‘demand’. It then becomes clear that those subject to regulatory measures have an enormous interest in influencing regulation and the associated allocation of resources. 4.2.1.2 The ‘Regulation Market’ The New Political Economy suggests that regulation involves various actors, each with their own specific interests. Stigler64 has described this situation as a ‘regulation market’ in which the regulators, acting as suppliers, interact with the regulated (consumers).65 This refers to a political market in which regulation is provided as a public good. In a somewhat broader sense, regulation can be understood as a playing field on which different actors come together and catalyse the development of regulation. The playing field is bounded by a ‘border’ of external requirements, which stem from sources including constitutional law, cultural traditions and socioeconomic or socio-ecological conditions. On the field, people engage in competition, negotiation or exchange to maximise their own benefits from regulation. The behaviour of regulators is a central focus of regulatory theories.66

60

See Sect. 4.2.4 below. Stigler (1971). 62 See Cowen (1992) for a contrast with theories of anarachy; Behrens (2009), pp. 49 ff. 63 For an introduction, see Sect. 1.2.3.7 above. 64 Stigler (1971); see Posner (1974), p. 335. 65 For models regarding supply and demand on the regulatory market, see Stearns et al. (2018), pp. 446 ff. 66 For an overview of relevant theories, see Windholz (2017), pp. 45 ff., 52 f. 61

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4.2.1.3 The ‘Regulatory Cycle’ Regulation is not an isolated event; it is better described as a process. The political cycle can be subdivided into several distinct stages: the identification of the need for regulation, definition of regulatory objectives, development of a legal regime, implementation of that regime and monitoring of compliance.67 In identifying the need for regulation, positive analysis can be used to explain how the appropriate agenda is developed.68 A normative analysis of this topic must consider the economic justification for state tasks.69 With regard to the regulation itself, it is important to identify the actors involved.70 These may be the decision-makers themselves (see Sect. 4.1) or entities who in some way influence the regulation, such as those subject to the regulation (capture theory), interest groups or other actors in the social sphere.

4.2.2

Capture Theory and Interest Groups

The earlier discussion of interest groups already mentioned that such groups seek legislation that benefits them, a process called ‘rent seeking’.71 This concept was initially developed in the field of political science as part of a more general theory of regulation.72 Marver H. Bernstein,73 in particular, highlighted the special influence of regulated entities in ‘capture theory’: entrepreneurs, industries and occupational groups are able to ‘capture’ and use ‘their’ regulators for the purposes of their own special interest group. This practice applies not only to particular regulated companies (e.g. providers of infrastructure for railways, energy grids, telecommunications or postal services in relation to regulatory agencies), but also in a more general sense. Bernstein explains that, over time, the regulators and the regulated (usually unconsciously and unknowingly) develop ‘cozy relationships’, which leads the thoughts and actions of regulated entities to have a greater and greater effect on the behaviour of the regulators.74 Economics has essentially adopted this approach. The theory nevertheless faces some criticism, not only for its use of somewhat militaristic terminology, but also for its one-sided perspective.75 Critics have also argued that political science does not provide a convincing theoretical foundation—a foundation that economics can

67

Cf. Lyon (2007), introduction, 1 ff. This is an important area of political science research. See, e.g., Knill and Tosun (2012), pp. 97 ff. 69 See Sect. 2.3 above. 70 See Baldwin et al. (2011), Ch. 5, for a detailed discussion. 71 See Sect. 3.3.2.2 above. 72 See, e.g., Posner (1974), pp. 341 ff. 73 Bernstein (1955). 74 For evidence regarding the US, see Wiener and Richman (2010), pp. 374 ff., which shows the concept of rent seeking can explain even the deregulation policies of the 1980s and 1990s. 75 See, e.g., Posner (1974), pp. 341 f. 68

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provide with the multipolar concept of a ‘regulation market’, in which supply interacts with demand for regulation. This dynamic was apparent, for example, in the development of environmental regulation, from command-and-control policies to economic instruments: the process was influenced by the regulated industry and by environmental organisations, which eventually changed their position on what policies should be defined in the public interest.76

4.2.3

Legal-Impact Research

4.2.3.1 Methodological Foundations In modern societies, law is not primarily an end in itself, but a means to an end. Roscoe Pound (1870–1964), a prominent figure in the field of sociological jurisprudence,77 coined the term ‘social engineering’ to describe the role of law as an instrument that attempts, on an ever-larger scale, to increase control over behaviour in the public interest. There has been considerable scientific interest in examining the effects of law—that is, in legal-impact research.78 Analysis in this field explores whether and to what extent intended goals are met and negative side effects are avoided. These questions can only be addressed satisfactorily in collaboration with other disciplines. Among these, sociology has traditionally played a central role. The importance of legal dogmatics in this context should not be overlooked, however; whether and to what extent the law achieves the desired effects can only be determined if the purpose of each law has been identified. This is a well-known function of jurisprudence, and not a trivial one. Of course, legal economics can also make an important contribution to legalimpact research. The assumption of rational behaviour can be used to formulate hypotheses about the reactions of entities that are subject to legislation. The New Political Economy also considers how the behaviour of legal professionals (Max Weber’s Rechtsstab) affects the realisation of the various objectives of law. The phenomenon of bounded rationality79 plays a greater role in legal-impact research than in virtually any other context. The considerable influence of anthropological, cultural and social factors on the reactions of legal subjects has already been established.80 An orientation to sanctions is therefore only one of many elements that motivates adherence to norms. Identification refers to the compliance with norms

76

See evidence and references in Wiener and Richman (2010), pp. 374 ff. Pound (1907), Pound (1909), Pound (1942). 78 See, e.g., Rodi (2002); Friedman (2016). 79 See Sect. 1.2.2.2.3.2 above. 80 Legal sociology categorises these as effectiveness factors in the sphere of norm-setting (e.g. intelligibility or consistency of the legal order) and in the sphere of norm enforcement (supply of human and material resources, self-reinforcing tendencies of authorities, variable enforcement in different federal states). On this typology, see Ryffel (1974), pp. 259 ff. 77

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that occurs when individuals orient their behaviour towards that of reference groups or specific role models. Geiger has argued in this context that norms are effective because of social interdependence.81 Similarly, Eugen Ehrlich observed that ‘man acts according to law first and foremost because social relations require it.’82 This position may seem overstated today in light of society’s increasing pluralism and the dwindling role of social groups as forces of order (e.g. the church, trade unions), but the essence of the argument still holds. Legal sociology also recognises internalisation (‘moral orientation’) as a motivation for adherence to norms. In such cases, those governed by norms (‘norm addressees’) act in a self-directed manner and comply with their own sense of justice (regardless of state surveillance or the compliance of others). Here, observance of norms is based on acceptance – that is, on the perception of a law’s legitimacy and thus the subjective reflection of the law in the mind. The predominance of cognitive, rational elements in this context is referred to as ‘legal consciousness’, while the predominance of emotional and irrational elements (‘intuitive perspective on legal questions’) is referred to as a ‘sense of justice’. The application of these principles to tax morale has been the subject of extensive debate in economics.83 The starting point for such discussions is the observation that tax morale is often inconsistent with traditional assumptions of ‘optimal’ or ‘rational’ tax evasion. In these cases, tax morale is higher than could be explained by the fear of sanctions alone. Evidence has shown that tax morale is higher when taxpayers are more convinced that the state’s actions are reasonable and legitimate. Parisi and von Wangenheim,84 following on work by Cooter, have developed an economic model substantiating the argument that the effectiveness of law is jeopardised if legal rules stray too far and too abruptly from social norms. If the law aligns with social norms, it is perceived as legitimate. When the content of the legal rules departs only slightly from these norms, the norms may adjust to a certain extent. Departing from the norms too dramatically, however, will strengthen people’s motivation to disregard it deliberately and in some cases with open protest (‘civil disobedience’). This reinforces social norms that are in violation of the law. The prohibition laws in place in the US between 1920 and 1932 illustrate this effect well.85 Pressure from puritanical and conservative groups in the West resulted in the passage of radical anti-alcohol legislation that prohibited the production, transportation and sale of alcoholic beverages. Despite draconian penalties, these measures failed to achieve their objective;86 instead, they led the mafia to flourish in cities on the East Coast.

81

Geiger (1987), pp. 8 ff., 40 ff. Ehrlich (1989), p. 65. 83 See Sect. 5.3.1.4.3.2 below. 84 Parisi and von Wangenheim (2006). 85 See Cotterell (1992), pp. 55 f.; Blocker (2006). 86 Violators faced fines of up to $10,000 and prison sentences of up to five years (possibly in combination), as well as the seizure of transport vehicles and buildings in which alcohol was 82

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4.2.3.2 Control by Procedure Niklas Luhmann, in particular, has called attention to the sizeable influence of procedure on the outcome of a decision.87 From the perspective of law and economics, this presents procedural rules as an option for solving agency problems.88 For example, extensive participation in environmental approval procedures (e.g. in immission control law or nuclear legislation) serves to improve the outcome of the decision. In law, however, procedural issues also affect acceptance and thus the effectiveness of law. Van Aaken outlined a ‘deliberative institutional economics’89 based on this effect: homo economicus is evolving into a homo rationalis communicans. A fair decision-making process, with elements of transparency and participation, makes it much more likely that rules will be followed.90 4.2.3.3 Regulatory Impact Analysis, Evaluation and Amendment of the Law The objective of regulation is to control behaviour. Whether and to what extent a regulation succeeds (i.e. achieves its intended effects without producing undesirable side effects) is thus central to any theory of regulation. An ex-post evaluation may be required by law. Under constitutional law, it may be necessary to examine whether a law still serves its original purpose or must be amended to protect basic rights. In addition, ordinary laws with evaluation clauses can mandate ex-post reviews.91 In practice, an (ex-ante) evaluation of the effects of proposed legislation, or regulatory impact analysis, is even more important.92 In recent decades, a new actor has been established for this purpose: regulatory oversight bodies (ROBs). ROBs are generally situated in the executive (and sometimes legislative93) branch of government.94 Because the use of empirical data is less feasible in the context of ex-ante than ex-post evaluations, economics plays a comparatively greater role in regulatory impact analysis.95 produced or sold. This resulted in 750,000 arrests, over $75 million in fines, and seizure of property totalling $205 million between 1920 and 1932. 87 Luhmann (1978), pp. 219 ff. 88 See, e.g., Cooter (2000), pp. 164 f. 89 Van Aaken (2007), pp. 85 ff. 90 See also Rose-Ackerman and Lindseth (2010), pp. 680 ff., which shows that this mainly reflects legislative practice in continental Europe and is more contested in the US and UK. 91 On the tendency to institutionalise legislative evaluations in Europe, see Weber et al. (2017). 92 On issues related to regulatory impact analysis, see, e.g., Carroll (2010). 93 An important example is the Conseil d’État in France, which has acted as an ROB since the French Revolution. 94 For further detail, see Wiener and Alemanno (2010), which focuses on the US Office of Information and Regulatory Affairs and the EU’s Impact Assessment Board. 95 For an economic perspective on systematic approaches to regulatory impact analysis, see Bizer and Gobaydullina (2007).

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4 Theory of State Decision-Making

‘Good Governance’

The content of ‘good governance’ cannot, of course, be determined scientifically. In fact, any effort by science to ‘dictate’ how lawmakers should legislate would be incompatible with the principles of democracy. It is, after all, the task of the democratically legitimised legislature to determine which public interest issues should be pursued and to balance these interests in a way that it considers appropriate. Nevertheless, it is possible to use scientific evidence to translate the concept of ‘good governance’ into concrete measures.

4.2.4.1 ‘Good Governance’ as an Interdisciplinary Challenge The issue of ‘good regulation’96 is necessarily an interdisciplinary one. Many different fields—above all political science, law and economics—can make valuable contributions. The role of normative economics is also not insignificant in this context. Of all the principles of jurisprudence, compatibility with higher-level law— which, in the European legal system, refers to constitutional or supranational law—is of course among the most important. In light of the considerable transaction costs and questions of political feasibility, whether or not a constitutional amendment is necessary for a legislative proposal makes a crucial difference. This is increasingly the case for modifications to European law, since these are largely outside the control of the national legislature. Falling within a legal ‘grey area’ in terms of conformity with European and constitutional law must at least be considered a disadvantage of proposed measures. Where empirical issues are concerned, factors such as the effectiveness of the law can be classified as questions of political science. (Regulatory impact research, however, is also a topic in law and economics, as discussed above.) Criteria like administrability, transparency, clear allocation of responsibility, expertise of the decision-makers and acceptance also play a role.97 A classic economic issue is that of efficiency,98 as evaluated in a cost-benefit analysis of goal attainment and overall economic costs.99 An exciting new topic is ‘dynamic efficiency’, which explores the effects of regulation on innovation.100 As discussed above, another important question is how various forms of market failure can most effectively be addressed.101

96

See, e.g., Baldwin et al. (2011), chap. 6. For an overview of the current literature, see Haines (2011), pp. 12 ff. 98 See Margolis (1987) for two definitions of efficiency in law. 99 This concept is based on a positive interpretation of efficiency. On the distinction between this and a normative interpretation, see Sect. 1.2.1.3 above. 100 See Kathuria (2015), regarding competition law. 101 For examples related to environmental policy, see Sect. 7.1.1 below. 97

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4.2.4.2 Diversity and Combination of Policy Instruments One problematic aspect of regulation through law is the choice of policy instrument. It is also challenging to select an appropriate combination of instruments from the diverse options available.102 Economic research, in particular, has contributed significantly to a differentiation of these various instruments. Forms of incentive regulation and self-regulation have emerged as alternatives to traditional regulatory law (command and control). This issue will be explored in greater detail later in connection with environmental policy.103 Because most regulatory problems cannot be solved with only one instrument, the legislature frequently combines several instruments. Combined instruments should work together to achieve set targets as well as possible without counteracting one another’s effects. Of course, there will never be a perfect design; in the creation of optimal policy, the challenge is to minimise market failure and government failure.104 To date, the issue of optimal instrument combination has not received sufficient attention from any of the relevant scientific disciplines.

4.3

Summary

The rational behaviour model is applied in the context of individual groups of policymakers (i.e. politicians and officeholders), exposing their special interests and the information asymmetries that exist in their relationship to citizens. The legislature must take these factors into account when regulating administration and administrative procedures. Smart approaches reflect alternatives (e.g. regulation by public or private law; hierarchical administration, self-administration or New Public Management). Regulation is interpreted as a public good in its own right, with suppliers and consumers interacting in a ‘regulation market’. The specific role of interest groups is analysed using ‘capture theory’. Economics contributes significantly to legal-impact research (ex ante) and thus to regulatory impact analysis. Procedure is identified as a specific factor in success. In this context, ‘good governance’ is described as a challenge of positive economics above all, although interdisciplinarity also plays an important role. In material terms, the goal is to create an instrument combination that has the ‘optimal’ legal effect.

102

Cf. Rodi (2000), pp. 236 ff. See Sect. 7.2.5 below. 104 Cf. Wiener and Richman (2010), p. 364. 103

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References Ansell C, Torfing J (eds) (2016) Handbook on theories of governance. Edward Elgar Publishing, Cheltenham Baldwin R, Cave M, Lodge M (2011) Understanding regulation. Theory, strategy, and practice, 2nd edn. Oxford University Press, Oxford Barnes J (2010) Towards a third generation of administrative procedure. In: Rose-Ackerman S, Lindseth PL (eds) Comparative administrative law. Edward Elgar Publishing, Cheltenham, Ch. 20 p. 336f Behrends S (2001) Neue Politische Ökonomie. Systematische Darstellung und kritische Beurteilung ihrer Entwicklungslinien. Vahlen, München Behrens P (2009) Economic law between harmonization and competition: the law & economics approach. In: Meessen (ed) Economic law as an economic good. Its rule function and its tool function in the competition of systems. Sellier European Law Publishers, Munich, pp 45–60 Bernstein MH (1955) Regulating business by independent commissions. Princeton University Press, Princeton Bizer K, Gobaydullina Z (2007) Das Verhaltensmodell der interdisziplinären Institutionenanalyse in der Gesetzesfolgenabschätzung. In: Führ M, Bizer K, Feindt PH (eds) Menschenbilder und Verhaltensmodelle in der wissenschaftlichen Politikberatung. Möglichkeiten und Grenzen interdisziplinärer Verständigung. Nomos, Baden-Baden, pp 37–51 Blais A, Dion S (1990) Are Bureaucrats budget maximizers? The Niskanen model & its critics. Polity 22:655–674 Blocker JS (2006) Did prohibition really work? Alcohol prohibition as a health innovation. Am J Public Health 96:233–243 Bonk HJ (2000) Rechtliche Rahmenbedingungen einer Privatisierung im Strafvollzug. JZ:435–442 Carnis L (2009) “He who is unfit to serve his fellow citizens wants to rule them”: the political dimensions of mises’ theory of bureaucracy. Journal des économistes et des études humaines (2011) 17:1–14 Carroll P (2010) Does regulatory impact assessment lead to better policy? Policy Soc 29:113–122 Cooter RD (2000) The strategic constitution. Princeton University Press, Princeton Cotterell R (1992) The sociology of law. An introduction. Butterworth, London Cowen T (1992) Law as a public good: the economics of anarchy. Econ Philos 8:249–267 D’Alberti M (2010) Administrative law and the public regulation of markets in a global age. In: Rose-Ackerman S, Lindseth PL (eds) Comparative administrative law. Edward Elgar Publishing, Cheltenham, Ch. 4, pp 63 f Dabbah MM (2010) International and comparative competition law. Cambridge University Press, Cambridge Downs A (1965) Non-market decision making. A theory of bureaucracy. Am Econ Rev Pap Proc 55:439–446 Downs A (1968) Ökonomische Theorie der Demokratie. Mohr Siebeck, Tübingen Downs A (1994) Inside Bureaucracy. Little Brown, Boston. Also: prospect heights. Waveland Press Dylla DW (2008) Eine ökonomische Analyse der Mediendemokratie. Der Rational-Choice-Ansatz und die Stimmenmaximierung. Verlag für Sozialwissenschaften, Wiesbaden Ehrlich E (1989) Grundlegung der Soziologie des Rechts. Duncker & Humblot 1913, 4th edn. München et al; Duncker & Humblot, Berlin Eriksson L (2016) Public choice theory. In: Ansell C, Torfing J (eds) Handbook on theories of governance. Edward Elgar Publishing, Cheltenham, pp 322–339 Friedman LM (2016) Impact. How law affects behavior. Harvard University Press, Cambridge Geiger T (1987) Vorstudien zu einer Soziologie des Rechts. In: Rehbinder M, Geiger T (eds) (1987) Vorstudien zu einer Soziologie des Rechts, 4th edn. Duncker & Humblot, Berlin Gersen JE (2010) Designing agencies. In: Farber DA, O’Connel AJ (2010) Ch. 10 p 333 f Gilboa I (2010) Questions in decision theory. Ann Rev Econ 2:1–19

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Haines F (2011) The paradox of regulation. What regulations can achieve and what it cannot. Edward Elgar Publishing, Cheltenham Halberstam D (2010) The promise of comparative administrative law: a constitutional perspective on independent agencies. In: Rose-Ackerman S, Lindseth PL (eds) Ch. 12, pp 185 f Hussein DS, Jermsittiparsert K, Ahmad P (2019) The importance of the rule of law in governance. J Raparin Univ 6:73–90 Kathuria V (2015) A conceptional framework to identify dynamic efficiency. Eur Compet J 11: 319–339 Kirchgässner G (2008) Homo oeconomicus. The economic model of behavior and its applications in economics and other social sciences. Springer, New York Kirchgässner G (2013) On the political economy of public deficits and debt. German Econ Rev 15: 116–130 Kirsch G (2004) Neue Politische Ökonomie, 5th edn. Lucius & Lucius, Stuttgart Knill C, Tosun J (2012) Public Policy: a new introduction. Palgrave Macmillan, Basingstoke, Hampshire et al Kolstad CD, Ulen TS, Johnson GV (1990) Ex post liability for harm vs. ex ante safety regulation: substitutes or complements? Am Econ Rev 80:888–901 Lagona F, Padovano F (2008) The political legislation cycle. Public Choice 134:201–229 Luhmann N (1978) Legitimation durch Verfahren. Luchterhand, Darmstadt u. a. 3rd edn. Thomas P (ed) (2007) The political economy of regulation. Edward Elgar Publishing, Cheltenham Lyon TP (ed) (2007) The political economy of regulation. Edward Elgar Publishing, Cheltenham Margolis SE (1987) Two definitions of efficiency in law and economics. J Legal Stud 16:471–482 Mashaw JL (2012) Public law and public choice: critique and rapprochement. In: Farber DA, O’Connel AJ (eds) Ch. 1 p 19 f McNollGast (Akronym für Cubbins MD, Noll RG, Weingast BR) (2007) The public economy of law. In: Polinski AM, Shavell S (eds) Handbook of law and economics, vol 2. North Holland, Amsterdam et al., pp 1651–1738 Morgan B, Yeung K (2007) An introduction to law and regulation. Text and materials. Cambridge University Press, Cambridge Mueller DC (2003) Public choice III. Cambridge University Press, Cambridge Niskanen WA (1968) Nonmarket decision making: the peculiar economics of bureaucracy. Am Econ Rev 58:293–305 Niskanen WA (1975) Bureaucrats and politicians. J Law Econ 18:617–643 Niskanen WD (1974) Bureaucracy and representative government, 2nd edn. Aldine Transaction, Chicago Nordhaus WD (1975) The political business cycle. Rev Econ Stud 42:169–190 Parisi F, Fon V (2009) The economics of lawmaking. Oxford University Press, Oxford Parisi F, von Wangenheim G (2006) Legislation and countervailing effects from social norms. In: Schubert C, von Wangenheim G (eds) Evolution and design of institutions. Routledge, London et al., pp 25–55 Parkinson NC (1957) Parkinsońs law: and other studies in administration. Cambridge (The Riverside Press). German: Parkinsons Gesetz und andere Untersuchungen über die Verwaltung. Econ, Düsseldorf Posner RA (1974) Theories of economic regulation. Bell J Econ Manage Sci 5:335–358 Posner RA (2011) Economic analysis of law, 8th edn. Aspen Publishers, New York Pound R (1907) The need for a sociological jurisprudence. In: Gale T (ed) The making of modern law. Farmington Hills, Mich, pp 607–615 Pound R (1909) Mechanical Jurisprudence. Farmington Hills, Mich Pound R (1942) Social Control Through Law. Arcon, Hamden, Conn Rodi M (2000) Die Subventionsrechtsordnung. Die Subvention als Instrument öffentlicher Zweckverwirklichung nach Völkerrecht, Europarecht und deutschem innerstaatlichen Recht. Mohr Siebeck, Tübingen

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Rodi M (2002) Recht und Wirkung. Greifswalder Beiträge zur Rechtswirkungsforschung. Carl Heymanns Verlag, Köln u. a., pp 1669 Rose-Ackerman S (2012) The regulatory state. In: Rosenfeld M, Sajó A (eds) Oxford handbook on comparative constitutional law. Oxford University Press, Oxford, pp 671–688 Rose-Ackerman S, Lindseth PL (eds) (2010) Comparative administrative law. Edward Elgar Publishing, Cheltenham Ryffel H (1974) Rechtssoziologie: Eine systematische Orientierung. Luchterhand, Neuwied et al Serpa S, Ferreira CM (2019) The concept of bureaucracy by Max Weber. Int J Soc Sci Stud 7:12–18 Martin Shapiro (2010) A comparision of US and European agencies. In: Rose-Ackerman S, Lindseth LP (2010) Comparative administrative law. Edward Elgar Publishing, Cheltenham pp. 293-306 Stearns ML, Zywicki TJ, Miceli TJ (2018) Law and economics: private and public. West Academic Publishing, St. Paul Stephenson MC (2010) Statutory interpretation by agencies. In: Farber DA, O’Connel AJ (eds) Research handbook on public choice and public law. Edward Elgar Publishing, pp 285–332 Stigler GJ (1971) The theory of economic regulation. Bell J Econ Manage Sci 2:3–21 Ulen TS (2007) The future of law and economics. In: Cafaggi F, Nicita A, Pagano U (eds) Legal orderings and economic institutions. Routledge, London et al., pp 21–45 Van Aaken A (2007) Recht und Rechtsanalyse - welches Modell menschlichen Verhaltens braucht die Rechtswissenschaft? In: Führ M, Bizer K, Feindt PH (eds) Menschenbilder und Verhaltensmodelle in der wissenschaftlichen Politikberatung. Möglichkeiten und Grenzen interdisziplinärer Verständigung. Nomos, Baden-Baden, pp 70–95 Weber M, Edwards N, Huber S (2017) EU review clauses in need of review? An analysis of review clauses in EU legislation in the context of better lawmaking. Eur J Risk Regul 8:121–139 Wiener JB, Alemanno A (2010) Comparing regulatory oversight bodies across the Atlantic: the office of information and regulatory affairs in the US and the impact assessment board in the EU. In: Farber DA, O’Connel AJ (eds) Research handbook on public choice and public law. Edward Elgar Publishing, Cheltenham, pp 309–355 Wiener JB, Richman BD (2010) Mechanism choice. In: Farber DA, O’Connel AJ (eds) Research handbook on public choice and public law. Edward Elgar Publishing, Cheltenham, pp 363–396 Williamson OE (1984) The economics of governance: framework and implications, Zeitschrift für die gesamte Staatswissenschaft. J Inst Theoret Econ 140:195–223 Williamson OE (1996) The mechanisms of governance. Oxford University Press, New York et al Windholz EL (2017) Governing through regulation. Public policy, regulation and the law. Routledge, London Windholz EL, Hodge G (2013) Conceptualising social and economic regulation: implications for modern regulators and regulatory activity. Monash Univ Law Rev 38:212–237

Part II Focus Areas

5

Public Finance

In order to apply and demonstrate the methodological principles of economics, we first turn to the field of public finance.1 We begin with this field not only because of the significance of public finance in the modern political system, but also because of the clear interest that economists have always shown in this issue. An analysis of the state budget must consider expenditures and focus in even greater detail on revenue (e.g. taxes and fees, national debt).

5.1

State Budget

If we consider finances to be the state’s ‘nervous system’ (Bodin), the state budget represents the ‘control centre’ where basic decisions are made (or at least where the effects of such decisions are reflected).2 The state budget balances projected state expenditures against anticipated revenue and is generally subject to approval by parliament. State budgets reflect decisions about the scale and structure of expenditures, on the one hand, and the scale and structure of revenue on the other. Ultimately, income must equal expenditures, which is typically accomplished through the line item for ‘borrowing’. From a parliamentary perspective, this process constitutes an important opportunity to determine state’s performance (policy design function) and a central right of control vis-à-vis the administration and state leadership (control function). It is therefore clear why the long struggle by parliament (and, before parliament, by corporate assemblies) to wrest this right from the sovereign is of such historical significance. In England, the Petition of Rights (1628) and the Bill of Rights (1689) prohibited the Crown from imposing taxes without the consent of Parliament. In Colonial America, opposition to taxation by the British Parliament—reflected in the

1 2

See, e.g., Stiglitz and Rosengard (2015), parts 3–6. See, e.g., the articles in Ho et al. (2019).

# Springer-Verlag GmbH Germany, part of Springer Nature 2022 M. Rodi, Economic Analysis of Public Law, Springer Textbooks in Law, https://doi.org/10.1007/978-3-662-66089-8_5

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rallying cry ‘No taxation without representation!’—led to the outbreak of revolution against colonial rule in 1765 and the founding of the United States of America. For administrations, the budget serves above all as a planning tool (planning function). The budget determines the distribution of the government resources for the fulfilment of state tasks. Differences between positive and normative economic problems are also evident in connection with the state budget. It has proved difficult, however, for economics to make assertions about the optimal size of the budget.3 A more realistic approach is to explain how state budget decisions are made,4 for example by introducing the ‘law of increasing state activity’.

5.2

Government Spending

5.2.1

Normative Determination of the Optimal Government Share

For economists, of course, determining the optimal size of the government’s share has always been a (normative) problem of great interest.5 Engagement with this issue makes it possible to determine the scope of the state’s tasks and to make proposals for generating necessary revenue.

5.2.1.1 How Can the Government Share (the ‘Public Spending Ratio’) Be Determined at All? The key economic indicator for the government share is the public spending ratio. This statistic measures the share of government-related expenditures (public spending) to the ‘gross domestic product’ (GDP) and thus indicates the extent of public sector involvement in the overall economy. The public spending ratio is generally defined as the ratio of total public spending to gross domestic product (GDP). Although this definition seems unambiguous enough, it reflects certain value judgements and is thus a subject of dispute. The controversy stems from the fact that, in some cases, the basis for comparison is the gross national product (GNP), while in other cases it is the gross national income (GNI). It is first important to determine how broadly the public sector is defined and, in particular, the types of institutions that should be taken into account. This sector clearly includes purely governmental institutions like local authorities as well as the public sector organisations (‘parafiscal’ organisations, such as social insurance agencies). Other aspects are less certain, however, such as the extent to which public enterprises should also be considered.

3

See Sect. 5.2.1 below. See Sect. 5.2.2 below. 5 See, e.g., Tanzi and Schuknecht (2000). 4

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At a more macro level, it is difficult to accurately determine financial flows. For example, federal financial transfers require particular attention to prevent double counting. In principle, hidden spending like tax credits should be taken into consideration as well, since these are tax instruments equivalent to direct subsidies (a point underscored by the term tax expenditures). As is well known, however, it is extremely challenging to draw a clear distinction between tax subsidies and tax reductions that comply with the system.6 In Western industrialised nations, the public spending ratio as a percentage of GDP ranges from approximately 25% in Mexico or Ireland to over 55% in Denmark, Finland and France.7 Changes in the public spending ratio over time are particularly informative: for example, while the public spending ratio in Germany has declined slightly over the last 20 years (from just under 50% to roughly 45%), it has increased in the US from approximately 37% to around 42%. Thus, the public spending ratios in both Germany and the US have converged from different directions. Evaluations of the ‘optimal’ public spending ratio are especially interesting in this context. Empirical analysis in this field is challenging, however; econometric observations on the relationship between the spending ratio and economic development provide only an approximation.8 Because there is no reliable basis for such assessments from an economic perspective, the question will likely remain a political one.

5.2.1.2 The Theory of Public Goods One starting point for determining an optimal public spending ratio is the theory of public goods.9 Still, this theory can only explain which tasks the state must fulfil. As shown above,10 the economic justification for state tasks is anything but an exact science and is frequently an evaluative question, especially where more peripheral activities are concerned. There is also considerable political leeway in the performance of these tasks, which in turn influences their cost. In light of these uncertainties, it hardly seems possible to identify the size of an ‘optimal’ budget with any accuracy using this approach. 5.2.1.3 The Tax-Price Theory The tax-price theory11 is based on individual preferences: how many benefits would citizens demand from the state and at what cost (tax price)? The demand for state services will increase as long as the ‘marginal utility’ of the service in demand is greater than the ‘tax price’; however, given the variation in the preferences and interests involved, it is almost impossible to answer this question exactly.

6

See Sect. 6.2.2.3.1. OECD, ‘Government at a Glance’, Paris 2021, Figure 2.22. 8 See, e.g., Forte and Magazzino (2014). 9 See Sect. 1.2.3.3 above. 10 See Sect. 2.3.2 above. 11 See, e.g., Zimmermann et al. (2021), pp. 46 ff. 7

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As a result, this approach can (at best) provide only rough indications of an ‘optimal’ budget size.

5.2.2

State Decisions on Government Spending

Budgetary decision-making is one area of research in positive economics that is as promising as it is practically significant. Because revenue finances the expenditures that have been deemed necessary, spending decisions are of primary interest here. Government expenditures are based on collective decisions, which are, in turn, the product of individual preferences; government spending can thus be attributed to individual value judgments.12 It is interesting, in this context, to take an (empirical) look at the historical development of government spending. If we measure total expenditures as a percentage of GDP at market prices or net national product at factor cost, we can observe a continuous increase in government spending in Germany, the UK and the US (among other countries) over the course of the twentieth century. Today, total expenditure is three to five times greater than the 1900 levels of 10–15%; in Germany, government spending currently accounts for nearly 45% of total expenditure. Worldwide, however, public spending ratios have stagnated or even declined slightly in recent decades.13 The law of increasing state activity and its possible causes is discussed in Sect. 5.2.2.1 below. The current phenomenon of stagnation (or decline) is explored in somewhat less detail, although a search for the causes of this phenomenon is illuminating (see Sect. 5.2.2.2).

5.2.2.1 The Law of Increasing State Activity As early as 1876, finance expert Adolph Wagner argued that the growth of the state is disproportionate to that of a country’s overall economic activity in ‘progressive civilised nations’. He presents this argument in the book Grundlegung der politischen Ökonomie [Foundations of Political Economy]:14 increasing industrialisation, he writes, leads to greater complexity in economic transactions. This intensifies the division of labour and increases competition, leading to more complicated transport conditions and legal relations. These conditions, in turn, necessitate an increase in state activity, especially state activity of a preventive nature. This effect is magnified by the indirect consequences of industrialisation: rising population density, increasing urbanisation and greater social conflict prompt the state to implement redistributive measures as more social control becomes necessary. In addition, demand for publicly produced goods like education, medical

12 For an introduction to the economics of government spending, see Stiglitz and Rosengard (2015), parts 3 and 4. 13 For an overview, see, e.g., Ortiz-Ospina and Roser (2016). 14 On ‘Wagner’s law’, see, e.g., Peacock and Scott (2000), pp. 1 ff.

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care and infrastructure demonstrates income elasticity: as the national income rises, so does the demand for such goods and the resources to produce them. For a long time, the research and theory behind the ‘law of increasing state activity’ reflected two main approaches to the topic. First, numerous studies presented empirical tests that generally confirmed the theory.15 Second, various explanatory models were developed to explain the causes of this continuous expansion.16 Some of these will be discussed in greater detail below (voter demand for redistribution, influence of interest groups and bureaucracy, fiscal illusion). Because government spending is based on collective decisions, statements about its development can be made only in the context of the decision-making structures of the respective states. It is therefore important to consider whether decisions are made in a direct or indirect democracy. The discussion below focuses on the (more) typical case of a representative democracy.17 5.2.2.1.1 Voter Demand for Redistribution As Wagner indicates, the ‘social question’ plays a crucial role in the expansion of state activity.18 This ‘driving force’ results from an interaction between the introduction of universal suffrage, on the one hand, and industrialisation, population growth and an increase in the number of low-paid, wage-dependent workers on the other. Subsequent theoretical work substantiated and refined this general principle. This provided support for the argument that the growing demand for state-provided goods and services, as well as that for redistributive measures, could be attributed to the influence of the median voter.19 Parties, which formed as alliances between households with similar economic characteristics, compounded this effect.20 Accordingly, party platforms reflect the median income of party members. The model of vote trading reinforces this effect. Minority groups may join together, resulting in a potentially unstable majority. Coalitions of this kind tend to agree on spending projects that are important to their members. Gordon Tullock was the first to recognise the dynamics of spending that are specific to parliamentary democracies as a result of this phenomenon, which is referred to as vote trading (or ‘logrolling’).21 He pointed out that new opportunities to trade votes arise frequently and that new government disbursements are generated continuously from ‘logrolling carousels’. One criticism of this perspective is that in many political systems, shifting majorities play little role in parliamentary votes taken on various

15

See, e.g., Dollery and Singh (1998) and Jaén-García (2018). For different models, see Hindriks and Myles (2013), 5.3. (123 ff.). 17 Regarding the formation of budgetary decisions in direct democracies, see Wegschal (1987). 18 Paparas and Richter (2019), with later empirical studies. 19 Cf. Corneo and Neher (2015); see also Meltzer and Richard (1981), which provides an early and extensive discussion of the topic. 20 Cf. Schneider (2009), pp. 99 ff. 21 Tullock (1959). 16

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measures. As a result, this theory has little application outside of coalition negotiations. 5.2.2.1.2 The Theory of Interest Groups (M. Olson 1965) and a Model of Lobbying (G.S. Becker 1983) As discussed above, interest groups try to influence the political process and state decisions through ‘rent seeking’.22 Numerous authors, most notably Olson and Becker, specifically address the influence of interest groups and lobby groups on government spending decisions.23 Empirical evidence has demonstrated a positive correlation between interest-group activity and the increase in government spending.24 According to Becker,25 government spending, taxes and regulations are the result of clashing interest-group pressures—as is illustrated, for example, in the conflict between the interests of subsidy recipients and those of taxpayers. Lobbying activity levels off (always with diminishing marginal returns) at a ‘lobby equilibrium’. Specific interests in subsidies typically win out in such cases. Olson emphasised that some interest groups can organise better than others; large groups fare worse, for example, because of the ‘free-rider problem’.26 In addition, certain interests in state funding can consistently be presented to the outside world as public goods. As established above,27 lobby groups are more successful if they can portray their interests as being in the public interest (and thus as public goods). Demands from the teachers’ lobby for more teaching positions will therefore be more successful than its demands for higher wages, and an initiative by the hospital lobby to expand hospitals will succeed over an attempt by the tobacco industry to gain tax breaks. Olson28 also argues that the number and power of interest groups increases over time if institutional conditions remain stable, while periods of upheaval, such as revolutions and wars, tend to break up established interest-group structures. As a result, the number of distributional coalitions and logrolling bargains—and thus the level of government spending—increases (provided that other conditions remain unchanged). The empirical robustness of this particular proposition has been disputed, however. The counterargument is also plausible: in ‘good times’, government revenue grows, and a corresponding increase in ‘good deeds’ can appease interest groups. In times of crisis, on the other hand, an increase in power struggles between

22

See Sect. 3.3.2.2 on interest group activity and Sect. 4.2.2 on regulation. E.g., Mueller and Murrell (1986). 24 See Sobel and Clark (2016), with empirical analysis. 25 Becker (1983), pp. 371 ff. 26 Olson (1965). 27 See Sect. 3.3.2.2 above. 28 Olson (1982), pp. 46 ff. 23

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interest groups may invigorate group activities and strengthen organisational structures.29 5.2.2.1.3 The Influence of the Bureaucracy The earlier discussion of bureaucracy and administration referred to the law of budget maximisation.30 According to this law, bureaucrats seek to maximise material and human resources, benefit from information asymmetries and influence the budget creation process, which contributes to a ‘staircase effect’ in budgetary expansion and an increase in government spending.31 Practical experience and empirical studies show, however, that this effect is frequently overestimated.32 5.2.2.1.4 Fiscal Illusion If the logrolling model and the hypothesis that small interest groups exert relatively large influence are accurate, then why is there no ‘large coalition’ of the disadvantaged (above all taxpayers)? One answer is that politicians and bureaucrats act as ‘political entrepreneurs’ and capitalise on the effects of fiscal illusion.33 Citizens generally believe that the state provides more for them than they provide it in taxes, which encourages an increase in government spending. While services and benefits are highly visible and tend to be rewarded at the ballot box, the effects of tax burdens are frequently less apparent. Under these circumstances, legislators typically rely on less visible taxes, especially indirect taxes.34 Politicians promote and exploit this effect in pursuit of their own interests. In order to minimise anger among voters, they attempt to choose the least conspicuous financing methods. Numerous strategies are available to them for this purpose. First, they can make the tax system as complicated as possible: tax revenue is derived from many sources, which confounds voters and causes them to underestimate their tax burden. Politicians also accept the consequences of a ‘cold progression’, which refers to the increase in taxes that results from the progressive effects of inflation.35 Second, the most visible projects are selected to receive government spending, while less attention is given to ‘invisible’ state services. Third, election dates are systematically included as part of the analysis (in accordance with the theory of the political business cycle36). After an election, it is temporarily possible to act without concern for voter preferences, which creates a kind of transitory autocracy; this period

29

Blankart (2007), chap. 9, C.3. See Sect. 4.1.2.2 above. 31 For an overview, see Ungureanu and Iancu (2012). 32 Stearns et al. (2018), pp. 781 ff. 33 On fiscal illusion as an accelerator of government spending, see Gaber and Gruevski (2019). For a critique of various manifestations of fiscal illusion that serve as a driving force for increasing government expenditures, see Schneider (2009), pp. 42 f. 34 Zamir and Teichman (2018), pp. 470 ff. 35 Cf. Koester (2009), pp. 126 ff. 36 See Sect. 2.2.3.2.3 above. 30

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provides an opportunity to satisfy the demands of interest groups that contributed to the electoral victory. 5.2.2.1.5 Problems with Limiting Government Spending The law of increasing state activity has inspired a growing recognition of the need to impose binding restrictions on the actions of politicians. In practice, however, this proves to be problematic. Difficulties in finding and implementing rules that would limit government spending can be seen as one factor contributing to the increase in government expenditure. This applies to quantitative fiscal limits as well as to procedural limits. 5.2.2.1.5.1 Material Limitations on Government Revenue

In both material and quantitative terms, government spending can be controlled by introducing (constitutional) limits and revenue caps, such as the determination of taxable events, maximum tax rates or limits on the tax ratio (as a percentage of GDP). In the US, for example, Proposition 13 was proposed by the citizens of California to cap property tax at 1% of its value (instead of at 2.5%).37 For several reasons, however, this ‘restrictions approach’ is not suitable for a larger-scale application. The approach is nearly impracticable because there are many opportunities to circumvent it; in particular, the establishment of legally independent government entities (e.g. public utility companies, research institutions, trust agencies) may lead to a ‘departure from the budget’. It would also infringe on the policymaking discretion of the democratically legitimised legislature and would thus hardly be justifiable under constitutional law. In this context, it is interesting to note that more and more constitutions have subjected governments to strict limits on borrowing; in Europe, for example, this has occurred in Austria, France, Germany, Italy, Poland, Spain and (the forerunner) Switzerland.38 It remains to be seen whether these debt limits, unlike previous measures, will be effective and whether restrictions on borrowing will directly curb state spending. 5.2.2.1.5.2 Procedural Restrictions to Limit Government Spending

In addition to quantitative fiscal limitations, various procedural restrictions could potentially limit government spending. In practice, however, the introduction and implementation of any procedural restriction is problematic. One possible measure is a restriction on ‘logrolling’ in parliament. This principle is the basis for Article 113 of the German Basic Law, according to which any additions to the federal budget that will increase expenditures or reduce revenue

37 38

On ‘Proposition 13’, see İmrohoroğlu et al. (2018). See Sect. 5.3.2.2 below.

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require the consent of the federal government.39 This condition, which was modelled after the rules of order of the British Parliament, significantly restricts parliamentary powers over the budget. The federalisation of decisions on revenue and expenditures is also considered a means to limit spending.40 In fiscal federalism, competition theoretically enables citizens to realise their preferences more successfully. Amortisation schedules for public debts represent an attempt to reduce government expenditures by imposing limits on borrowing. The schedule of binding debtsettlement plans can be linked to usage of the financed investments (‘pay as you use’). Requiring qualified majorities for decisions related to spending, taxation and debt may also have a restraining effect. This is the course taken in California in the context of Proposition 13, which made a two-thirds majority a prerequisite for the introduction of new taxes.41 Many US states followed this example by instituting ‘supermajority provisions’.42 This practice is problematic, however, because it places serious constraints on a democratically legitimised legislature.43 The concept of ‘sunset legislation’ follows from the observation that spending decisions will often remain in effect in the future, because no provisions have been made for their review. Establishing expiration dates for spending decisions should counter the ‘staircase effect’ observed in budgetary expansion (as is the case with subsidies, for example).44

5.2.2.2 Reasons for a Potential Trend Reversal For a long time, it seemed as though the law of increasing state activity would remain valid indefinitely. Questions about possible countermeasures have thus been dominant in academic literature. As discussed above, however, recent decades have seen a reversal in this trend (except for in the period after the Second World War and during financial and epidemiological crises). This reversal has raised questions about the permanence of the trend and the reasons for the turnaround. The factors that have received the most attention are external limitations on government revenue, including restrictions on direct taxes due to international tax competition45 and restrictions on borrowing resulting from widespread recognition of its negative consequences.46 In light of the recent financial crisis (2007–2009) and the epidemiological crisis of

Relatedly, see Section 144(6) of the Spanish Constitution: ‘Any non-governmental bill or amendment which involves an increase in appropriations or a decrease in budget revenue shall require previous approval by the Government before its passage.’ 40 On related issues in the context of fiscal federalism, see Sect. 2.4.2.2.1 above and Sect. 5.4 below. 41 See Lee (2014), pp. 414 ff. 42 See, e.g., Schultz (2004), pp. 409 ff. 43 For more disadvantages, see Schwartzberg (2014), pp. 105 ff. 44 For a historical and normative perspective, see Kouroutakis (2017). 45 See Sect. 5.3.1.4.3.6 below. 46 See Sect. 5.3.2 below. 39

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2020–2021, however, it is unclear whether this ‘trend reversal’ will continue or simply signals a renewed growth in spending for the purposes of crisis management. In this context, it is important to note that Wagner related his theory of increasing state activity specifically to the emergence of industrialisation and its consequences. This theory no longer holds for Western industrialised countries, which are on the brink of becoming post-industrial states; as a result, new theoretical approaches are needed. It is thus not surprising that, while available empirical studies have largely supported Wagner’s analysis, their results apply to the final phase of the industrialisation process and not to the time thereafter. It is interesting to examine whether ‘Wagner’s law’ actually undermines itself. The correlation between government expenditure and economic growth is a crucial factor in this context: while the expanding government share has a positive effect on economic growth in the initial stages of industrialisation, this trend is reversed in the course of the growth process. These considerations are based on a model by Barro, who points to the negative effects of increasing government expenditures for consumption (but not investment).47 As income levels rise, the ‘median voter’ experiences not only the consequences of rising taxes, but also the longer-range negative income effects of declining economic growth. The ageing of the population observed in all late-stage industrialised countries intensifies this effect.48

5.3

Government Revenue

Practically speaking, states have few opportunities to finance the fulfilment of state tasks. For obvious reasons, the modern state rejects certain historical models, such as an appropriation of needed finances through warfare (as in the Roman Empire) or the exploitation of colonies. Because of constitutional considerations, other historical approaches play only a minor role today. This applies, for example, to the conscription of private parties (at their expense), although this practice continues in certain cases, such as the Compulsory Fire Service in Southern Germany. The same also applies to state entrepreneurial activities that contributed significantly to state finances, such as those conducted during the mercantilist period (and even into the twentieth century, in the case of the energy and railroad sectors); today, such activity can only be justified for the fulfilment of public tasks (no longer solely for the purposes of generating revenue). By contrast, government borrowing has become increasingly popular in recent decades. At the same time, however, there has been a growing recognition that this approach ultimately allows one generation to live at the expense of the next, which must pay off the national debt or at least bear the interest burden. Especially in recent

47

Barro (1990). This correlation has since been empirically verified; see, for OECD countries, Lamartina and Zaghini (2011). 48 For empirical data, see Schneider (2009), pp. 182 ff.

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years, the devastating effects of national economic crises and (impending) government insolvency have become apparent. These circumstances have raised awareness of the need for a binding regulatory framework that limits the national debt (and thus government borrowing). This framework will receive closer attention below in a discussion of borrowing as a means of financing the public sector.49 This leaves modern constitutional states with one potential source of regular funding for public functions: the collection of taxes and fees. The modern constitutional state is a finance state and (in particular) a tax state50—that is, a state which meets its financial requirements primarily through taxation and for which taxes represent its principal source of revenue. Its status as a tax state is both a descriptive characterisation and a normative claim. Most modern states—at least, most OECD member countries—can be described as true tax states. The tax ratio (i.e. the tax revenue as a percentage of GDP) lies roughly between 30% and 50%.51 It is important to note that this descriptive characterisation would change considerably if taxes were more narrowly defined and excluded social security contributions. In Germany, for example, this narrower definition would reduce the GDP-tax ratio from 45% to just above 25%. These high tax-GDP ratios indicate that taxes in a broad sense—that is, including social security contributions—account for 80–90% of total government revenue in OECD countries.52 Germany is also a tax state in a normative sense: as a general rule, taxes finance government spending. Based on the provisions of the Basic Law (particularly those on finance and the right to freedom), the Federal Constitutional Court has justifiably reached the normative conclusion that Germany is a tax state that must finance government responsibilities through taxes.53 Other sources of revenue, especially other fees, thus require specific justification. This requirement is intended to counter the state’s constant attempts to tap new funding sources (including tuition fees, toll roads and extra fees), which threaten certain freedoms. Various interpretations of the constitution can be used as justification, as shown in the following examples (the first two of which carry the most weight): (1) Fiscal constitution: ‘The financial code of the Basic Law assumes that overhead costs are financed through taxes.’54 The unified and finely differentiated tax constitution would be subverted if the relative significance of taxes as a revenue source decreased substantially.

49

See Sect. 5.3.2 below. See, e.g., Wagner (2015); regarding tax revenues in premodern states, see Kiser and Karceski (2017), pp. 77 ff. 51 See, e.g., OECD (2019b), pp. 2 ff. 52 OECD (2019a), p. 67. 53 BVerfGE 55, 274, 300 ff.; 78, 249, 266 f. 54 BVerfGE 91, 186, 201. 50

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(2) Basic rights: The constitutionally protected equalisation of burdens from public costs can be best established through taxation. (3) Rule of law: Taxes are the best means of ensuring the independence of the finance state from its ‘financiers’ and are thus advantageous. (4) Economic constitution: Taxes ensure that the state shares in the economic success of private parties. (5) Democracy and budgetary constitution: Taxes safeguard the budgetary system and in particular the parliament’s overall responsibility with respect to revenue and expenditure (budget right). The following discussion will focus more closely on the role of taxes and fees as a state revenue stream (Sect. 5.3.1). Government borrowing will then be addressed as a second significant source of revenue (Sect. 5.3.2).

5.3.1

Taxes and Fees

Economic analysis addresses many different aspects of taxation systems.55 Especially in the field of tax law, legal practitioners and legislatures must not ignore insights from economics. Tax law builds on economic elements and is designed to establish appropriate tax-related legal consequences on the basis of these elements. As a result, the economic approach is a common method applied in the interpretation of tax law. Like other objects of economic analysis, the tax system can be examined from both positive (actual) and normative perspectives. The framework for analysis is as follows: (1) The analysis begins by examining the concept and effects of taxes as well as possible points of reference. (2) Normative economics makes it possible to formulate questions about an ideal tax system and to develop a perspective from which to critique the current tax system. (3) Theories of taxation in economics provide (empirically verifiable) explanations for the development of the existing tax system. These theories are instructive for legal policy, particularly with regard to potential constitutional requirements. (4) Economics can be used to interpret the phenomenon of international tax competition and to draw legal policy conclusions based on this interpretation.

5.3.1.1 The Concept and Effects of Taxation Of course, economics also addresses questions related to the nature and effects of taxation, i.e. questions of tax theory.

55 See, e.g., James and Nobes (2018), Canegrati (2012), Kaplow (2008), Koester (2009), Salanié (2000) and Brennan and Buchanan (1980).

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5.3.1.1.1 The Concept of Taxation It is difficult to define a general concept of taxation.56 Many economists interpret taxes broadly, as a required payment to the government.57 Legal scholars tend to prefer a narrower definition of taxation. A tax, in a legal sense, is a compulsory payment or other levy imposed on a taxpayer (an individual or legal entity) by a state or the functional equivalent of a state to fund various public expenditures.58 This definition is useful as long as other compulsory payments to the government (e.g. charges, fees and fines) have their own justification and are governed by a separate legal regime. It should be noted that in some legal orders—mainly those in common law countries—the meaning of taxation may vary depending on specific systematic circumstances.59 5.3.1.1.2 The Effects of Taxation The effects of taxation can be divided into three categories: financial (burden) or distributional effects, impact effects and simplification effects.60 Taxes necessarily have financial effects in the sense that they (directly or indirectly) withdraw finances from certain (natural or legal) persons. The tax burden is particularly difficult to determine because, to a greater or lesser extent, it can be passed on to third parties, as typically occurs in the case of indirect taxes (tax incidence).61 Every tax also has steering effects to the extent that it influences individual decisions or social conditions. Unlike financial effects, these may arise without taxable events (‘announcement effect’),62 with consequences including: (1) behavioural effects: a husband or wife turns down a job because the extra income would raise the family’s tax rate too much; a craftsman is paid under the table to avoid value-added tax. (2) organisational effects: a business chooses its legal form in part due to tax considerations. Whether these impact effects should be regarded as ‘distortionary effects’ is a matter of perspective. This issue is more normative and is related to the concept of tax neutrality.63 Such effects can only be considered in the context of ideal or guiding

56

Thuronyi (2003), p. 45. For an overview of definitions of tax, see Morabito and Barkoczy (1996). 58 OECD Glossary of Tax Terms, https://www.oecd.org/ctp/glossarytaxterms.htm. 59 Thuronyi (2003), pp. 49 ff. 60 See, e.g., Stiglitz and Rosengard (2015), pp. 513 ff. 61 For greater detail on tax incidence, see Stiglitz and Rosengard (2015), chap. 18. 62 On announcement effects, see, e.g., Stiglitz and Rosengard (2015), pp. 512 ff. and 516. 63 See, e.g., Shaviro (2017), p. 111. 57

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Fig. 5.1 Macroeconomic overview of tax collection

principles, however, as each tax will necessarily have impacts on behaviour and decisions.64 The state can use steering or behavioural effects to its advantage if it employs them to pursue policy objectives, for example by imposing high energy taxes to incentivise energy conservation. These can be described as ‘deliberately non-neutral taxes’.65 Environmental taxation has long applied this concept to interalise external environmental effects, following on the work of Pigou.66 ‘Sin taxes’ on tobacco and alcohol are another well-known example.67 These taxes can be referred to as ‘steering taxes’, ‘corrective taxes’68 or more accurately ‘regulatory taxes’, as they are closely linked to political and legislative concepts. Simplification effects result from technical regulations that are not based on any material valuation and are only intended to simplify the application of tax law. Examples include standards that regulate the calculation and collection of annual taxes (principle of periodicity).69

5.3.1.2 Options for Government Tax Collection and Types of Tax In abstract terms, the government can collect taxes from three sources: earned income, spent income and wealth (saved income). For a macroeconomic overview of tax collection, see Fig. 5.1.

64

See, e.g., Stiglitz and Rosengard (2015), p. 610. Shaviro (2017), pp. 112 f. 66 See Sect. 7.2.3.1 below. 67 Zamir and Teichman (2018), pp. 490 f. 68 See Stiglitz and Rosengard (2015), pp. 517 ff. 69 Ibid., 683 f. 65

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In most countries, tax law is based on a multiple-tax system. This structure evolved over time: when new taxes or types of taxation were ‘invented’, they supplemented existing taxes rather than replacing them. Challenges to this practice had emerged at least by the nineteenth century, when income tax was introduced as a tax oriented towards individual ability to pay. This feature made (and makes) this the most suitable tax for a ‘single tax system’.70 Although the legislature in Germany has abolished several minor taxes in recent years, it has left the structure of the existing multiple-tax system largely intact.71

5.3.1.3 Tax Equity and Principles of Taxation Regardless of their main purpose or structure, all types of taxes are primarily intended to distribute tax burdens equitably.72 In this context, equity has two dimensions.73 Horizontal equity requires individuals who are the same in all relevant aspects to be taxed at the same rate. Vertical equity requires individuals to pay higher (or lower) taxes based on differences in their characteristics that determine the fairness of the tax burden (e.g. ability to pay). Principles of taxation were established to make the terms of fair taxation more concrete. In developing these principles, the main question is how tax burdens can be distributed equitably among individuals. There is ready agreement on the more abstract fundamental principles: equality and fairness. These must then be translated into practice-oriented principles of taxation, whose effectiveness in ensuring equity is accepted or disputed to varying degrees. The principles of tax equity are closely intertwined with the constitutional interpretation of tax equality.74 Tax equity could potentially be understood to mean that every taxpayer should bear an identical tax burden. Today, however, this ‘poll tax’ is widely regarded as unfair (thus, the poll tax imposed as a ‘community charge’ in Great Britain in the 1980s created considerable controversy).75 5.3.1.3.1 Equivalence Principle (Benefit Approach) Historically, the tax equivalence principle has played a large role in the justification and assessment of state benefits afforded to individual groups of taxpayers. (This should not be confused with the ‘equivalence principle’ associated with fees and charges, which refers to a concrete, quid-pro-quo relationship between government services and remuneration.) According to this principle, a higher tax is justified for individuals who benefit more from state services. The concept of individual rationality suggests that citizens are willing to pay the tax price commensurate with the ‘demand’ for public goods.

70

See Sect. 5.3.1.3.2 below. See, e.g., Thuronyi (2003), pp. 56 ff. 72 See, e.g., Stiglitz and Rosengard (2015), pp. 523 ff.; James and Nobes (2018), pp. 77 ff. 73 See Stiglitz and Rosengard (2015), pp. 523 ff. 74 For an overview, see Thuronyi (2003), pp. 82 ff. 75 Smith (1991). 71

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The tax equivalence principle has largely receded into the background; today, it is used only to support the justification for taxes. In Germany, for example, the local trade tax has been considered an integral component of a ‘union of interests’ between commercial enterprises and local authorities: it imposes burdens on local governments (e.g. infrastructure, allocation of land for commercial zones) but also provides them certain advantages (taxes, including their share of the income tax, and jobs).76 5.3.1.3.2 Ability-to-Pay Principle Since the nineteenth century, the ability-to-pay principle has been regarded as the most equitable principle of taxation:77 those with an equal ability to pay should pay the same amount of tax (horizontal tax equity), while those who are able to pay more should contribute a greater amount than those who are not (vertical tax equity). The ability-to-pay principle is a generally recognised constitutional principle,78 even in the absence of an explicit rule to this effect.79 Income tax has been considered an ideal realisation of the ability-to-pay principle since the 1800s. In this context, a particularly sensitive question is whether a single-tax system based on income tax would constitute the most equitable tax system—and, if so, what justifies the continued existence of a multiple-tax system. The prevailing argument is that a single-tax system would not be feasible because multiple taxes are necessary to secure state finances and offset deficiencies in individual taxes. Constitutions have more or less explicitly confirmed the decision in favour of the multiple-tax system. Although it is widely agreed that the ability-to-pay principle is the most appropriate to ensure equitable taxation, opinions vary considerably with regard to the implications of this principle for the structure of the tax system. One source of controversy is the role that it should play in taxes other than the income tax, such as in determining whether corporations have their own ability to pay that justifies a special corporate tax. Even the design of the income tax leaves several questions unresolved. For instance, does calculating taxes in proportion to income comply with the abilityto-pay principle? John Stuart Mill was the first to call for a consideration of equivalent ‘sacrifice’ in this context.80 According to this principle, a tax must 76

See Rodi (1994), pp. 23 ff. See Rodi (1994), pp. 15 ff., 25 f. This is also deeply rooted in public attitudes; see Zamir and Teichman (2018), pp. 481 ff. 78 See, e.g., BVerfGE 66, 214, 223: ‘It is a basic principle of fair taxation that taxes be assessed on the basis of financial ability to pay.’ 79 There are few exceptions, including Section 31 of the Spanish Constitution or Article 53 of the Italian Constitution; see Thuronyi (2003), p. 95. Like most constitutions worldwide, the German Basic Law constains no explicit rule, although one was included in Article 134 of the constitution that preceded it, the Weimar Constitution: ‘All citizens, without distinction, shall contribute in proportion to their means to all public expenses, in accordance with the law.’ 80 Mill (1921–1924), book V, chap. 2, 468. 77

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demand an ‘equal sacrifice’ from all taxpayers—that is, it must impose the same loss of welfare on every taxpayer. This condition would provide strong support for a progressive tax rate. But critiques of utilitarian thinking also apply here: in practice, it is virtually impossible to determine cardinal utility functions with respect to income.81

5.3.1.4 Theories of Taxation Economics attempts to formulate consistent theories of taxation that account for the effects and normative principles of taxation and enable a systematic analysis of taxation.82 Proposals for reform can then be created on the basis of these theories. 5.3.1.4.1 Welfare-Economic Theory of Taxation Classical welfare economics is based on the assumption that it is possible to determine a level of state revenue and expenditures that will maximise welfare.83 Restrictions of a political nature (i.e. a utility-maximising government) are ignored. It is widely accepted, however, that all taxes have steering effects that affect taxpayer behaviour, leading to distortions and welfare losses. This highlights the importance of optimising taxes (i.e. minimising undesirable side effects). Identifying tax effects (tax incidence) is the first step in this process.84 Welfare economists have already recognised the difficulties involved: in addition to quantifiable, direct losses in welfare caused by paying taxes, there is a hidden ‘excess burden’, which is conditional on factors such as the extent of administrative costs or the unwelcome regulatory effects of taxation.85 Welfare-economic analyses of taxation remain important today.86 Identifying a model tax without distortionary effects is a first step in isolating all other effects that can be attributed to the legislature and require a (separate) constitutional justification. Some refer to this ‘neutral’ tax as ‘economically efficient’.87 5.3.1.4.2 New Political Economy and Normative Theories of Taxation The main criticism of theories of taxation that are based on the principles of welfare economics is that they ignore the utility-maximising behaviour of state actors, which has a number of consequences that are taken into account in other theories of taxation. Politicians are primarily interested in re-election; this suggests that their decisions are guided by voter preferences. These circumstances have resulted in the

81

Stiglitz and Rosengard (2015), pp. 533 f. For a general discussion of utilitarism, see Sect. 1.2.1.3. For an overview of the various theories of taxation, see Kaplow (2008), pp. 96 ff. 83 For an introduction to welfare-economic theory of taxation, see Stiglitz and Rosengard (2015), pp. 606 ff; for greater depth, Salanié (2000), chap. 1–3. 84 See, e.g., Salanié (2000), chap. 1. 85 Cf. Lind and Granqvist (2010). 86 Cf. Kaplow (2008). 87 Stiglitz and Rosengard (2015), pp. 512 ff. 82

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application of the median voter model to tax law.88 Politicians approach taxation opportunistically, however, and implement unpopular tax increases after the election.89 They take advantage of taxpayers’ ‘fiscal illusion’ by concealing tax burdens in a complex, multiple-tax system that has little transparency; they thus prefer ‘hidden taxes’.90 Empirical evidence demonstrates that parties also use their discretion regarding tax policy to implement their ideological views (ideology maximisation).91 Because of this practice, normative theories of taxation emphasise the need for constitutional restrictions on legislators who make decisions on taxation. The theory of democratic taxation is related to the age-old call for democratic accountability for the (tax) legislator. The demand for ‘no taxation without representation’ has surfaced in many different contexts throughout history—not only as a rallying cry for political independence, but also as an appeal for democratic participation in important state decisions. The theory of democratic taxation goes further: it demands greater democratic accountability for tax decisions through referenda on budget decisions (e.g. in Switzerland and some US states) or qualified majorities. This basic form of the theory was introduced by Knut Wicksell at the end of the nineteenth century (1886). Numerous practical difficulties render it unworkable in most constitutional states, however; legally, for example, it is not feasible under the German Constitution. According to the Leviathan theory of taxation, the state can use monopoly-like powers to push through tax increases and tends to maximise the budget.92 The taxpayers, on the other hand, are powerless and cannot escape the resulting tax burden (except through tax evasion). This concept, which was developed in particular by Brennan and Buchanan, primarily serves to justify the need for constitutional limitations, such as the definition of a tax basis or tax rates in the constitution. The Leviathan theory of taxation has been criticised not only for its limited epistemological value in justifying the need for and design of tax constitutions, but also for its somewhat crude underlying assumptions.93 5.3.1.4.3 Feedback Theories of Taxation Each of the theories mentioned above offers a unique and valuable perspective. None of them, however, satisfy the need for a comprehensive analysis of the tax system. As emphasised above, economics—particularly its positive variant—is highly relevant to legal policy. As early as the 1990s, Edward McCaffery introduced

88

On the median voter model, see Sect. 2.2.3.3.3 above. See also Canegrati (2012), 4.1. For empirical evidence in German tax policy, see Koester (2009), 3.5. 90 McCaffery (2014), pp. 602, 609; for empirical evidence in German tax policy, see Koester (2009), 3.4. 91 For empirical evidence in German tax policy, see Koester (2009), 3.6. 92 On the Leviathan theory of taxation, see Brennan and Buchanan (1980) and Beckmann and Lackner-Frey (2002). 93 See, e.g., Beckmann and Lackner-Frey (2002). 89

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insights from behavioural law and economics to the field of taxation.94 Since then, it has been demonstrated impressively that taxpayers often do not react rationally, but exhibit typical patterns of bounded rationality, like loss aversion.95 It is clear, of course, that the tax legislator will react accordingly, taking advantage of enormous ‘framing possibilities’.96 Additionally, tax legislators themselves are subject to bounded rationality.97 Only by better understanding how tax decisions are actually made can we use them as the basis for normative claims. This applies as much to the phenomenon of fiscal illusion as it does to the influence of the bureaucracy or interest groups. Tax-policy reform inertia is one insight relevant to legal policy.98 The primary reasons for reform inertia are the unpopularity of tax decisions99 and the high ‘political costs’ associated with them (for example, struggles between parties to assert their ideological positions). These factors explain why old taxes are not repealed when new ones are introduced. The current tax system is thus a multipletax system that incorporates tax types associated with different historical periods of tax policy. The most instructive theory may be one that takes a closer look at potential feedback effects, particularly the (legal, though in some cases illegal) influence of taxpayers on taxation through tax planning, tax avoidance, tax sheltering and tax evasion.100 Blankart calls this approach the theory of evolutionary taxation;101 it could also be referred to as the feedback theory of taxation. This theory was developed to address the limitations of the theories discussed above. Constitutional provisions often limit the applicability of the theory of democratic taxation; the theory of optimal taxation disregards the reality of self-interested actors; and the Leviathan theory underestimates the influence of voters and taxpayers. 5.3.1.4.3.1 Tax Planning and Tax Avoidance

The principles of traditional rational choice theory clearly suggest that taxpayers will seek to minimise their taxes. Some methods to reduce taxes may be legal. These include tax planning, tax mitigation, tax minimisation or tax optimisation. Other actions, such as tax evasion and tax fraud, violate tax laws and are therefore punishable.102 Tax avoidance is the most difficult of these behaviours to define. In

94

McCaffery (1993/94). McCaffery and Baron (2006); Boadway (2012), pp. 34 ff., 217 ff. For an overview, see Zamir and Teichman (2018), pp. 465 ff. 96 McCaffery (2014), pp. 608 ff. and further reference. 97 Delmotte (2019), pp. 135 ff. 98 For empirical evidence regarding German tax policy, see Koester (2009), 3.3. 99 On public aversion to taxes, see McCaffery (2014), p. 608 and further reference. 100 Giertz (2009) provides an overview of studies and findings quantifying these effects. On the significance and implications of ‘tax resistance’, see Wilson (2006). 101 See, e.g., Blankart (2007), chap. 11, E. 102 See Sect. 5.3.1.4.3.2 below. 95

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a general sense, it refers to any activity that is intended to reduce taxes but is not criminal in nature. This term should be reserved for cases of tax-minimising behaviour that skirts the law or that is in fact legally ineffective due to special rules against tax avoidance.103 One simple form of tax minimisation that is relevant to law and economics occurs when taxpayers alter their behaviour so that they will be charged lower taxes or none at all. For example, they can forgo taxable activities in favour of more leisure time or choose to purchase or consume products that are untaxed or taxed less (in Germany, for example, by drinking wine instead of beer, which is subject to beer tax). Such behaviour is referred to as tax planning or tax avoidance. The structure and design of tax laws also present many opportunities for ‘tax optimisation’.104 For example, taxpayers can exploit the principle of annuities that applies to many taxes: by transferring taxable income to a year in which they expect a lower income (for example, by setting payment dates accordingly), they can lower their tax rate in a progressive tax system. There are many options to shift income to (individual or corporate) persons with a lower tax rate. Multinational corporations, for example, can set prices for services within the enterprise (‘transfer pricing’) and thus shift profits to countries with lower taxes. Even this legal method to optimise or minimise taxes significantly affects taxpayer behaviour and thus the economy and society at large. These ‘steering effects’, in turn, influence legislative decisions: excessively evasive reactions could make tax collection less practical. This is particularly applicable in cases where multinational corporations are subject to (excessive) taxation, because corporations will then (legally) divert their profits to another country.105 5.3.1.4.3.2 Tax Evasion and Tax Fraud

Of course, in addition to engaging in these legal forms of tax avoidance, taxpayer can take advantage of the limited auditing capacity of tax authorities by illegally underreporting or failing to pay taxes. This practice is referred to as tax evasion and is generally a criminal offence. Economic explanations for ‘optimal tax evasion’106 have attempted to interpret taxpayer decisions from the perspective of individual rationality. According to this perspective, individuals maximise their expected income when the expected marginal cost of concealing income (i.e. the marginal tax rate weighted by the probability of detection) is equal to the expected marginal revenue from concealing it (i.e. the marginal tax rate avoided).107 Thus, in the following example, a taxpayer would decide to evade taxes and and not declare his or her taxable income of €2000: the

103

For a suggestion regarding appropriate terminology, see Thuronyi (2003), pp. 154 ff. For an overview, see Stiglitz and Rosengard (2015), chap. 24. 105 See Sect. 5.3.1.4.3.4 below. 106 On the classic theory of ‘optimal tax evasion’, see Allingham and Sandmo (1972). 107 See, e.g., Blankart (2007), chap. 11, E.2. 104

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marginal tax rate is 50%, the expected probability of detection is 25% and the tax penalty is 100%. Penalties for violating tax law have a deterrent effect.108 It is, however, easy to demonstrate empirically that the theory of optimal tax evasion is based on highly simplified assumptions and thus does not reflect reality.109 This may be due to the fact that taxpayers are often simply unaware of the opportunities for tax evasion. Another possible explanation is that taxpayers overestimate the probability of penalties, as they tend to be risk averse.110 Perhaps most importantly, the theory of optimal tax evasion ignores other factors relevant to tax payment, especially the question of ‘tax morale’ and motives for ‘voluntarily’ satisfying tax obligations. Taxpayers do take into account that taxes serve the provision of public goods and there is a tendency and wish to contribute to public goods.111 The level of tax morale is closely related to the general tendency to comply with the law,112 which, in turn, is largely contingent on legal culture.113 Ethics and morality can also have an important behavioural influence.114 According to social interaction theory, tax compliance is highly dependent on social norms and thus may be guided by feelings such as shame or guilt.115 In particular, the close association between taxpayer honesty and religious affiliation is striking: research has shown, for example, that because of past confrontations between the Catholic Church and the state, Catholics tend to view the state more sceptically, while Protestants exhibit the opposite tendency due to the closer historical relationship between the Protestant Church and the state.116 Individuals’ loyalty to the state (i.e. attitudes towards ‘civic duties’)—and especially individuals’ belief in the reasonableness and legitimacy of government action—has proved to be a key factor in tax compliance.117 The perception that a tax system is ‘fair’ significantly increases tax compliance.118 It is also interesting to note that, based on experimental analyses, Bizer has proposed that tax fraud increases rather than decreases as tax law becomes more complex, contrary to previous assumptions. Bizer accounts for this finding by arguing that a decrease in transparency escalates taxpayers’ fears that others could 108

See, e.g., the study by Feld and Schneider (2011), pp. 85 f., although the authors also point out the negative repercussions of tax compliance. 109 McCaffery (2014), pp. 603 ff. 110 Alm (2014), pp. 266 ff. 111 Ibid., 264, 269. 112 For an overview, see Orviska and Hudson (2006). 113 See, e.g., Torgler (2003), p. 504; with an overview of existing research, Alm (2014), pp. 268 ff.; on cultural differences, with an emphasis on tax compliance within states (Switzerland, Belgium, Spain), see Torgler and Schneider (2006), pp. 2 ff.; for a comprehensive treatment of tax compliance in Germany, Schöbel (2008). 114 Alm (2014), pp. 266 ff. 115 Ibid., 264 f. 116 For relevant studies, see Kirchgässner (2011), pp. 351 ff. 117 See, e.g., Orviska and Hudson (2006); Torgler and Schneider (2006). 118 For evidence from relevant studies, Kirchgässner (2011), pp. 347 ff.

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exploit these circumstances to their advantage, which depresses taxpayer morale.119 This insight indicates that a tax-compliance law that is successful in one jurisdiction is not necessarily easily transferable to another. In addition, as has been demonstrated in experiments,120 both tax evasion and tax compliance are path dependent: taxpayers tend to adhere to traditional patterns of behaviour, even after changes to the law. 5.3.1.4.3.3 Shadow Economy

In an economic analysis of tax evasion, the emergence of the shadow economy is another important phenomenon.121 The term shadow economy refers to the economic activities that produce goods and services whose value is not reported and therefore not reflected in the GDP. Such activities deprive the state of a considerable amount of tax revenue; social security systems are, of course, also negatively affected.122 One of the central objectives of economics is to gain an understanding of the scale of this hidden economic activity. Doing so is difficult, of course, because this ‘underground’ value creation is by definition the result of illegal (criminal) activities or activities that are legal but deliberately concealed, contrary to law. Direct methods (surveys) to determine the scope of this activity are prone to error because, for obvious reasons, respondents are loath to incriminate themselves for unlawful conduct. Reliable criteria for indirect methods are lacking; thus, measurements of the shadow economy typically depend on estimates of cash holdings, based on the assumption that the shadow economy, and the illegal activity associated with it, typically operates in cash.123 The scope of the shadow economy varies considerably between nations, particularly between developed and developing countries. The estimated size of the shadow economy in OECD countries ranges from under 10% (Japan, Switzerland, US) to nearly 30% (Greece).124 Identifying the reasons for the emergence and growth of the shadow economy is important in the context of both economic and fiscal policy. The level of the overall tax burden appears to play a crucial role in the scale of this phenomenon, but tax compliance, disposable income per capita and the unemployment rate are also important factors to consider. 5.3.1.4.3.4 Transfers to Other Jurisdictions as a Method of Tax Sheltering and Tax Evasion

Taxpayers can also avoid a tax obligation by transferring their place of residence (or corporate domicile) from one tax jurisdiction to another (with a lower tax

119

Bizer (2008). Bruttel and Friehe (2014). 121 See, e.g., Orviska et al. (2006). 122 On different definitions of the term shadow economy, see Feld and Schneider (2011), p. 80. 123 Orviska et al. (2006) and Kirchgässner (2016) provide a good overview of the methods used. 124 Tiszberger (2022). 120

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Fig. 5.2 The Laffer curve. Based on: Blankart (2007), Figure 11.15

burden). In accordance with the ‘residence principle’, this process changes their status as taxable persons.125 In principle, the practice of tax sheltering is legal on the basis of fundamental rights and freedoms; however, the tax codes of many countries impose exit taxes. Tax sheltering is illegal when the individual only appears to have vacated their place of residence or retains their domestic residence while moving the basis for taxation abroad (e.g. by transferring assets to Luxembourg). In any case, the danger of losing tax revenue as a result of tax evasion has a considerable impact on state tax policy. This is one reason for the international trend towards low corporate tax levels.126 The relationship between levels of taxation and the evasive reaction of taxpayers is reflected in the famous Laffer curve. Models are used to illustrate the association between the level of taxation and the size of the shadow economy. 5.3.1.4.3.5 Consequences for Tax Policy and Tax Rates: The ‘Laffer Curve’

Arthur B. Laffer drew a simple conclusion from the fact that taxpayers react negatively to taxation, especially at higher levels of taxation. He proposed that, although rising tax rates theoretically generate more revenue, the increasing tax rate provokes an increasingly negative taxpayer response. This produces a point of diminishing returns, at which increasing tax avoidance and evasion cause tax revenue to taper off even as tax rates rise. This relationship is illustrated in the famous Laffer curve, which is shaped like an inverted U (see Fig. 5.2).127

125

On the motives for tax sheltering, see, e.g., Orviska and Hudson (2006). For an overview of studies, see Devreux and Loretz (2013) and Sect. 5.3.1.4.3.6 below. 127 See Tanzi (2014). 126

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Fig. 5.3 Shadow economy. Based on: Blankart (2007), Figure 11.15

Similar models provide insight into the relationship between the tax rate and the size of the shadow economy (see Fig. 5.3). One implication of the Laffer curve has proved especially influential in the political realm. The curve suggests that, at a certain income tax rate, lowering the rate may increase (rather than decrease) the tax revenue collected by the government; at another tax rate, increasing the rate may in fact reduce overall tax revenue. For obvious reasons, the Laffer curve has been extremely popular among conservative tax politicians and remains the subject of much political controversy. 5.3.1.4.3.6 International Tax Competition

Tax policy is an important factor for international investments. This can affect policy decisions, as states seek to attract (or hold) investments. International tax competition128 results from states’ attempts to design business-friendly tax laws that encourage investment (or corporate activity). This effect can be demonstrated empirically with the tendency in the past of reducing the corporate tax rate.129 The reasons for the rise in tax competition are complex. The underlying factor is, of course, the increasing mobility of production factors—especially capital—and thus of bases for taxation. Mobility has been facilitated by the increasing homogeneity of local conditions around the world (particularly in the EU, for example). A dense network of double-taxation agreements has also made considerable progress in addressing the problem of double taxation, which had significantly limited mobility. Finally, multinational corporations can use the leeway that they are granted in the valuation of internal transactions (‘transfer pricing’) to shift profits to countries with lower taxes. 128

For an introduction to international tax competition, Keen and Konrad (2013) and the articles in Diesch and Rixen (2016). For statistics, see Azémar et al. (2020). 129 See, e.g., Rodi (2008); Devreux and Loretz (2013).

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The consequences of international tax competition are the subject of much debate. Proponents of (greater) tax competition argue that it increases welfare130 by restricting the otherwise unlimited power of the state to impose taxes and curbs the influence of politicians.131 According to this view, positive effects include restrictions on state activity and state expenditures—and, on the other side of the ledger, a cap on the tax rate and in some cases even tax decreases. Supporters argue that tax competition thus compels states to give greater consideration to taxpayer preferences. The primary criticism of tax competition is that it poses risks to the welfare state.132 Critics argue that tax decreases could lead, on the one hand, to a painful reduction in state benefits, and on the other to increased pressure on state finances (especially due to a rise in state debt). In addition, critics contend that tax competition threatens the right of sovereign states to determine the structure of their own tax system.133 Tax competition, they argue, would also reduce direct taxes, particularly those on corporate profits and capital gains while increasing the socially unjust consumption tax and the tax burden on labour, which has undesirable effects on employment.134 States have little power to defend themselves against these developments: they find themselves in a typical prisoner’s dilemma, which limits their political agency.135 In general, states seek to prevent capital export and encourage capital import; even if they acknowledge at an abstract level that tax law should be neutral, in practice they are tempted to take advantage of a specific tax structure (at the expense of other states). This may lead to a ‘ruinous competition’, or a ‘race to the bottom’, in terms of tax revenue and the production of public goods.136 The rational behaviour of individual states can result in harmful effects for others (‘fiscal externalities’137) and potentially in an overall welfare loss. In view of the above, it is clear that a ‘blanket assessment’ of tax competition is virtually impossible. Still, the following basic statements apply: (1) Empirical evidence clearly demonstrates the existence of tax competition.138 This evidence indicates that investment decisions are at least partially guided by

130

This argument, which is most prominently championed by neoclassicists, can be traced back primarily to Tiebout (1956). 131 Brennan and Buchanan (1974); see Rixen (2007), p. 64. 132 See, e.g., ILO (2004); for a more differentiated analysis, Genschel (2002). 133 On structural changes to the tax system that have resulted from tax competition, see Tanzi (1996). 134 Rixen (2007), p. 67 and further reference. 135 Ibid., 70. 136 Nicodème (2007), p. 185 and further reference. 137 Rixen (2007), p. 63. 138 Nicodème (2007), pp. 185 f.; Baskaran and Lopes da Fonseca (2014) and further reference.

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(2)

(3)

(4)

(5)

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tax conditions139 and that states systematically seek to achieve individual advantages from these conditions. The welfare effects of tax competition cannot be generalised: some states stand to lose, while others could gain. The ‘winners’ tend to be smaller states (and likely developing countries); ‘losers’ typically include (industrialised) states140 and developing countries.141 This is referred to as asymmetric tax competition.142 The effects of tax competition on taxation are often overestimated. In the EU, for example, the corporate tax rate and capital gains tax rate have fallen significantly.143 This decline has had little impact on the real revenue from these taxes, however, because the decrease in tax rates has been accompanied by a broadening of the tax base. The feared ‘race to the bottom’ has therefore failed to materialise.144 Despite the many differences between individual studies, findings show that, in general, effective tax rates on marginal investments have remained relatively stable due to a simultaneous broadening of the tax base.145 There is also empirical evidence on the factors affecting corporate investment decisions. Changes to corporate tax alter little regarding real investments but do affect whether profits are reported in one country or another.146 Above all, it encourages multinational corporations to use profit-shifting strategies.

In general, there are good reasons for states to take action against unfair tax competition. Doing so protects a key function of states, which is to secure reliable funding sources to finance the provision of public goods; it also reduces inequality between (individual and corporate) taxpayers and states.147 In practice, it is difficult for states to adopt policies that promote international tax competition while retaining their fiscal autonomy. The desire among states to maintain their autonomy over tax matters is reflected in the provisions of EU law that require unanimous consent for harmonisation measures. In general, consensus is reached only after prolonged discussions that search for a ‘least common denominator’; this has become clear from the efforts by the OECD and G20 to oppose harmful tax competition.148 Attempts to establish principles for determining transfer prices in the context of

139

Mutti (2003), pp. 5 ff., 49 ff. Mutti (2003), pp. 12 ff.; Nicodème (2007), pp. 182 f. and further reference. 141 Dietsch (2018), pp. 212 f. 142 Rixen (2007), p. 64; on other factors in this asymmetry, see Nicodème (2007), pp. 181 f. 143 Rixen (2007), pp. 64 f.; Nicodème (2007), p. 184. 144 Rixen (2007), pp. 64 f. 145 Nicodème (2007), pp. 185 ff. 146 See, e.g., Nicodème (2007), pp. 192 ff. and further reference. 147 Dietsch (2018). 148 An OECD study on harmful tax competition (1998) represented an initial step in this process. Since then, (slow) progress has been made; see OECD (2019). 140

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double-taxation treaties are only partially effective. For now, the goal of enacting an institutional reform of global tax governance, e.g. through the establishment of an International Tax Organization (ITO),149 remains out of reach. States tend to find themselves in an ‘asymmetric prisoner’s dilemma’, which is difficult to overcome.150

5.3.2

Government Debt

Borrowing represents a much smaller source of state financing than taxes and fees. Its prominence in political debate is largely due to the problem of government debt.151

5.3.2.1 Foundations The history of public debt dates back centuries—and the phenomenon has been a topic of intense debate for just as long.152 Initially, public debt served primarily as a means to fund wars. Later, when its main function became the financing of public goods, it became closely intertwined with the rise of states. In the age of industrialisation and the period of general optimism that accompanied it, publicsector lending became the greatest lever to advance economic progress and thus the high culture of the European nations. Despite its obvious utility, it has often been considered a fundamental evil of mankind; according to Ricardo (1820), for example, public debt is ‘one of the most terrible scourges which was ever invented to afflict a nation’.153 5.3.2.1.1 The Concept and History of Government Debt Government debt (also referred to as ‘public debt’ or ‘state debt’) includes all liabilities of the state and its subdivisions to third parties. It refers to explicit debts, i.e. financial debts. Other obligations, such as liabilities for future pension entitlements, are not included, even though the source of these liabilities is already known; this is sometimes considered hidden government debt. Public debt is a stock variable, while annual net new borrowing is a flow variable. The history of government debt has shown an upward trajectory. Significant events can lead to periodic surges in growth. For example, government debt rose markedly in the 1970s, in the 1990s, and again following the 2009 financial and economic crisis.154 An even larger increase is expected to occur as a result of the

149

See the proposal in Rixen (2016). See Dietsch and Rixen (2016), pp. 6 ff. 151 For an introduction, see Abbas et al. (2020). 152 For a historic overview, see, e.g., Eichengreen et al. (2020). 153 Churchman (2001), p. 71, for this citation and more generally regarding Ricardo’s position on public debt. 154 OECD (2019a), pp. 58 ff. 150

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Fig. 5.4 Global debt

COVID-19 pandemic.155 In some countries, government debt far surpasses annual GDP (see Fig. 5.4). 5.3.2.1.2 Effects of Government Debt Classical welfare economists assumed that the financing structure of the state (e.g. taxes or borrowing) had no influence on social welfare. The Ricardo-Barro equivalence theorem,156 named for D. Ricardo (1817) and R. J. Barro (1974), proposes that the percentage of state spending that is financed by debt is irrelevant to citizens because they must pay for it sooner or later in the form of taxes. In anticipation of this burden, citizens take steps to counteract it: they save more, particularly with regard to the future tax burden, and possibly purchase government bonds. This argument is largely rejected today; according to the New Political Economy, there are sound reasons for the continuous growth of government debt and for the negative consequences resulting from it.157 This school of thought criticises the interpretation of public debt as the product of rational decision-making by voters between financing expenses through higher taxes or higher public loans; such interpretations reflect an unrealistic idealisation of modern democracies. Voter decisions on the issue, according to this argument, are highly influenced by a wide variety of considerations and interests.158 Today, the prevailing opinion is that public debt is an impediment to economic development and employment.159 Even in the work of Keynes, ‘deficit spending’ is

155

Allen (2021). Cf. Abel (1991). 157 For an overview, see, e.g., Alesina and Passalacqua (2017). 158 This contrast between ideal democratic consensus and monopolistic versions of democracy is elaborated in Eusepi and Wagner (2017); see, e.g., 85 ff. 159 See, e.g., Greiner and Fincke (2015). 156

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not promoted as a policy of economic development; it is instead described as one phase among three and regarded as a last resort to address disequilibrium if (and when) it arises.160 Because public debt must be financed by future taxpayers, it raises concerns about intertemporal equity. In light of this problem, it is important to consider whether and to what extent the revenue from loans is used for investments that bring advantages to future generations. Auerbach, Gokhale and Kotlikoff have attempted to calculate an intergenerational fair tax burden.161 From the standpoint of political economics, however, it appears unlikely that present voters will be motivated by a desire to strike a fair balance between the benefits of borrowing for the current generation and the costs that will be deferred to future generations.162 The impact of future budget constraints is regarded as another significant consequence of government debt. Interest and principal payments are placing an increasing strain on future budgets. Germany may serve as a typical example: its interest burden rose from 1% of GDP in 1970 to approximately 4% in 2009. Because the €42 billion applied to interest payments has not repaid government debt, 20% of non-credit revenue has been committed to service the debt.163 In other countries, public debt accounts for 10–20% of GDP and, in extreme cases, up to 100% of tax revenue.164 According to the World Bank (2021), it can reach 50% of GDP; however, on average, it fell from 10% in 2000 to 5–6% in 2021 before interest rates began to rise again.165 The recent rise in interest rates will likely stabilise this tendency. If taxes do not satisfy monetary requirements, the state may ultimately be driven to insolvency; it would then finance interest and repayments with new debt. This practice has been criticised as a Ponzi scheme, named after the American Charles Ponzi, who promised customers high returns on investments but funded the payment of ‘dividends’ using money deposited by new investors. Historically, the market has reacted to an increase in government debt by raising interest rates, although such raises have generally been smaller than expected.166 However, the credit crisis that emerged in some European countries in the wake of the 2009 financial crisis demonstrated emphatically that conditions can change abruptly and that a shift in market sentiment can lead to an explosion in costs for the budgets of governments in debt. A rapid rise in inflation then follows. Inevitably, then, increasing budgetary restrictions would have negative repercussions for economic development.167 It would lead to a decrease in state expenditures; citizens would also have less available income as a result of increasing

160

See Armstrong (2017), which include a thorough analysis of the collected works of Keynes. Auerbach et al. (1991). 162 See, e.g., Alesina and Passalacqua (2017), p. 7. 163 Ryczewski (2011), p. 19. 164 See, e.g., Debrun and Gueguil (2013), Figure 1. 165 World Bank (www.data.worldbank.org/indicator/GC.XPN.INTP.RV.Z5). 166 Burman et al. (2010). 167 Ibid., 575 ff. 161

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taxes and, most likely, social-service reductions. Economic growth would decline accordingly.168 5.3.2.1.3 Causes of Government Debt Once a budget has been prepared, borrowing—and thus public debt—is typically the only means to close the gap between state spending and the (lower) state revenue without loans.169 Therefore, all of the factors that cause increases in state spending also drive the growth of public debt.170 Alongside these indirect causes, there are many reasons for public borrowing and debt rooted in the interests of voters and politicians. The option for governments to borrow in order to generate revenue plays an important role in overcoming crises (including past financial recessions, wars and the more recent coronavirus pandemic). Financial challenges of this magnitude would clearly overburden present taxpayers; public debt thus provides a suitable mechanism to ‘flatten’ the tax burden over time, a concept referred to as tax smoothing.171 This basic principle can be applied to public investments to the extent that these provide advantages for future generations (the golden rule), although this is difficult to assess.172 Keynes’s advocacy of deficit spending to stabilise the economy in times of crisis is even more controversial.173 There is evidence that politicians tend to utilise these counter-cyclical fiscal policies in recessions, though not in times of expansion, when such policies would entail raising taxes to repay debts.174 In addition to the positive potential of borrowing and public debt, insights from political economics offer many reasons for this. This begins with the voters, who value their current interests over those of future generations and thus act rationally, consigning the financial problems of government debt to the future.175 As a result, current voters enjoy the benefits of state spending now without knowing whether they will be among the taxpayers required to participate in its repayment. Social spending is particularly important in this context as a driving force behind government debt.176 Nearly 50% of the population currently utilises social services, and this proportion is rising; it is thus clear that the voter group representing these interests has a large and growing political influence on public finances. Population ageing, which reflects changing demographics, has the same effect; especially for older

168

Merrifield and Poulson (2016), pp. 13 f., 31 ff. See Sect. 5.1 above. 170 See Sect. 5.2.2.1 above. 171 Yared (2019), pp. 118 ff. 172 For a critical assessment, see Kellermann (2007). 173 See Sect. 6.3.2.2 below. 174 Fatás et al. (2020), 2.2. and further reference. 175 See Ryczewski (2011), C.V.3, 118 ff. (voter interests); Alesina and Passalacqua (2017), p. 7, with reference to empirical studies. 176 See Czech and Tusinska (2016), though with rather mixed results. 169

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generations, it is rational to postpone payment for current spending until a later date. In the US, social welfare organisations and associations for older adults have even (successfully) campaigned against the introduction of constitutional provisions limiting debt.177 These factors indicate that the assumptions of the Ricardo-Barro equivalence theorem are incorrect: the theorem proposes that there are intergenerational links between utility functions, but the present value of a specified debt amount with a finite time horizon appears to vary among citizens according to life expectancy. Political economics provides many explanations for the tendency of politicians to finance increasing state expenditures with loans. In the short term, politicians are primarily interested in re-election and thus rely on the assumption that voters make decisions with imperfect information. According to the principle of the political budget cycle—a special application of the political business cycle178—politicians tend to increase expenditures before elections.179 They also try to boost their popularity with promises and ‘electoral boons’ regarding new expenditures (or tax cuts) while ‘hiding’ the public debt associated with them; this debt is not as noticeable—at least not directly or to the same degree—as the potential advantages (the principle of fiscal illusion).180 The incompleteness of the information available to voters, and thus the information asymmetry (principal-agent problem) in politics, is particularly evident with regard to government debt. This leads to the phenomenon of debt illusion.181 Even if competing politicians or parties are aware that there will likely be long-term negative repercussions to their actions, they cannot adjust their behaviour to reflect this knowledge. They find themselves in a classic prisoner’s dilemma: fearing that the other party will continue to exploit voters’ fiscal illusion, they do so themselves. But public spending and deficits are not driven only by a desire for re-election; all explanations of rent-seeking activity support this tendency.182 Increasing public debt can be described as a common-pool problem.183 In this context, it is interesting to note that the external effects of public debt do not only affect future generations. Externalities may differ between regions in countries with a large number of constituencies, especially in federal states. Such external effects may also affect other countries to the extent that these countries are financially

177

See Ryczewski (2011), pp. 123 f. See Sect. 2.2.3.2.3 above. 179 See Alesina and Passalacqua (2017), 3.2., with references to empirical studies. These studies show, however, that the effect is only responsible for minor deviations from ‘optimal policy’. 180 See Ryczewski (2011), pp. 103 ff., 125 f.; Buchanan and Wagner (1977), who coined the term fiscal illusion. 181 Ryczewski (2011), pp. 125 f. 182 Alesina and Passalacqua (2017), p. 8. 183 Alesina and Passalacqua (2017), p. 6; Fatás et al. (2020), 3.1. 178

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integrated; this is evident, for example, in the Euro area.184 In addition, rational politicians are aware that the benefits of higher state spending will be attributed to the current administration, while disadvantages (i.e. budgetary restrictions due to higher interest rates) may harm subsequent administrations that take a different policy direction. This grants a certain measure of leeway for strategic manipulation.185 There have been several other attempts to define the conditions that encourage government debt.186 An empirical study by Leachman et al.187 has demonstrated that weak administrations (i.e. those that consist of several parties and/or have slim majorities) tend to create government debt, which can be explained by the phenomenon of logrolling and the strong influence of interest groups. ‘Classical’ hypotheses proposing that government debt is greater under ‘left-wing’ administrations and in federal states have not been corroborated; in the case of the latter, there are even indications to the contrary. It would be reasonable to assume that a rise in interest rates provides a market signal to the political sphere that government debt will become unsustainable in the long run. Empirical evidence indicates, however, that this effect is reflected in the markets only after a significant delay. In fact, increases in government debt are often accompanied by sinking interest rates.188 This decrease may be due to the expectations of creditors that others will take on liability for debts where necessary (‘collective’ or other obligations to assume liability).189 The European financial crisis after 2009 provides a striking confirmation of this effect. Individuals with authority over budgetary legislation and policy also systematically overestimate revenue growth. On the revenue side, the state is increasingly constrained by limits on its ability to increase tax revenue. Meanwhile, globalisation forces adjustment processes in the form of poorer wages (fewer taxes and fees) and lower taxes (tax competition). A chronically ineffective system of taxes and fees encourages tax avoidance and facilitates the growth of the shadow economy.190 Debt crises ultimately nourish and perpetuate themselves. This is not only because a rising share of state revenue must cover a rise in interest, but also because repayment becomes more challenging once the debt reaches a certain level. As the consequences of recovery plans become more painful, opposition hardens on the part of political stakeholders. The state then finds itself in a ‘debt lock-in’.191

184

On these aspects of the tragedy of the commons, see Yared (2019), pp. 125 ff. Alesina and Passalacqua (2017), p. 5. 186 For an overview, see Leachman et al. (2007), pp. 371 ff.; on this and other empirical studies, see Ryczewski (2011), pp. 114 ff. 187 Leachman et al. (2007), pp. 375 ff. 188 Burman et al. (2010), pp. 567 ff. 189 On disincentives in collective obligations to assume liability, see Ryczewski (2011), pp. 130 ff. 190 See Sect. 5.3.1.4.3 above. 191 For empirical evidence, see Alesina and Passalacqua (2017), pp. 18 ff. 185

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5.3.2.2 Material Approaches to Limit Government Debt The most promising option for a state to restrict public dept is to set up binding limits in the constitution.192 This is not a common practice, however, and for good reason: perhaps most importantly, such limits would violate the democratic principle of budgetary sovereignty granted to parliament.193 Nevertheless, since the beginning of the twenty-first century,194 a growing number of states have introduced higherranking (mainly constitutional) limits on public debt.195 This trend, which began in Switzerland (Article 126 of the Swiss Constitution196), became more widespread among European states as a result of the financial (budgetary) crises of 2009 and the failure to establish national laws that would implement the ceilings imposed under European law. It is especially clear in Section 135(3)(3) of the Spanish Constitution (as amended in 2011), according to which ‘the volume of public debt of all the public administrations in relation to the State’s gross domestic product may not exceed the benchmark laid down by the Treaty on the Functioning of the European Union.’ Article 216(4)(1) of the Polish Constitution provides another example: ‘It shall be neither permissible to contract loans nor provide guarantees and financial sureties which would engender a national public debt exceeding three-fifths of the value of the annual gross domestic product.’ These examples indicate the main challenge in setting constitutional limits on public debt: the need to establish criteria for an acceptable level of government debt. There are many other problems associated with this approach. It is useful to base a discussion of these issues on the debt limit policy formerly in place under the German Basic Law and on the policy introduced in the second stage of federal reforms.197 The explicit clause on debt limits in Article 115 GG (old version)

192

For an overview, see, e.g., Palermo and Kössler (2017), pp. 236 ff. See OECD (2015), pp. 31 ff. 194 For a detailed discussion, see Merrifield and Poulson (2016), pp. 19 ff. 195 For an overview and a summary of the historical development, see Kirchgässner (2013), pp. 122 ff. See also Article 13(2) of the Austrian Constitution: ‘The Federation, the Länder and the Municipalities shall seek to establish in their financial management the safeguarding of an overall balance.’ 196 Article 126 (Financial management): 193

(1) The Confederation shall maintain its income and expenditure in balance over time. (2) The ceiling for total expenditure that is to be approved in the budget is based on the expected income after taking account of the economic situation. (3) Exceptional financial requirements may justify an appropriate increase in the ceiling in terms of paragraph The Federal Assembly shall decide . . . (4) If the total expenditure in the federal accounts exceeds the ceiling in terms of paragraphs 2 or 3, compensation for this additional expenditure must be made in subsequent years. (5) The details are regulated by law. 197 See, e.g., Thiele (2015), Kirchgässner (2017) and Heintzen and Utz (2013) for a comparison of German law and policy to that of the US.

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referred only to the federal government.198 In the new version of the Basic Law, the third paragraph199 of Article 109 establishes a limit valid for the federal government and the Länder and modifies this limit for the federal government in Article 115 GG (new version).200 The old version had at least one major drawback: it was hardly

198

Article 115 GG (old version) reads: (1) The borrowing of funds and the assumption of surety obligations, guarantees, or other commitments that may lead to expenditures in future fiscal years shall require authorisation by a federal law specifying or permitting computation of the amounts involved. Revenue obtained by borrowing shall not exceed the total of investment expenditures provided for in the budget; exceptions shall be permissible only to avert a disturbance of the overall economic equilibrium. Details shall be regulated by federal law. (2) With respect to special trusts of the Federation, exceptions to the provisions of paragraph (1) of this Article may be authorised by a federal law.

199

Article 109(3) GG (new version) reads: The budgets of the Federation and the Länder shall in principle be balanced without revenue from credits. The Federation and Länder may introduce rules intended to take into account, symmetrically in times of upswing and downswing, the effects of market developments that deviate from normal conditions, as well as exceptions for natural disasters or unusual emergency situations beyond governmental control and substantially harmful to the state’s financial capacity. For such exceptional regimes, a corresponding amortisation plan must be adopted. Details for the budget of the Federation shall be governed by Article 115 with the proviso that the first sentence shall be deemed to be satisfied if revenue from credits does not exceed 0.35 percent in relation to the nominal gross domestic product. The Länder themselves shall regulate details for the budgets within the framework of their constitutional powers, the proviso being that the first sentence shall only be deemed to be satisfied if no revenue from credits is admitted.

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Art. 115 GG (new version) reads: (1) The borrowing of funds and the assumption of surety obligations, guarantees, or other commitments that may lead to expenditures in future fiscal years shall require authorisation by a federal law specifying or permitting computation of the amounts involved. (2) Revenues and expenditures shall in principle be balanced without revenue from credits. This principle shall be satisfied when revenue obtained by the borrowing of funds does not exceed 0.35 percent in relation to the nominal gross domestic product. In addition, when economic developments deviate from normal conditions, effects on the budget in periods of upswing and downswing must be taken into account symmetrically. Deviations of actual borrowing from the credit limits specified under the first to third sentences are to be recorded in a control account; debits exceeding the threshold of 1.5 percent in relation to the nominal gross domestic product are to be reduced in accordance with the economic cycle. The regulation of details, especially the adjustment of revenue and expenditures with regard to financial transactions and the procedure for the calculation of the yearly limit on net borrowing, taking into account the economic cycle on the basis of a procedure for adjusting the cycle together with the control and balancing of deviations of actual borrowing from the credit limit, requires a federal law. In cases of natural catastrophes or unusual emergency situations beyond

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justiciable as a result of its vague language, such as provisions stating that debt ‘shall not exceed the total amount of expenditure’ or ‘shall be permissible only to avert a disturbance of the overall economic equilibrium’.201 The new rule introduced an extremely rigid cap; it remains to be seen whether this will strengthen the constitutional ceiling. 5.3.2.2.1 Importance of Future Utility with Regard to Intergenerational Justice If intergenerational redistribution is considered the main problem associated with government debt, investment may be an effective tool to limit it. This is the principle underlying the ‘investment clause’ (or ‘joint performance clause’) in Article 115(1) (2)(1) GG (old version).202 From an economic perspective, the basic premise of intergenerational redistribution at first seems compelling: borrowing done at the expense of future generations is justified if it creates value that will benefit these same generations. This provision has been abandoned because of the obvious problems with the approach.203 First, the assumption that investments will provide future benefits (the pay-as-you-use principle) is largely illusory, as investments may finance replacement purchases or soon lose their value (as with motor vehicles). Democratic theory also raises concerns about decision-making regarding future benefits, because one generation is essentially deciding on the needs of the next generation.204 But the most crucial shortcoming was the indeterminacy (and thus the limited justiciability) of the concept: it was interpreted by public policymakers, for example, as referring to ‘gross investment’, which meant that depreciation or ‘disinvestment’ were not taken into account.205 The practical difficulties associated with precise allocation and calculation would be nearly insurmountable, however, even if only net investments were taken into account. 5.3.2.2.2 Importance of Factors Related to Macroeconomic Equilibrium The business cycle theory proposed by John Maynard Keynes has been influential, though not without controversy. According to this theory, public spending should be expanded in economic downturns (recessions) to stimulate growth through public

governmental control and substantially harmful to the state’s financial capacity, these credit limits may be exceeded on the basis of a decision by a majority of the Bundestag’s Members. The decision has to be combined with an amortisation plan. Repayment of the credits borrowed under the sixth sentence must be accomplished within an appropriate period of time. 201

For the practices of the German Constitutional Court, see Heintzen and Utz (2013), pp. 82 ff. See Ryczewski (2011), pp. 30 ff. 203 Heintzen and Utz (2013), pp. 78 ff. 204 Ryczewski (2011), pp. 38 ff. and further reference. 205 This interpretation, though contentious from the standpoint of constitutional law, was ultimately accepted by the Federal Constitutional Court; see Ryczewski (2011), pp. 34 ff. 202

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demand. Keynes argued that this spending should be financed by increasing levels of borrowing, because raising taxes would have the opposite effect (‘deficit spending’). The debt incurred should then be repaid in times of economic prosperity by cutting expenditures or imposing additional payment burdens (such as higher taxes or surcharges) on economic units in order to prevent the economy from overheating. This reasoning was the basis for Article 115(1)(2)(2) of Germany’s Basic Law (old version), but here, too, there were practical difficulties with implementation. The model has been problematic in large part because ‘macroeconomic equilibrium’ is a concept far too vague to guide policy or establish limits on its justiciability.206 In addition, today the economy suffers less from the effects of classical economic cycles—which would justify the limit rule—than from acute economic crisis and the effects of structural unemployment. Finally, while utility-maximising politicians readily invoke the first part of the theory in order to justify new public borrowing, they tend to ‘forget’ the second part in boom times because spending cuts and tax hikes are unpopular. Article 115 GG (old version) contained few concrete directives related to this issue, e.g., there were no criteria regarding how much credit could be obtained in the event of a disruption to the macroeconomic equilibrium. Under Article 109(3) GG of the new legal framework, the Länder are at least required to account ‘symmetrically’ for the consequences of upturns and downturns that deviate from normal economic conditions, as well as to adopt an appropriate redemption plan in the case of any exceptions. Article 115(2) GG obligates the federal government to maintain a ‘control account’ that will record any divergence between actual borrowing and the borrowing limit. According to the terms of this provision, which are more generous than those for Länder, debt must be reduced in accordance with the economic cycle only if it accounts for more than 1.5% of nominal GDP. This stipulation leaves actors with considerable leeway to further increase the total debt; political and economic incentive structures indicate that this leeway will be exploited.207 It is even conceivable that new borrowing will have procyclical effects below the reference value of 0.35% of nominal GDP.208 5.3.2.2.3 Control and Sanctions In general, binding debt limits reflect a delicate balance between commitment and flexibility (which budget legislators require).209 We have thus far seen various approaches to organise flexibility, such as the adoption of different kinds of escape clauses. But in cases where commitment is clear-cut (as in the German system), is it realistic to assume that such limits will be enforced? Are there sufficient means to control and sanction? First, it is often challenging to monitor the behaviour of budget authorities and to clearly state a breach of debt limit rules. This requires laws to prevent

206

Ryczewski (2011), pp. 41 ff. Ryczewski (2011), pp. 191 ff. 208 Ibid., 53 ff., 70 ff. 209 Yared (2019), pp. 130 ff. 207

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circumventions such as overly rosy prognoses of future revenue, the choice of indirect financing options (a problem of defining the scope of public debts)210 or the use of independent public-sector entities to take out loans.211 Increased transparency is one simple approach to control and sanction, although it is not always very effective.212 This approach requires a reporting system and an institution in charge of monitoring. ‘Blaming and shaming’ then becomes one possible sanction. Another method is to integrate courts into the control process. This, of course, presents problems related to the separation of powers, as it allows judges—who in most cases are not legitimised through direct-democratic processes—to share control over the budget decisions of legislators.213 In this case, it is necessary to determine who will have standing in respective court procedures.214 In Germany, sanctions offered minimal reinforcement for Article 115 GG (old version), weakening its effectiveness.215 The Federal Constitutional Court has the authority to identify a violation during judicial review and has identified such violations in the past.216 But this determination is an extremely ‘blunt sword’: it is typically issued years after the violation, perhaps even after the original applicant— who was a member of the opposition at the time of the violation—has become part of the government. No provision was made for redemptions.217 With the exception of the redemption plan mentioned above, the revision of Articles 109 and 115 GG has made no major changes in this respect. A proposal by Ryczewski in this context is interesting from the perspective of political economics: it suggests that excessively high deficits should be repaid with automatic tax surcharges in the following year.218 This plan would enable voters to perceive the burdens of public borrowing directly, reducing the incentive for politicians to initiate new borrowing. Ryczewski points out that this method has been highly successful in scaling back public debt in Swiss cantons. Brazil, South Africa and some other countries have taken this approach one step further to void transactions that are based on an unconstitutional budget.219 An even more forceful reaction would be the imposition of criminal sanctions (for persons in

210

Awadzi (2015), pp. 12 ff. and 33 ff. regarding contingent liabilities. Ibid., 29 ff. 212 Ibid., 49. 213 Awadzi (2015), pp. 5 f. 214 Ibid., 4 ff. 215 Cf. Ryczewski (2011), pp. 53 ff., 70 ff. 216 A constitutional complaint was generally dismissed for lack of authority to file; see Ryczewski (2011), pp. 71 f. 217 Ryczewski (2011), p. 70. 218 Ibid., 198 ff. 219 Awadzi (2015), pp. 51 f. 211

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positions of authority or for institutions) under the law.220 This, however, would cause various unintended negative side effects. 5.3.2.2.4 Limits on Public Debt in EU Law Limits on public debts of Member States are a central element of the EU Economic Constitution (Article 126 TFEU in conjunction with Protocol No. 12 on the Excessive Deficit Procedure). This regime, which is rooted in the European Treaties, imposes a standard ceiling of 3% GDP (yearly net new borrowing) and 60% (public debt). The ‘excessive deficit regime’ was further elaborated in the European Stability and Growth Pact (SGP) and in a range of secondary legislation.221 Its purpose is to prevent Member States from free riding by coordinating their national economic policies within a ‘Common Market’.222 This framework was introduced following the creation of a common monetary policy and a common currency (with special rules established in Article 136 TFEU).223 Although the limits are of course somewhat arbitrary, they are considered to be reasonable overall, especially because a formal numerical approach provides advantages for application. There is virtually no economic justification for it, however; the figures were based partially on debt practices and partially on realistic opportunities to cut costs.224 The SGP is an interesting example that demonstrates the delicate balance between commitment and flexibility of fiscal rules. It was only possible to reach an agreement on the regime with the establishment of flexible coordination rules225 based on a typical EU governance system, information exchange and political bargaining.226 The system allows considerable flexibility and thus leeway to EU organs (Commission, Council) with regard to the establishment of legal consequences;227 larger states are even better able than small states to avoid sanctions.228 The political nature of the deficit procedure is also reflected in the fact that violations cannot be contested before the European Court of Justice (Article 126(10) TFEU): actions against the Commission or the Council for failure to act are considered only if these bodies refuse to take action against a Member State through any of the measures defined in Article 126 TFEU. Theoretically, Article 126(11) TFEU threatens ‘deficit sinners’

220

Ibid., 50 f. For an overview of the development, see Constantini (2017), pp. 335 ff. 222 Hansen (2015), pp. 479 ff. 223 For background, Schnellenbach (2018), pp. 328 ff. 224 On the budget criteria, including related criticism and justification, see Ryczewski (2011), pp. 85 ff. 225 Yared (2019), pp. 133 ff. 226 See for that Constantini (2017), pp. 336 ff. 227 The Council’s discretionary power in the deficit procedure was confirmed on 13 July 2004 in a landmark decision by the European Court of Justice (ECJ, C-27/04, Commission/Council, OJ 2004 I-6679). 228 Cf. Rodi (2012), paragraph 16 ff. of Article 126 AEUV. 221

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(in the euro area) with penalties ranging from substantial sanctions to ‘appropriate’ fines. Whether these measures are realistic is questionable, however, because they worsen the budgetary situation in the relevant Member State and economic need is the main factor driving violations of the Generalised Scheme of Preferences (GSP).229 A striking indicator of the limited credibility of European budget supervision is the fact that, at the end of 2009, deficit proceedings were pending against 20 of 27 EU Member States. The Eurozone crisis, which resulted from the global financial crisis in the years after 2009, proved the potential danger in limiting national debt with a weak legal framework when there is a common currency. The asymmetry between an integrated monetary union and a loosely coordinated economic union has long been criticised as economically unsustainable. A shift towards a true economic union or ‘European economic government’ seems inevitable. The strengthening of Eurozone cooperation on economic and monetary policy—which was made possible through secondary legislation (‘Sixpack’) based on the new Article 136 TFEU—and the efforts to institute joint banking supervision (‘banking union’) indicate the limits on possibilities for increasing integration above current levels.230 Only a fundamental reform of primary law on the Economic and Monetary Union (EMU) will resolve the issue of exploding government debt at the European level. This issue is especially urgent because the Eurozone crisis has effectively obliterated a second pillar of the EMU: the rule that the Member States have no liability for the debts of other Member States (the ‘no bail-out’ clause in Article 125 TFEU).231 This provision reflects the fact that the EU does not constitute a federal state with a system of fiscal equalisation and a reciprocal obligation to assume financial liabilities. It is also consistent with the logic that Member States with excessive national debt should be ‘punished’ and persuaded to change course by increasing interest rates. From the outset, however, there were concerns that there would not be a swift response, in which case ‘market-mediated’ effects would occur too suddenly and too dramatically in the event of a deteriorating budgetary situation and thus lose their ‘disciplinary’ impact.232 Driven by the ‘power of the facts’, the euro rescue fund was created largely praeter legem and contra legem.233

5.3.2.3 Formal Approaches to Limit Government Debt The fact that legal authorisation is required for government borrowing234 once served as a significant formal limitation of the government debt; in most cases, this was the only restriction. For the reasons discussed above, however, the people

229

Constantini (2017), pp. 487 f. See, e.g., Constantini (2017), pp. 344 ff. 231 Schnellenbach (2018), pp. 330 f. 232 Cf. Rodi (2012), paragraph 3 f. of Article 125 AEUV. 233 Rodi (2012), paragraph 9 ff. 234 For a comparative law perspective on the legal mandate to borrow, see Awadzi (2015), pp. 18 ff., 40 ff. 230

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and parties represented in parliament cannot effectively evade the political and economic forces driving the growth in government debt. It is conceivable that policymakers might impose limits on themselves (‘self-binding’) by adopting constitutional or ordinary legislation that institutes additional formal constraints. The democratic requirement for consent can be replaced by introducing referendums on borrowing or using qualified quorums for parliamentary decisionmaking. A drawback to the referendums is that only the parliament, as the budget legislator, is able to balance all revenue and expenditures. A drawback to the ‘qualified quorum’ approach is that limits on the freedom of legislative budget officers raise concerns rooted in democratic theory. An additional formal approach to limit government debt is to establish an advisory panel of experts, such as the German Council of Economic Experts or the Bundesbank.235 Another potential measure is to require the approval of expert commissions (Financial Planning Council). The influence of these commissions depends largely on the authority of their expert members. According to democratic theory, however, binding approval requirements are also problematic. Yet another formal method to limit public debt is to link expenditures to financing rules. These requirements stipulate that public borrowing must be offset in compliance with set requirements, such as automatic tax adjustments. Regulations like these can restrict government debt by quickly making the adverse effects of debt clear to citizens.

5.4

Public Finances Under Federalism

Earlier sections on statehood have discussed the special importance of the economic theory of federalism.236 The organisation of public finances plays a key role in the context of this theory, specifically with regard to the processes of collecting, allocating and borrowing money required to reconcile federal revenue and expenditures. These processes are the focus of the economic theory of fiscal federalism. In the design of the EU, for example, the very restricted decision-making power that the Union can exercise over its own revenue is characteristic of its continued lack of statehood.

5.4.1

Basic Principles

Issues related to fiscal federalism cannot be resolved ‘at the drawing board’ on the basis of economic theories. In an abstract sense, it seems easy to argue that all state (public) entities should have the financial resources to fulfil their tasks; finance should follow function.237 But the underlying principles of separation and

235

See Awadzi (2015), pp. 44 ff. See Sect. 2.4.2 above. 237 Palermo and Kössler (2017), p. 200. 236

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correspondence can provide the foundation for many different structures, which has led to a variety of historical approaches.238 These can be refined in accordance with respective constitutions but cannot be entirely reformulated from one day to the next. In addition to economic efficiency and tradition, fairness is an important consideration, as are aspects of political transparency and stability. Because the federal structures that have evolved are so diverse, the basis for a comparative analysis must be federal structures and problems (functional comparison) rather than the characteristics of the federal system. The experiences of individual federal states must also be classified typologically where possible. Due to the heterogeneity encountered in practice, however, it is extremely difficult to produce this kind of typology; only general classifications are possible. Fiscal centralism (e.g. Germany), for instance, can be juxtaposed with the fiscal competition category (e.g. the US). In addition, dualistic models of federalism—which, for certain issues, centralise legislative competences, administrative competences, taxing power and spending power—can be distinguished from integrated models, which assign these powers to units at different levels in accordance with various criteria.239 How to distribute functions (and competences) among the various levels of government is a key decision in the development of federal structures.240 In the literature on fiscal federalism, the central focus is which level of government should have decision-making power over revenue and spending.241 In general terms, the fiscal powers consist of revenue powers (especially taxing power)242 and spending powers.243 In addition to relatively simple rules (for example, the principle of subsidiarity or the benefit principle between users and taxpayers244), increasingly sophisticated models have emerged on the basis of efficiency considerations, public goods and/or external effects.

5.4.2

Spending Power

Spending power is closely linked to the question of financing, i.e. who bears the expenses incurred for the performance of a given function. A further distinction can be made between questions about who is able or authorised to spend (spending competence) and who must bear the expenditure (spending responsibility or obligation).245

238

Nicolini (2018), pp. 85 ff. Anderson (2010), 2.3. 240 See Sect. 2.4.2 above. 241 Cf. Boadway and Shah (2009), chap. 3 (on expenditures) and chap. 4 (on revenue). 242 See Sect. 5.4.3 below. 243 See Sect. 5.4.2 below and Palermo and Kössler (2017), pp. 228 ff., for a comparative legal analysis. 244 Cf. Kaplow (2008), pp. 209 ff., 403 f. 245 Nicolini (2018), pp. 90 ff., draws the attention to the fact that there is a puzzling variety of terms for these fiscal competences. 239

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Intuitively, one would assume that the entity that performs the function would also bear the costs. As is clear from the distinction noted above, however, this answer is too simplistic. While the assumption may be relatively accurate in consistently dualistic models of federalism, it does not apply to integrated models (in which functions and competences at different levels are interwoven to carry out certain tasks). Even in a clearly dualistic model, however, there are questions about whether and to what extent the federal government can finance (and thus influence the performance of) functions that are, in principle, the responsibility of the federal states. (German-speaking countries refer to ‘golden reins’ in this context.) In this case, the financing competence is not exclusive.246 The financing entity is particularly influential when the payments are subject to certain conditions (e.g. co-financing requirements). In contrast to the US Constitution, the German Basic Law has significantly curtailed the ability of the central government to impose such conditions.247 Federal states regulate financing responsibilities and competences very differently at each level. In principle, economic theory can be useful in developing criteria for allocation.248 It is important to note, however, that there are political factors (in particular the distributive justice) to consider in addition to welfare and efficiency criteria. Where public goods are provided in the national interest, as in the case of defence, they will of course be financed by the general government, although here, too, there are exceptions (for example, federal states in Australia and the US have limited authority to recruit military personnel). As a result, the share of financing from the central government can range from 30–40% (Belgium, Germany, Canada, Switzerland) to as much as 80% or more (Venezuela, Malaysia).249 Finally, in some cases (e.g. in the US), the central government obligates the federal states to finance certain functions, even without providing the financial resources needed to do so.250 Germany has introduced a specific principle of connexity [Konnexitätsprinzip] to address this issue: in accordance with Article 106(8) GG, the federal government must compensate Länder and municipalities for any increases in expenditures or reductions in revenue that it has caused.

5.4.3

Revenue Powers, Especially Tax Sovereignty

A crucial decision in the context of federal structures is whether any one level of government should have its own financial resources or ‘live’ exclusively or primarily from distributed or allocated revenue and/or financial transfers (as in the case of the

246

See Anderson (2010), 2.4. See Article 104b GG. 248 Cf. Anderson (2010), 2.2. 249 Anderson (2010), 2.5. 250 Cf. Anderson (2010), 2.6. 247

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EU and the Member States).251 In addition to fees, loans (public debts) and the exploitation of natural resources, taxes play a central role in this context (taxing power).252 Federal states and entities must thus determine what kind of taxes can be used to raise revenue at which level of government. Sources of taxes can be allocated for exclusive or concurrent use. Shared taxes represent a middle ground between these two alternatives: although these taxes fall within the tax competence of one level, another level shares the revenue in accordance with specific criteria.253 For the purposes of economic analyses, however, this scenario should be treated as a case of allocation. As indicated above, the allocation of independent tax sources to the federal states in the case of mobile sources of tax revenue raises a key economic question: what are the advantages and disadvantages of federal tax competition?254 As with federalism in general, there are arguments for and against the establishment of revenue assignment practices that are more federalised (extreme case: exclusive taxes for subnational entities) or more centralised (extreme case: financing subnational entities via grants). A decentralised allocation of fiscal powers is consistent with the correspondence principle of federalism.255 Proponents of national tax competition emphasise the opportunities arising from the fact that, according to economic theory, decentralised allocation allows federal states to provide packages of public goods at specific tax prices; only under these circumstances can states provide a comprehensive policy approach and assume the responsibility for it.256 Opponents point out potential drawbacks, such as fiscal externalities or the dangers of a ‘race to the bottom’ or ‘tax dumping’. The US and Switzerland have demonstrated that tax competition works in principle; both cases have shown, however, that success is highly dependent on elaborate and effective central legislation that prevents negative tax competition and can provide at least minimal tax harmonisation.257 Empirical research does not provide a clear picture of the advantages and disadvantages; a decision in favour of national tax competition thus remains a largely political one. There are also equity issues to consider: structurally poorer regions have correspondingly smaller tax resources and could be disadvantaged.258 In many federal states, specific sources of tax revenue are allocated to various levels of government for independent and exclusive use; this is the system in India,

251

For an overview of revenue powers from a comparative legal perspective, see Palermo and Kössler (2017), pp. 210 ff. 252 For an overview of international practices of revenue assignment, see Ambrosiano et al. (2018), pp. 123 ff. 253 Cf. Anderson (2010), 3.1.; Färber (2018), pp. 150 f. 254 Wilson (2006). See also Sect. 5.3.1.4.3.6 above on international tax competition. 255 See Sect. 2.4.2.2.1 above. 256 Ambrosiano et al. (2018), pp. 119 ff. 257 Regarding the US, see Arel-Bundock and Parinandi (2018). 258 Ambrosiano et al. (2018), pp. 122 f.

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for example.259 The problem with such models is that this allocation was generally developed in the context of an earlier tax system, and the significance of taxes has fundamentally changed since then. This rigid allocation can have negative results. For example, the allocation of mobile sources of tax revenue may have undesirable consequences, particularly by stimulating a tax competition that, in the worst-case scenario, could result in a ‘race to the bottom’ and a depletion of the tax source. To avoid unwanted tax competition, the main taxes assigned to subnational entities are those on property and inheritance, while income and consumption taxes are subject to the central taxing power.260 The allocation of immovable tax revenue sources (e.g. property taxes) to subnational entities may also cause problems, especially by producing undesirable distributional effects. The potential for such problems is especially clear in the case of revenue from resource taxes, which is dependent on the availability of the corresponding resources.261 Another possible approach is to allocate the same source of tax revenue (e.g. income or business taxes) to several levels of government for competing uses.262 This is the method employed in Canada and the US, for example.263 A competitive allocation of taxing powers is useful in enabling both levels of government to access important sources of tax revenue. It is important to note, however, that both sides share a ‘common tax space’ that cannot be extended at will; any expansion of one side necessarily imposes restrictions on the other and will thus have vertical externalities.264 This tax-sharing system will therefore function only if there are restrictions on the portion controlled by each side. Taxpayers face a greater administrative burden, however, because they must contend with two different tax systems for one source of tax revenue. This points to the importance of establishing rules to harmonise competing taxation. The effects of tax competition are less clear in the case of competitive tax allocation: vertical tax competition may lead to higher tax rates, while horizontal tax competition will have the opposite effects.265 Because federal tax allocation practices vary widely around the world, an international comparison is difficult. It may be possible to compare diverse systems by defining indices to measure tax autonomy.266

259

See Palermo and Kössler (2017), pp. 212 ff. For an overview of international practices, see Färber (2018), pp. 153 f. 261 Cf. Anderson (2010), 5.5. 262 Ibid., 3.4. 263 See Palermo and Kössler (2017), pp. 214 f. 264 Ambrosiano et al. (2018), pp. 132 ff. 265 Ibid., 133 ff. 266 For an overview of studies, see Ambrosiano et al. (2018), pp. 139 ff. 260

5.4 Public Finances Under Federalism

5.4.4

215

Transfer Payments and Fiscal Equalisation Schemes

Equalisation schemes can remedy concerns associated with competitive federalism, including equity issues and horizontal and vertical financial imbalances.267 As a result, these schemes, along with transfer payments, play a significant role in the theory of fiscal federalism.268 They can harmonise the principles of fiscal autonomy and federal solidarity. The US and Germany provide examples of this approach, although they represent opposite ends of the spectrum.269 The US Constitution establishes a system of competitive federalism with a large degree of fiscal autonomy that tolerates inequalities in living conditions; accordingly, no provision is made for specific equalisation schemes.270 Although the states receive enormous fiscal transfers from the central government,271 these conditional grants serve more as an instrument of policy coordination than as an equalisation scheme. Germany is an integrated federation, not a dualistic federation like the US. The German Constitution thus provides for various methods of fiscal equalisation.272 First, aspects of fiscal equalisation are apparent from the allocation of tax revenue (in Germany, this is referred to as ‘primary fiscal equalisation’ in reference to Article 106 GG). Equalising aspects are particularly evident when (abstract) need criteria play a role in the allocation (as was the case for the turnover tax in Article 106(3) GG). Second, tax revenue can be allocated on the basis of specific needs; in Germany, this process, which is referred to as ‘secondary vertical fiscal equalisation’, is achieved through supplementary funding allocations from the federal government (Article 106(2)(3) GG). The mechanisms of the final approach, ‘secondary horizontal fiscal equalisation’, are particularly controversial; this approach is employed in Germany in accordance with sentences 1 and 2 of Article 107(2) GG.273 Many federal systems largely or completely forgo equalisation mechanisms. The radical approach reflected in EU law is interesting in this respect. The euro crisis has revealed how problematic it can be for member states that share a common currency to maintain an independent fiscal policy when fiscal equalisation measures are generally absent.

267

For an overview, see Palermo and Kössler (2017), pp. 240 ff. Boadway and Shah (2009), chap. 9 and 10. 269 See Saunders (2018). 270 Saunders (2018), pp. 43 ff. 271 Ibid., 45 ff. 272 See Palermo and Kössler (2017), pp. 243 ff.; Saunders (2018), pp. 51 ff. 273 See Anderson (2010), 5.2, on various equalisation programmes. 268

216

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Macroeconomic Responsibility

One topic relevant to fiscal federalism is macroeconomic management in federal states.274 There is a risk that independent fiscal policies in the individual federal states will result in inconsistent or even contradictory management approaches. This problem is mitigated somewhat by the fact that federal states typically have a common monetary policy and central bank.275 Occasionally, there are also uniform guidelines on the implementation of fiscal policies to maintain ‘macroeconomic equilibrium’ (e.g. Article 109 GG in Germany276). This applies in particular to the issue of borrowing.277

5.5

Summary

The economic analysis of public finances focuses primarily on the state budget, specifically with regard to decisions about government spending and revenue. The theory of public goods and the tax-price theory are useful only in making very broad normative statements about the amount of government spending and revenue and thus about the optimal government share. For a long time, the positive analysis of public spending was dominated by the law of increasing state activity. The activities of interest groups, the influence of the bureaucracy, the illusion of voters regarding taxes and fees and the demand for redistribution were identified as the major driving forces. In addition, constitutional provisions that impose material and procedural limitations on public spending have proved to be problematic. The modern constitutional state obtains most of its revenue from the collection of fees, especially taxes. By applying principles of taxation to public finance, we can identify the various effects of taxes (burden effects and impact effects) and address questions of equitable distribution (ability-to-pay principle, equivalence principle). In the context of positive theories of taxation, attention has shifted from classical welfare-economic theories to the feedback theory of taxation. Tax planning, tax avoidance, tax evasion, tax sheltering, the shadow economy and taxpayer reactions are all factors that influence the design of tax law. Another influential factor is international tax competition, although the normative assessment of this concept remains controversial. By contrast, views on the role of public debt as a crucial state revenue source are today unambiguously negative. The forces driving public debt are largely consistent with those underlying the law of increasing state activity. Thus far, all efforts to establish constitutional provisions limiting public debt have failed; it remains to be

274

Boadway and Shah (2009), chap. 19. Cf. Anderson (2010), 6.2. 276 Cf. Rodi (2004), Article 109 GG. 277 See Sect. 5.3.2.2.2 above and Anderson (2010), 5.4. 275

References

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seen whether this will hold true for the strict upper limits that were recently introduced. The economic analysis of public finance under federalism is even more challenging. This is an especially complicated topic in the context of Germany’s mixed system: in accordance with the Basic Law, the system divides legislative competence, financing competence and taxing power between the federal government and the Länder and provides for transfer payments and fiscal equalisation. These measures largely prevent federal tax competition.

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Boadway R (2012) From optimal tax theory to tax policy. Retrospective and prospective views. The MIT Press, Cambridge, MA Boadway R, Shah A (2009) Fiscal federalism: principles and practices of multiorder governance. Cambridge University Press, Cambridge Brennan G, Buchanan JM (1974) Towards a tax constitution for Leviathan. J Public Econ 8:255– 273 Brennan G, Buchanan JM (1980) The power to tax: analytical foundations of a fiscal constitution. Cambridge University Press, Cambridge u.a. Bruttel L, Friehe T (2014) On the path dependence of tax compliance. Eur Econ Rev 64:90–107 Buchanan JM, Wagner RE (1977) Democracy in deficit. The political legacy of Lord Keynes. Academic Press, London et al. Burman LE, Rohaly J, Rosenberg J, Lim KC (2010) Catastrophic budget failure. Natl Tax J 63:561– 583 Canegrati E (2012) Economics of taxation. Normative and positive theories. Nova Science Publishers, New York Churchman N (2001) David Ricardo on public debt. Palgrave, New York Constantini O (2017) Political economy of the stability and growth pact. Eur J Econ Econ Policies Interv 14:333–350 Corneo G, Neher F (2015) Democratic redistribution and the rule of the majority. Eur J Polit Econ 40:96–109 Czech S, Tusinska M (2016) Economic growth, public debt and social spending. Should welfare state take the blame? Economia I Prawo (Econ Law) 15:33–45 Debrun X, Gueguil M (2013) That squeezing feeling: the interest burden and public debt stabilization. IMF Working Paper 13/125 of May 2013 Delmotte C (2019) The concept of taxation. The Romantic versus the realistic point of view. In: Boudreax DJ, Coyne CJ, Herzberg B (eds) Interdisciplinary studies of the political order. New applications of public choice theory. Rowman & Littlefield, London/New York, pp 131–155 Devreux MP, Loretz S (2013) What do we know about corporate tax competition? Natl Tax J 66: 745–774 Dietsch P (2018) The state and tax competition. A normative perspective. In: O’Neill M, Orr S (eds) Taxation. Philosophical perspectives. Oxford University Press, Oxford, pp 203–223 Dietsch P, Rixen T (2016) Global tax governance: what it is and why it matters. In: Dietsch P, Rixen T (eds) Global tax governance. What is wrong with it and how to fix it. ECPR Press, Colchester, pp 1–23 Dollery B, Singh S (1998) A note on the empirical analysis of Wagner’s law. Econ Anal Policy 28: 245–257 Eichengreen B, El-Ganainy A, Esteves RP, Mitchener KJ (2020) Public debt through the ages. In: Abbas SA, Pienkowski A, Rogoff K (eds) Sovereign debt. A guide for economists and practitioners. Oxford University Press, Oxford, pp 7–55 Eusepi G, Wagner RE (2017) Public debt: democratic political economy. Edward Elgar Publishing, Cheltenham/Northampton Färber G (2018) Taxing powers of subnational entities: between domestic and supranational constraints. In: Valdesalici A, Palermo F (eds) Comparing fiscal federalism. Brill Nijhoff, Leiden/Boston, pp 149–168 Fatás A, Ghosh AR, Panizza U, Presbitero AF (2020) The motives to borrow. In: Abbas SA, Pienkowski A, Rogoff K (eds) Sovereign debt. A guide for economists and practitioners. Oxford University Press, Oxford, pp 102–150 Feld LP, Schneider F (2011) Survey on the shadow economy and undeclared work in OECD countries. In: Schneider F (ed) Handbook on the shadow economy. Edward Elgar Publishing, Cheltenham/Northampton, pp 78–130 Forte F, Magazzino C (2014) Optimal size of government and the optimal ratio between current and capital expenditure. In: Forte F, Mudambi R, Navarra PM (eds) A handbook of alternative

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McCaffery EJ (2014) Behavioral economics and the law: tax. In: Zamir E, Teichman D (eds) The Oxford handbook of behavioral economics and the law. Oxford University Press, Oxford, pp 599–622 McCaffery EJ, Baron J (2006) Thinking about tax. Psychol Public Policy Law 12:106–134 Meltzer AH, Richard SF (1981) A rational theory on the size of government. J Polit Econ 89:914– 927 Merrifield JD, Poulson BW (2016) Can the debt growth be stopped? Rules-based policy options for addressing the federal fiscal crisis. Lexington Books, Lanham et al. Mill JS (1921–1924) Principles of political economy with some of their applications to social philosophy, 1848; deutsch: Grundsätze der politischen Ökonomie mit einigen Anwendungen auf die Sozialphilosophie, Jena Morabito V, Barkoczy S (1996) What is a tax? The erosion of the Latham definition. Revenue Law J 6:43–63 Mueller DC, Murrell P (1986) Interest groups and government size. Public Choice 48:125–145 Mutti JH (2003) Foreign direct investment and tax competition. Inst. For International Economics, Washington D.C. Nicodème G (2007) Cooperate tax competition and coordination in the European Union: what do we know? Where do we stand? In: Read C (ed) International taxation handbook: policy, practice, standards, and regulation. Elsevier, Amsterdam u.a., pp 171–208 Nicolini M (2018) The principles of separation and correspondence, the comparative method, and the problem of semantic change. In: Valdesalici A, Palermo F (eds) Comparing fiscal federalism. Brill Nijhoff, Leiden/Boston, pp 83–114 OECD (2015) Prudent Debt Targets and Fiscal Frameworks, OECD Economic Policy Paper No. 15, July 2015 OECD (2019a) Governance at a glance. OECD Publishing, Paris OECD (2019b) OECD/G20 Base Erosion and Profit Shifting Project. Harmful Tax Practices – 2018 Progress Report on Preferential Regimes. OECD Publishing, Paris Olson M (1965) The logic of collective action: public goods and the theory of groups, 21st print 2003. Harvard University Press, Cambridge Olson M (1982) The rise and decline of nations: economic growth, stagflation, and social rigidities. Yale University Press, German Edition: Olson M (1985) Aufstieg und Niedergang von Nationen: Ökonomisches Wachstum, Stagflation und soziale Starrheit. Mohr Siebeck, Tübingen Ortiz-Ospina E, Roser M. Government Spending, 2016 (www.ourworldindata.org/governmentspending) Orviska M, Hudson J (2006) Quiet in the Cathedral: who is the law abiding citizen? Homo Oeconomicus 23:129–152 Orviska M, Caplanova A, Medved J, Hudson J (2006) A cross-section approach to measuring the shadow economy. J Policy Model 28:713–724 Palermo F, Kössler K (2017) Comparative federalism. Constitutional arrangements and case law. Bloomsbury Publishing, London Paparas D, Richter C (2019) A synthesis of empirical research on the validity of Wagner’s law. Int J Bus Glob 22:555–583 Peacock A, Scott A (2000) The curious attraction of Wagner’s law. Public Choice 102:1–17 Rixen T (2007) Taxation and cooperation - international action against harmful tax competition. In: Schirm SA (ed) Globalization - state of the art and perspectives. Routledge, London u.a. Rixen T (2016) Institutional reform of global tax governance: a proposal. In: Dietsch P, Rixen T (eds) Global tax governance. What is wrong with it and how to fix it. ECPR Press, Colchester, pp 325–349 Rodi M (1994) Die Rechtfertigung von Steuern als Verfassungsproblem. Dargestellt am Beispiel der Gewerbesteuer. Beck, München Rodi M (2004) Kommentierung des Art. 109 Grundgesetz. In: Dolzer R, Vogel K (eds) Bonner Kommentar zum Grundgesetz. HJR Verlag, Heidelberg Rodi M (2008) Internationaler Steuerwettbewerb. StuW 85(4):327–336

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Rodi M (2012) Energiepolitik, Transeuropäische Netze, Wirtschafts- und Währungsunion, Europäische Investitionsbank, Statistik. In: Vedder C, Heintschel v. Heinegg W (eds) Europäisches Unionsrecht. EUV, AEUV, Grundrechte-Charta. Nomos, Baden-Baden Ryczewski C (2011) Die Schuldenbremse im Grundgesetz. Untersuchung zur nachhaltigen Begrenzung der Staatsschulden unter polit-ökonomischen und bundesstaatlichen Gesichtspunkten. Duncker & Humblot, Berlin Salanié B (2000) Microeconomics of market failures. The MIT Press, Cambridge Saunders C (2018) Financial autonomy vs. solidarity: a dialogue between two complementary opposites. In: Valdesalici A, Palermo F (eds) Comparing fiscal federalism. Leiden/Boston, Brill Nijhoff, pp 40–59 Schneider U (2009) Staatsausgaben und Sozialtransfers. Theoretische und empirische Analyse der Entwicklung der Staatstätigkeit. Nomos, Baden-Baden Schnellenbach J (2018) Fiscal sovereignty in a globalized world: the pressure of the European economic governance on domestic public finance. In: Valdesalici A, Palermo F (eds) Comparing fiscal federalism. Brill Nijhoff, Leiden/Boston, pp 328–346 Schöbel E (2008) Steuerehrlichkeit. Eine polit-ökonomische und zugleich finanzsoziologische Analyse der Einkommensteuerrechtsanwendung und -befolgung in Deutschland. Haag + Herchen, Frankfurt a.M. Schultz D (ed) (2004) Encyclopedia of public administration & public policy. Facts on File, New York Schwartzberg M (2014) Counting the many: the origins and limits of supermajority rule. Cambridge University Press, New York Shaviro DN (2017) Economics of tax law. In: Parisi F (ed) Public law and legal institutions. The Oxford handbook of law and economics, vol 3. Oxford University Press, Oxford, pp 106–125 Smith P (1991) Lessons from the British Poll Tax Desaster. Natl Tax J 44:421–436 Sobel RS, Clark JR (2016) Interest group activity and government growth: a causality analysis. Cato J 36:507–533 Stearns ML, Zywicki TJ, Miceli TJ (2018) Law and economics: private and public. West Academic Publishing, St. Paul Stiglitz JE, Rosengard JK (2015) Economics of the public sector, 4th edn. W. W. Norton, New York/London Tanzi V (1996) Globalization, tax competition and the future of tax systems. International Monetary Fund Working Papers 141:1–21 Tanzi V (2014) The Laffer curve muddle. In: Forte F, Mudambi R, Navarra PM (eds) A handbook of alternative theories of public economics. Edward Elgar Publishing, Cheltenham/ Northhampton, pp 104–115 Tanzi V, Schuknecht L (2000) Public spending in the 20th century: a global perspective. Cambridge University Press, Cambridge Thiele A (2015) The “German Way” of curbing public debt: the constitutional debt brake and the fiscal compact – why Germany has to work on its language skills. Eur Constit Law Rev 11:30– 54 Thuronyi V (2003) Comparative tax law. Kluwer Law International, The Hague/London/New York Tiebout C (1956) A pure theory of local expenditures. J Polit Econ 64:416–424 Tiszberger MG (2022) Shadow economy: a comprehensive concept and the interpretation of its size. Int Soc Sci J 72:175–191 Torgler B (2003) Does culture matter? FinanzArchiv Public Finance Anal 59(4):504–528 Torgler B, Schneider F (2006) What shapes attitudes towards paying taxes? Evidence from Multicultural European Countries, Bonn (IZA Discussion Papers No. 2117, May 2006) Tullock G (1959) Problems of majority voting. J Polit Econ 67:571–579 Ungureanu M, Iancu D (2012) The economic analysis of bureaucracy and government growth. Theor Appl Econ XIX 11(576):59–74 Wagner RE (2015) The tax state as source of perpetual crisis. In: Boettke PJ, Coyne CJ (eds) The Oxford handbook of Austrian economics. Oxford University Press, Oxford, pp 445–463

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Wegschal U (1987) Direct democracy and public policy making. J Public Policy 17:223–245 Wilson JD (2006) Tax competition in a federal setting. In: Ahmad E, Brosio G (eds) Handbook of fiscal federalism. Edward Elgar Publishing, Cheltenham/Northampton, pp 339–354 Yared P (2019) Rising government debt: causes and solutions for a decades-old trend. J Econ Perspect 33:115–140 Zamir E, Teichman D (2018) Behavioral law and economics. Oxford University Press, Oxford Zimmermann H, Henke K-D, Broer M (2021) Finanzwissenschaft: eine Einführung in die Lehre von der öffentlichen Finanzwirtschaft, 13th edn. Vahlen, München

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Public Economic Law

Economic analysis can also provide important insight into the norms that are associated with the framework regulating the economy and economic policy. In accordance with the continental law approach, this analysis considers the norms associated with economic activities from a public law perspective, i.e. with regard to the regulation of the economy to promote public goods, rather than as part of a framework that guarantees the functioning of the economy.

6.1

Basic Principles

6.1.1

General Economic History

Because the global economy and its regional subsystems are largely the product of social and technological conditions, they can only be understood in the context of historical developments. The questions addressed in the following pages illustrate the important role of a historical perspective in economic analysis. First, the social influences that have been instrumental in the development of economic systems are clearly influenced by historical factors. The theories of Karl Marx, for example, explained economic development in terms of the modes of production and ownership of the means of production. Max Weber later emphasied the influence of the ‘Protestant ethic’ on the development of capitalism. Present-day perspectives focus increasingly on the influence of globalisation on national economies.1 Today, the argument that there is a consistent, even inevitable course to the historical development of economic systems remains of great interest. This is the position represented in the works of Karl Marx and other historical materialists; however, support for this view has diminished over time.

1

See Sect. 6.4.1 below.

# Springer-Verlag GmbH Germany, part of Springer Nature 2022 M. Rodi, Economic Analysis of Public Law, Springer Textbooks in Law, https://doi.org/10.1007/978-3-662-66089-8_6

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6.1.2

6

Public Economic Law

Constitutional and European Legal Framework for Economic Policy

An economic analysis of economic law and economic policy must, of course, indicate which rules are anchored in or shaped by higher-ranking law.

6.1.2.1 Economic Policy Guidelines in European Primary Law The main objective of the European legal framework is to create an internal market (Article 26 TFEU)2 that is based on the ‘fundamental freedoms’ guaranteed in Article 45 ff. TFEU. This is the foundation of European economic policy, which is committed to ‘the principle of an open market economy with free competition’ (cf. Article 119(1) TFEU). It provides relatively weak guidelines regarding competences, however, and aims to ensure ‘closer coordination’ of the economic policies of Member States (Article 121 TFEU). Title VII of the treaty contains competition rules—such as antitrust provisions for businesses (Article 101 ff. TFEU) and review procedures for state aid (Article 107 ff. TFEU)—and is thus particularly significant in the context of the economic constitution. Still, European constitutional law does not explicitly or unambiguously declare support for the development of a market or competitive economic system. Various dirigiste (‘interventionist’) approaches are included in the constitution, reflecting the traditions of certain Member States; the influence of these traditions is particularly evident with regard to agricultural policy (Article 39 ff. TFEU), transport policy (Article 90 ff TFEU) and structural policy (Article 174 ff. TFEU). The regulation on public enterprises also reflects a compromise (Article 106(2) TFEU). On the whole, the European economic constitution establishes a ‘mixed system’3 that incorporates both market and interventionist elements and grants considerable leeway to economic policymakers. 6.1.2.2 National Economic Constitutions National constitutions rarely include detailed provisions on the basic structures of economic governance, although some form of these provisions is included in the new constitutions of Eastern European countries to emphasise the transition from Communist systems. Article 20 of the Polish Constitution, for example, states: ‘A social market economy, based on the freedom of economic activity, private ownership, and solidarity, dialogue and cooperation between social partners, shall be the basis of the economic system of the Republic of Poland.’ For EU Member States, vague stipulations to this effect already follow from the European ‘constitution’.4 Interpretations of general constitutional principles would likely also produce the same result. The German Constitutional Court has stated,

2

On the European economic constitution, see Hofmann and Pantazatou (2019). See, e.g., Froufe (2019). 4 See Sect. 6.1.2.1 above. 3

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however, that the absence of specific provisions does not mean that the ‘financial constitution’ of the Basic Law is ‘open ended’:5 the general constitutional principles (i.e. basic rights and defined state goals) also apply to the economic sphere. The objective values reflected in the fundamental economic rights (freedom of profession and freedom of property), for example, indicate that the economy must be organised around the institution of private property and a fundamentally market-oriented structure. A centrally planned economy would be incompatible with these requirements.

6.1.3

Topics in Legal Economics

6.1.3.1 Economic Analysis of Public Economic Law 6.1.3.1.1 Public Economic Law as a State Regulatory Instrument The present treatment of public economic law reflects one assumption, i.e that the social subsystem of the economy is controlled by the state in the public interest. Regulation is often mentioned in this context. Here, this term refers to the targeted influence of the state on individual behaviour.6 The present discussion refers to regulation only as it concerns economic activities.7 More specifically, the phenomenon of regulation is interpreted from an economic perspective, i.e. as direct market interventions in cases of ‘market failure’ or as the creation of markets where they are missing—that is, as economically motivated state intervention to limit market mechanisms or take over market functions (production and distribution) in the absence of a market. 6.1.3.1.2 Public Economic Law as a Public Good The function of public economic law is to activate the qualities of competition that increase prosperity as well as to eliminate cases of market and state failure. In principle, no one can be excluded from these positive effects. It is therefore logical to consider public economic law as a ‘public good’ that is offered to voters or citizens on the ‘regulation market’8 at a certain price (primarily through taxes).9 Peters correctly emphasises the analytical utility of the paradigm regarding competition in comparing competition between legal systems (as ‘products’).10

5 The Basic Law makes no definitive statements in favour of a particular economic system; see Leaman (1988). 6 See Morgan and Yeung (2007), pp. 16 ff. (Chap. 2), in which the authors distinguish this narrow definition of the term from other, broader definitions; see also Windholz (2017), pp. 7 f. 7 Literature in the Anglo-American tradition distinguishes the narrower concept of ‘economic regulation’ from the broader concept of ‘social regulation’; see Ogus (1994), pp. 4 ff. 8 See Sect. 4.2.1.2 above. 9 See Sect. 3.1 above. 10 Peters (2010), pp. 14 ff.

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6.1.3.1.3 The Economy as a System The analysis of public economic law and economic policy is decisively influenced by a preliminary consideration: which economic order will provide the framework for analysis? There are certainly basic research questions that concern the economy as such or as a social system. For more concrete questions, however, economic orders must be assigned to specific economic systems, such as free, social or socialist market economies or various forms of centrally planned economies.11 Of course, in Western constitutional states, free or social market economies are generally used as the basis. When we exclude a centrally planned economy from the analysis, we accept the premise that the economy is a system outside the state, constituted by independent communication structures based on independent principles.12 From a systems perspective, the state intervenes in this social subsystem ‘from outside’ through legal guidelines and incentives. At the same time, the economy itself has a significant impact on the state (which is another topic of great interest in economic analysis), which results either from targeted influence (lobbying) or simply from the fact that state must accept the functional and operative logic of the economy (e.g. the process of globalisation). In light of these considerations, there is some justification for interpreting this concept in terms of interaction rather than merely intervention. 6.1.3.1.4 Competition Between Economic Systems and Economic Orders It is also important to consider why differences in economies exist, and above all why different systems have varying degrees of success. Douglass C. North proposed an institutional approach to these questions that breaks from classical theory13 by focusing on the nature of human coordination and cooperation rather than on scarcity and competition. He argued that, in order to facilitate cooperation, societies develop institutional frameworks that vary in efficiency (in particular, they create incentives). The ideas of Karl Marx (e.g. the significance of the means of production) and Max Weber (e.g. the significance of cultural influences) can be integrated into this approach. The impact of institutional design on the success of economic orders can be analysed through this lens, especially with regard to growth and development.14 Ultimately, of course, this is a question of the effectiveness (and effects) of public economic law itself.15

6.1.3.2 Economic Analysis of Markets and Firms Every economic analysis of economic systems focuses on the market as the mechanism of coordination. This was the focus in classical economics as well, at least as far

11

For a corresponding typology, see, e.g., Kim (2012), pp. 11 ff. For this perspective on the economy, which is based on Luhmann’s systems theory, see Boldyrev (2013). 13 See, e.g., North (1990), pp. 11 ff., 131 ff. 14 For an overview, see Voigt (2009), p. 5.3 and 5.4; for further detail, Guangdong (2014). 15 Schanze (2009), pp. 65 ff. 12

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back as Adam Smith. In the words of Walter Eucken, the market represents ‘the meeting of supply and demand’.16 The analysis of markets has been substantially refined by the New Institutional Economics,17 which perceives the market as a network of (more or less) rational contracts between individuals (potential buyers and sellers, vertical or horizontal). It is an organisation consisting of institutional rules and the people who create and apply them in the belief that doing so will yield a higher level of utility. Unlike classical economics, the New Institutional Economics examines the role of informational constraints and transaction costs. It is also important to distinguish between the role of positive and normative analysis in an economic analysis of economic policy and public economic law. Positive analysis explains the causes for the development and modification of institutions and orders on the basis of the rational decision-making calculations of participating actors. Normative analysis builds on the insights from positive analysis to evaluate existing or potential economic orders and provide recommendations for their reorganisation or further development. In Germany, ordoliberalism—developed in large part by Walter Eucken of the Freiburg School—was especially influential in this context.18 This school of thought predicates its search for efficient solutions on an evaluative concept: the principle that individual rights to freedom are just as important in the context of an economic order as they are in the context of a politico-institutional order. The Freiburg School thus advocates the creation of a private market economy, in which individuals act according to self-defined goals and make economic decisions based on competitive market processes.

6.2

State and Competition

6.2.1

Guarantee of Effective Competition Between Private Parties

The guarantee of effective competition between private parties is one of the main responsibilities of the state.19 While competition is not an end in itself, there is broad consensus that (functional) competition is an indispensible tool to ensure an efficient supply of goods and services, which increases the welfare of the society as a whole and of producers and consumers as individuals.20 For this reason, rules establishing economic competition are often fundamental constitutional principles.21

16

Eucken (1950), p. 109. See Sect. 1.2.2.3.2 above. 18 On ordoliberalism and the Freiburg School, see Crane (2013). 19 See Sect. 2.3 above; see also Coyle (2020), chap. 1 and 2. 20 Dabbah (2010), pp. 8 ff. 21 See Sect. 6.1.2.2 above. 17

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6.2.1.1 Protection of (Existing) Competition Competition is threatened when the state fails to protect it through regulation. In such cases, self-interested economic actors try to obtain advantages by violating the basic rules of functional (fair) competition. In addition to prohibiting unfair practices, it is essential to counter the natural tendency of market participants to undermine competition through agreements, mergers or even monopoly formation.22 (It is no coincidence that the ‘law and economics’ movement has its roots in cartel (antitrust) law.)23 These kinds of interferences can distort the beneficial (efficient) effects of competition. Competition law has long been considered necessary to prevent these market failures.24 The famous Sherman Antitrust Act, which was enacted in the US in 1890, served as a model for such measures; since its passage, more than 120 states around the world have adopted more or less detailed competition laws.25 Competition law traditionally governs national competition within a state territory. As globalisation has increased, competition has taken on a more transnational character. But even under these circumstances, it is possible for competition between private economic actors to become endangered and distorted, leading to losses in efficiency and benefits. In contrast to the system in place at a national level, there is no regulatory authority for international competition, and states are reluctant to enter into binding agreements. This concerns material rules of international law on competition as well as institutional arrangements; the competences of international organisations regarding competition are thus relatively weak.26 From an economic perspective, this is rooted in the fact that functional competition, like international competition law itself, is also a public good at the international level. The application of national competition rules to transboundary transactions provides one option for states to resolve this dilemma (the unilateral option).27 It is unlikely that this extraterritorial assertion of jurisdiction will lead to efficient results, however; it also leads to legal problems and disputes regarding the limits of the territoriality principle of public international law (and thus raises transaction costs).28 6.2.1.2 Creation of (New) Competition A relatively new task for the state is to create competition in areas that previously had, or still have, monopolistic structures characteristic of natural monopolies. The state attempts to enable competition in these areas, which include grid-based power

22

On the law and economics of market power, see Raitt (2019), pp. 39 ff. On the Chicago School, see Mercuro and Medema (1997), chap. 2. For an overview of antitrust law, see Kaplow and Shapiro (2007). 24 Dabbah (2010), pp. 10 ff. 25 Dabbah (2010), pp. 3 ff. For details on the Sherman Act, see 238 ff. 26 Dabbah (2010), Chap. 2. 27 Ibid., Chap. 8. 28 On unilateral options of international competition law, see Dabbah (2010), Chap. 8. 23

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supply, railroads and telecommunications. The development of suitable instruments for this purpose is also a challenging task.29

6.2.2

State Activities Related to Competition

Economic analysis focuses more closely on the relationship between the state and the economy. From an economic perspective, any state activity that influences the economy must be considered, including all intervention in economic markets by the state or sub-state entities that have the potential to infringe on the legal rights of market participants. Such activities fall into four main categories: (1) direct competition, particularly the economic activity of the public sector (see Sect. 6.2.2.1); (2) state influence on the competitive position of private market players through effects on demand (e.g. product warnings or product testing); (3) influence on the competitive position of private market players through state regulatory measures, including state economic governance in particular; and (4) influence on the competitive position of private market actors through measures favouring certain competitors over others, such as the granting of subsidies or public contracts (see Sects. 6.2.2.2 and 6.2.2.3 below).

6.2.2.1 State-Owned Enterprises (SOEs) In economics, companies have always been the topic of greatest interest. The economic analysis of public law focuses mainly on the activity of the state as an entrepreneur.30 Since the free trade concept was introduced, the prevailing view has been that economic activity should primarily be carried out by private parties while the state monitors and regulates this activity and participates in the economic success of private parties, chiefly through taxation. This view is reflected in the principles of modern constitutions. In light of the classical understanding of economic analysis that competition takes place between private actors, it is necessary to justify state participation in it. This justification will provide insight into the appropriate legal framework to govern the role of the state in public business activities. 6.2.2.1.1 The State as an Entrepreneur: Current and Historical Relevance States have participated in entrepreneurial activities ever since the formation of states in the modern sense of the word.31 Under the mercantilist system that was predominant in Europe during the Age of Absolutism, state engagement in commercial activity was a matter of course and a core component of economic organisation.

29

See Sect. 6.3.3 below. For an introduction, Backhaus (2005); for greater depth, Bernier et al. (2020). 31 For a historic overview, see Bognetti (2020). 30

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There was no need to consider the deeper meaning of this economic activity or its justification; the fact that it contributed significantly to state revenue was sufficient. After a period of privatisation (mainly in the 1980s and 1990s), SOEs regained importance, especially due to the effects of the financial crisis after 2009. They have been rediscovered as an important policy tool.32 Today, there are roughly 2500 SOEs worldwide (except for China) and more than 50,000 in China alone. SOEs around the world (outside China) are valued at $2.4 trillion and employ around 10 million people. In China, SOEs are valued at $29.2 trillion and employ 20 million people.33 SOEs are active in three main sectors: finance (26%), electricity and gas (21%) and transportation (18%).34 6.2.2.1.2 Definition and Forms of Public (State-Owned) Enterprises The terms public enterprises and state-owned enterprises are often used as synonyms,35 although the latter has a relatively narrow meaning. As a rule, there is no formal legal definition of these terms, except in free trade agreements; they are thus understood and applied differently in national and international contexts. Still, the definition of public enterprise or state-owned enterprise is central to the concept of state commercial activity and to the set of rules that regulate it. Various interpretations of the terms have begun to converge to create one functional definition due to the influence of OECD activities36 and the case law of the European Court of Justice. For the purposes of protecting competition, a ‘concept of control’37 has evolved based on three criteria:38 (1) An organisational entity exists that is de facto or de jure independent (regardless of the legal status of the entity or the way in which it is financed). If the concept included only independent legal persons, it would apply too narrowly to protect competition.39 (2) The enterprise is engaged in an economic activity (that could at least in principle be carried out by a private undertaking to generate profit). (3) The enterprise is owned by the state or controlled through a public authority. An enterprise is ‘owned by the state and controlled through a public authority’ when the public sector can exercise direct or indirect influence over it by virtue of their ownership, financial investments, charters or other provisions that govern the

32

Howlett and Ramesh (2020). OECD (2017), p. 13. 34 Ibid., 17. 35 See, e.g., Bottini (2020). 36 See, e.g., OECD (2015), pp. 14 f. 37 Willemyns (2016), p. 665. 38 For further detail, see Bottini (2020). 39 See Bottini (2020), pp. 261 ff. 33

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activities of the enterprise. In EU competition policy, the EU Commission defines a public undertaking as an undertaking over which the public authorities directly or indirectly exercise dominant influence by virtue of their ownership, financial participation, or the rules which govern it. A dominant influence of public authorities is presumed in particular when they a) hold the major part of the undertaking’s subscribed capital, b) control the majority of votes attached to shares issued by the undertaking or c) are in a position to appoint more than half of the members of the undertaking’s administrative, managerial or supervisory body.40

Public enterprises are typically diverse in form and structure. In principle, the organisational autonomy of the public sector provides the freedom to choose whether public-sector enterprises will be operated under private or public law.41 If the public sector opts for an organisational form under private law, this transformation occurs through formal privatisation. This form benefits the state by enabling it to evade the strict provisions of national organisational and budgetary policies in its competition with private enterprises; for example, it can provide more competitive salaries. 6.2.2.1.3 Market Failures Associated with Public Enterprises Because of their strong financial position, SOEs generally have a competitive advantage that they can exploit. This can lead them to interfere in private markets and distort competition. As discussed above, functioning competition is a public good and should be protected from unjustified government intervention. From the perspective of law and economics, any intervention—and the legal framework that permits it—must be justified on the grounds of market failure. Theoretically, the market failures resulting from such intervention can take many forms.42 For example, failures may be associated with a lack of competition (especially in the case of natural monopolies), the provision of public goods (public enterprises serve public interests) or information asymmetries (especially in the financial sector with regard to high risk or venture capital). In practice, governments are more likely to justify SOE ownership as a means to support ‘national economic and strategic interests’ than to supply specific public goods.43 From a national perspective, SOE ownership may be seen as a tool to enable competition, such as by helping a national champion gain a foothold in the world market. Such interventions may be justified if corresponding market failures are identified. From an economic perspective, it is more challenging to specifically justify the market activities of public enterprises than to simply identify private market failures for a number of reasons. First, states may have instruments that can address market failures with less intervention in competitive markets, for example by directly

40

European Commission (2003). Bottini (2020), p. 262. 42 Putniņš (2020), pp. 218 ff. 43 For relevant statistics, see OECD (2018), p. 19. 41

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providing public goods that are not available on private markets. Second, state activities on private markets may themselves lead to serious economic problems. The main concern in this context is the alleged lack of (technical and allocative) efficiency in public enterprises,44 which can crowd out desirable private investments. Another challenge is the clear principal-agent situation that emerges in the relationship between state authorities (the principal) and managers of the public enterpise (the agents).45 In every private enterprise, managers are primarily concerned with optimising shareholder value, because this is an apparent yardstick to assess their success (often in combination with economic advantages like bonuses); this is especially true in cases of public-private partnerships.46 Their function to serve the public interest is thus easily ignored. State authorities often have few options to monitor whether public interests are adequately considered.47 On the part of state actors (implementing and supervising public enterprises) this may be accompanied by government failure, in the form of behaviour ranging from rent-seeking to corruption.48 These risks are especially pronounced because such scenarios often involve several principals.49 For example, the Frankfurt airport (commonly known as Fraport) is owned by the German federation, the state of Hessen, the city of Frankfurt and private shareholders. In such constellations, it is difficult to harmonise the interests of different principals and ensure that the agent (s) will be effectively monitored and controlled. As a result, the justification for public enterprises and rules enabling their market activity requires a careful assessment that balances market failures against government failures and inefficiencies in public enterprises. 6.2.2.1.4 The Legal Framework for Public Enterprises The existence of public enterprises poses a significant challenge for legal systems. It also illustrates the seeming impossibility of ensuring the freedom of economic activities while protecting the public interest. European law, like national law, recognises public enterprises50 but acknowledges that the special legal status of public enterprises must be justified

44

For an overview of arguments, see Putniņš (2020), pp. 228 ff. Stewardship theory provides an alternative framework for interpreting public enterprises. In contrast to principal-agent theory, stewardship theory suggests an alignment of actors through collective, cooperative and pro-organisational behaviour based on intrinsic motivations. Empirical studies of this alternative have been rare; see Papenfuß (2020), p. 436 and further reference. 46 See Prosser (2014), pp. 194 ff. 47 Prosser (2014), pp. 191 ff. 48 Putniņš (2020), p. 231 and further reference. 49 See Papenfuß (2020), p. 435. 50 Neutrality vis-à-vis the public sector in European law is based on Articles 14 and 106 AEUV in conjunction with Article 345 AEUV, according to which national systems of property ownership remain unaffected. In Germany, this conclusion follows indirectly from the wording of the Basic Law, which refers to the commercial enterprises of the federal government in Article 110(1) GG 45

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objectively in the public interest.51 Realisation of profits is no longer accepted as a justification. European law has recognized that the pursuit of state interests may be inconsistent with competition law. Article 106 TFEU presents a solution that at least initially appears elegant: ‘[i]n the case of public undertakings and undertakings to which Member States grant special or exclusive rights, Member States shall neither enact nor maintain in force any measure contrary. . .to this Treaty’ (Article 106(1) TFEU). It continues: Undertakings entrusted with the operation of services of general economic interest. . .shall be subject to the rules contained in the Treaties, in particular to the rules on competition, in so far as the application of such rules does not obstruct the performance, in law or in fact, of the particular tasks assigned to them (Article 106(2)(1) TFEU).

Tension between these principles nevertheless emerges in specific circumstances, which can cause significant problems. Constitutions typically do not provide general rules on public enterprises. The Polish Constitution, for example, establishes no material guidelines but contains provisions requiring the specific enactment of a parliamentary statute for all state financial and commercial activities. There are three general categories of constitutional rules: (1) rules defining areas of sovereign state activities that cannot be privatised or executed in the form of economic undertakings (see, e.g., Article 33(4) of the German GG); (2) rules defining state monopolies or setting up preconditions for them (see, e.g., Article 177 of the Brazil Constitution in respect to Petrobras); and (3) rules regulating public infrastructure enterprises (see, e.g. Article 21, sections 11–12 of the Brazil Constitution, or Articles 87e and 87f of the German Constitution) and other ‘services of common interest’ (see Article 106 TFEU). In addition to these explicit rules, there is an important question of constitutional dogmatics: to what extent are public enterprises entitled to, and bound by, basic rights?52 Entitlement to these rights may be denied to purely public enterprises on the grounds that these enterprises qualify as part of the state.53 The Federal

(‘federal enterprises’) and Article 135(6) GG (‘[h]oldings of the former Land of Prussia in enterprises established under private law shall pass to the Federation’). 51 For European law, see European Court of Justice Reports 1993 I, 2533, 2569. 52 The prevailing view is that this question can be answered in the affirmative due to rules governing private-law transactions of public bodies—provided that the functions performed by public enterprises are directly public, as in the case of services in the common interest; on the jurisprudence of the German Constitutional Court (especially the Fraport case), see Bumke and Voßkuhle (2019), annotation 39 ff., 840 ff. 53 On the jurisprudence of the German Constitutional Court, see Bumke and Voßkuhle (2019), annotation 26 ff.

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Constitutional Court also justifiably denies this entitlement to state-controlled mixed enterprises.54 There are generally good reasons for the legislature to establish certain preconditions for public enterprises. In the present context, the most relevant of these are the requirements to define legitimate public interests and the duty of the administration to identify the specific public interests that a given public enterprise will support. These requirements must be met before the legality of the justification can be tested. In the past, market failures that resulted from indivisibilities and natural monopolies were important arguments for a justification in the public interest. Today, however, there is a growing recognition that these factors do not necessarily require economic intervention by the state. The economic perspective primarily considers whether and to what extent public enterprises produce public goods.55 In European law, this question concerns ‘services of general interest’. There is a growing consensus that corporate governance codes should provide a framework for managing and monitoring public enterprises.56 In practice, these are often informal. Considering their importance for the underlying principal-agent situation, they should have a legally binding form.

6.2.2.2 Public Procurement The role of public contracts, and thus of public procurement, is increasingly important in the economic debate. This is not only because of the quantitative importance of such contracts in government budgets, but also because of their significance for competition.57 The importance of public contracts for the economy and competition is clear from their volume alone: around the world, governments spend an estimated $9.5 trillion on public procurement—an average of 13–20% of GDP.58 The scope of public contracts has steadily increased in recent years as states have diverted a growing number of public tasks to the private sector. 6.2.2.2.1 Economic Analysis of Public Contracts The challenges associated with public contracts generally arise in the following areas: (1) sound budgetary management, (2) proper adminstration of public expenses,

54

On the jurisprudence of the German Constitutional Court, see Bumke and Voßkuhle (2019), annotation 22. Exceptions are made only in the event that ‘basic rights are specifically threatened’, as in the case of universities or broadcasting companies. 55 See, e.g., Backhaus (2005). 56 See Papenfuß (2020). 57 For an introduction, see Sánchez Graells (2018). 58 The World Bank (2020).

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(3) protection and promotion of competition and (4) promotion of other societal goals. Traditionally, the law only considers the budgetary implications of public contracts. It is clearly in the state’s interest to purchase works and services that are subject to the most economically advantageous conditions. That is why public contracts have long been regulated (only) by budgetary law. Today, states are becoming increasingly aware that the management of public procurement is an important task in itself. It is challenging for the administration (and the legislature) to develop adequate procedural and organisational rules to ensure sound control and execution of this task. In addition, public procurement must be viewed as demand-side market behaviour of the public sector. The enormous (and growing) ‘buying power’ of states threatens the competitive interests of potential providers of works and services. On the other hand, this power may actually promote competition. There is some reason to doubt that public contracts can be adequately analysed from the perspective of classical markets, as such ‘markets’ are largely dominated by public actors.59 This reasoning suggests that general competition law does not provide an adequate and sufficient framework for regulation, which makes special regulations necessary for public procurement.60 Finally, public procurement is a strategic tool to advance public-interest objectives, from support for mid-size companies to environmental protection.61 In general, states have recognised the benefits of instituting this mechanism. Still, implementing a public procurement system could conflict with the interests of potential providers and undermine competition. In light of these possible conflicts and the different functions that public procurement can serve, it is obvious that special regulation is necessary to strike the optimal balance between the varied interests of state and private actors. Public procurement law encompasses all rules and regulations that prescribe a specific procedure for the government, its subdivisions or other contracting authorities with regard to any purchase of goods and works or use of other services on the market. In designing the appropriate legal framework, it is important to consider the potential market failures involved in the process of public procurement. The most important category of market failures relates to the potential for public contracts to endanger the proper functioning of competition, which is a clear example of a public good.62 The relationship between state agencies or other public entities is characterised by a two-fold principal-agent structure: on the one hand, the state acts as a principal to private entities that supply goods and services; these can— and likely will—try to exploit their informational advantage, such as their

59

For further detail, see Sánchez Graells (2015), pp. 41 ff. Sánchez Graells (2015), pp. 135 ff. 61 See, e.g., Grandia and Meehan (2017). 62 Sánchez Graells (2015), pp. 93 ff. 60

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knowledge regarding quality and production costs. On the other hand, and even more importantly, the state can function as a principal (in a narrow sense of the term) and use its dominant market role (‘buying power’) for strategic market behaviour; public entities may then seek to achieve advantages through collusion, such as by forming buyer cartels.63 This can lead to significant transaction costs and inefficient competition, which may be detrimental to taxpayers. As regards to the regulatory function of public contracts as an instrument to promote other political objectives, the situation is similar to other forms of regulation: here, the state entities can serve as principals in their relationship with ‘regulated’ companies as agents. 6.2.2.2.2 Regulatory Framework As mentioned above, national legislation often lacks an adequate regulatory framework for public procurement. Many such regulations only consist of budgetary rules for the expenses associated with public procurement (and thus address only one of its functions). It seems clear that legislatures must resolve this tension by regulating the rights and obligations of participants—as well as the process itself—clearly and in accordance with the principle of legal certainty. These regulatory necessities are related to the administrative, regulatory and competition function of public procurement. It is interesting to note that EU primary law (the ‘European Treaties’) contains specific competition rules on private (and state) enterprises and especially on state aid, but none on public procurement. Since 2004, this gap has been filled by directives requiring minimum harmonisation of public procurement law (based on the harmonisation competence of Article 114 TFEU).64 The General Procurement Directive was substantially revised in 2014.65 In keeping with the principle of minimum harmonisation, these rules only apply above certain thresholds.66 Unfortunately, many states, including Germany, implemented the EU requirements as a 1: 1 minimum solution, which has led to a suboptimal situation in which smaller contracts are governed by the traditional budgetary rules. The result has been a bifurcation of procurement law that has alarming implications in a constitutional state.

63

Ibid., 73 ff. See Directive 18/2004 of 31 March 2004 on the coordination of procedures for the award of public works contracts, public supply contracts and public service contracts, OJ L 134/14; and Directive 17/2004 of 31 March 2004 coordinating the procurement procedures of entities operating in the water, energy, transport and postal services sectors, OJ L 134/1. 65 Directive 2014/24/EU of 26 February 2014 on public procurement, OJ L 94/65. 66 The main thresholds are €5,186,000 for public works contracts; €134,000 for public supply and service contracts (€207,000 Euro regarding special products and services listed in Annex III); and €750,000 for public service contracts for health, social and other specific services listed in Annex XIV. 64

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6.2.2.2.3 A Law-and-Economics Perspective on Procurement Procedures (the ‘Most Economically Advantageous Tender’) Public procurement is based on the core principle that public contracts are awarded in accordance with the most economically advantageous tender (Article 67(1) Directive 2014/24). This principle was integrated into EU law in more concrete terms in Article 67(2) Directive 2014/24: The most economically advantageous tender from the point of view of the contracting authority shall be identified on the basis of the price or cost, using a cost-effectiveness approach, such as life-cycle costing in accordance with Article 68, and may include the best price-quality ratio, which shall be assessed on the basis of criteria, including qualitative, environmental and/or social aspects, linked to the subject-matter of the public contract in question.

In spite of these relatively specific provisions, the basic principle proves complicated in practice. As in many other contractual relationships, there is a structural asymmetry of information concerning the quality of goods and services. The state must therefore specify its requirements as precisely as possible regarding the type and quality of goods, works and services. This may mean that the offers of fewer companies are considered; in extreme cases, the tender description is so narrow that only one company can be considered. This company, a quasi-monopolist, could then set the price, effectively eliminating competition. This problem is exacerbated by the fact that, at least for major contracts, the field of bidders often has an oligopolic structure or at least presents an opportunity for strategic bidding behaviour (above the expected costs). These situations also frequently lead to bidding cartels.67 Ultimately, the contract allocation process is not unilaterally disadvantageous to the bidder, because it presents various opportunities for opportunistic behaviour, including in the fulfilment of the contract itself.68 This is particularly the case when services cannot be described precisely or comprehensively in advance and subsequent negotiations take place; because of the ‘sunk cost’, the contracting authority can only refuse to complete the contract in extreme cases, which leaves it largely at the mercy of the contractor in this respect. The public procurement process generally begins with a call for tenders that invites participants to submit sealed bids; tenders are awarded in accordance with the best-price rule. This process favours the interests of the authority that awards contracts and creates significant problems for the bidders, who bear the risks associated with under- or overestimating costs. If we assume for the sake of simplicity that the costs are the same for all bidders, it is clear that bidders who overestimate their costs will not be awarded the contract. Underestimating costs, on the other hand, may increase their chances of winning the contract but heightens the risk of carrying out the contract at a loss, a phenomenon known as the ‘winner’s

67 68

Heimler (2012). Yakovlev et al. (2020).

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curse’.69 The risk of bidding too low also follows from a second consideration: in order to win the contract, it may be rational for companies to submit a bid at or below a price that includes variable costs but not long-run marginal costs.70 This produces an economically unsustainable price that does not cover investments in the long term or provide an adequate return on investment. There is also a danger that limited liability will encourage companies to submit overly risky bids; in such cases, the state bears the risk that a contractor will become insolvent while performing the contracted works and services.71 A third danger associated with abnormally low tenders is that the company offering the low price can afford to do so because it is not complying with all legal requirements (like labour or social law obligations) or is receiving state aid. To counter this danger, the law specifies selection criteria. Article 58(1) of Directive 2014/24 permits Member States to select criteria related to ‘(a) suitability to pursue the professional activity; (b) economic and financial standing; and (c) technical and professional ability’. For the contracting authority, these stipulations can reduce the risk that the contract performance will violate the terms of the agreement. In addition, European Court of Justice (ECJ) jurisprudence on ‘abnormally low tenders’ now addresses the economic concerns discussed above.72 This case law has been incorporated into Article 69 Directive 2014/24. Contracting authorities are obligated to obtain and assess information on details of any tender that appears to be abnormally low in relation to the works, supplies or services. Based on this analysis, authorities may reject the tender; if the abnormally low offer is due to the acquisition of state aid or the breach of (environmental, social or labour) regulations, rejection is mandatory. The UNCITRAL Model Law on Public Procurement suggests a similar rule in Article 20.73 One of the main functions of the law is to limit opportunistic behaviour resulting from information asymmetries. EU Directive 2014/24 emphasises the obligation of Member States to promote competition (see Article 18(1)); this principle is elaborated in detailed regulations, especially those governing the various procurement procedures (Article 26 ff. Directive 2014/24). The US Federal Acquisition Regulation (US FAR) provides for ‘dual sourcing’, an instrument used to ensure that no single supplier dominates the market for the specific tender. In certain circumstances, the tender authorities are obliged to consider other companies than the leading (‘incumbent’) provider in order to stimulate competition on the market.74

69

Hong and Shum (2002); Kirchgässner (2008), pp. 197 ff. Kirchner (2010), pp. 734 f. 71 This problem is of great practical significance. In the US, for example, 80,000 contractors went bankrupt between 1990 and 1997; failed contracts cost the state more than $21 million. See Piga and Thai (2007), p. 2. 72 See Sánchez Graells (2015), pp. 400 ff. 73 United Nations Commission on International Trade, UNCITRAL Model Law on Public Procurement, New York 2014. 74 For further detail, see Sánchez Graells (2015), pp. 462 ff. 70

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In procurement procedures, information asymmetries can lead to a specific problem: reliance of public procurement officials on ‘tried-and-tested’ contractors. This is, in certain respects, a rational practice to avoid poorly performing companies. On the other hand, it may hinder better companies from entering the market and thus limit competition for the best tender. Empirical studies have found evidence to support both arguments, but no evidence that one has benefits over the other.75 This is reflected in the differences between policies adopted in various countries: the US has a long tradition of considering past performance as a factor in selection, while the EU has rejected this practice as a risk to competition.76 Article 57(4)(b) EU Directive 2014/24 outlines an intermediatory approach: contracting parties may exclude an economic operator that ‘has shown significant or persistent deficiencies in the performance of a substantive requirement under a prior public contract, a prior contract with a contracting entity or a prior concession contract which led to early termination of that prior contract, damages or other comparable sanctions’. 6.2.2.2.4 A Law-and-Economics Perspective on Extraneous Criteria in Public Procurement As discussed above, the potential for public contracts to achieve substantial policy goals must be weighed against the threat to competition and efficient public procurement that may result if only one or few companies are able to meet the criteria for contracts. Traditionally, European law and policies have been highly receptive to ‘piggybacking’ arrangements, which couple neutral policy instruments like taxes or public procurement with other policy objectives. Article 11 TFEU even makes this practice partially obligatory in the context of environmental goals. As a result, ‘green’ public procurement has a long tradition in Europe.77 The provisions of Directive 2014/24, which are based on the jurisprudence of the ECJ, grant Member States considerable discretion to integrate environmental, social and other aspects into public contracts (see Article 42).78 Any such aspects must comply with the principles of transparency and equal treatment and must be linked to the subjectmatter of the contract and proportionate to its value and objectives. 6.2.2.2.5 Enforcement of Public Procurement Rules Related to Bid Rigging The relationship between the procurement agency and the bidder reflects a clear principal-agent problem. Bidders have an economic incentive to obtain public contracts through illegal means. Bid-rigging cartels are one of the most challenging aspects of public procurement law.

75

Spagnolo and Castellani (2018). Ibid. 77 For an overview, see Schebesta (2014). 78 See Pircher (2020), pp. 518 f. 76

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Lawmakers first responded to this challenge by imposing fines and other sanctions to deter bid-rigging activity.79 In Europe, however, fines have proved to be inadequate: not only is it difficult to detect bid rigging, but even if sufficient evidence of a legal violation is provided, the fine must be proportional to the offence. Exclusion from the procurement procedure has therefore become an important additional sanction. The new EU General Public Procurement Directive 2014/24 provides stringent regulations on this policy in Articles 57 and 58. Relative to the policies implemented under the US FAR, however, such measures appear suboptimal, though for different reasons80—namely because these rules continue to grant the procurement agencies ample discretion (see Article 57, paragraphs 2 and 4). In contrast to US law, EU law does not institute a general debarment procedure to exclude bidders for a fixed time period; in addition, the US assigns responsibility for such sanctions to a separate agency (debarment officer) in order to avoid collusion. In the face of these challenges, governments and legislatures have attempted to design additional indirect instruments to enforce public procurement rules. As a result of these efforts, there has been a shift away from awarding contracts to the lowest bidder and towards the most economically advantageous tender (which includes a life-cycle assessment), an approach that appears to make bid rigging more difficult.81 Another option is the ‘dual-sourcing’ policy implemented in the US, because it can help avoid ‘lock-in’ situations with a leading bidder (along with the respective rent-seeking opportunities).82 Another interesting approach is ‘private enforcement’: this practice, which was established by the jurisprudence of the ECJ, allows individuals to claim compensation for damage resulting from a breach of EU competition law.83 Although the Commission has tried to integrate specific rules on this policy into procurement directives, its efforts have thus far been unsuccessful.

6.2.2.3 Subsidies Subsidies, like public contracts, are relevant to budgets and competition and are thus of great interest to economists.84 The amount of money spent on subsidies represents roughly 4% of global GDP.85 6.2.2.3.1 Definition and Forms The term subsidy is derived from the Latin word subvenire (to come to the aid of or assist).

79

Weishaar (2014), pp. 103 f. Sánchez Graells (2015), pp. 470 ff. 81 Weishaar (2014), pp. 112 ff. 82 See Sánchez Graells (2015), pp. 464 ff. 83 See Weishaar (2014), pp. 106 ff. 84 For basic information on subsidies, see WTO (2006); Rodi (2000). 85 WTO (2006), p. 45. 80

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No definition of subsidy is universally accepted in all branches of science—or even in all areas of law. The term is thus defined based on its specific application in various contexts. For the purposes of the perspective discussed here—that is, the view that subsidies are an instrument of economic policy—we will apply the definition used in the theory of taxation.86 According to this definition, subsidies are financial contributions that a public authority grants to a private party without corresponding compensation in order to promote behaviour that serves the public interest. As defined here, subsidies have the following characteristics: (1) they are a financial contribution that is (2) paid by a public authority (from public funds) (3) to a private entity; (4) they are not given as compensation for private behaviour (a ‘favour’) (5) or for damages sustained; and (6) they are contingent on specific behaviour by the recipient (7) that is intended to achieve a goal in the public interest. The definition of subsidy is of great importance for the purposes of European (Article 107 ff. TFEU) and international law (articles VI and XVI GATT and the Agreement on Subsidies and Countervailing Measures, i.e. the 1994 Subsidy Code) that limit national subsidies. These legal regimes apply a broad interpretation of the term to allow subsidy elements in legal systems to be detected as fully as possible, making it more difficult for states to circumvent restrictions. According to Article I of the Subsidy Code of 1994 (Definition of a Subsidy), a subsidy is: . . .a financial contribution by a government or public body within the territory of a Member (referred to in this Agreement as ‘government’), i.e. where: (i) a government practice involves a direct transfer of funds (e.g. grants, loans and equity infusion), potential direct transfers of funds or liabilities (e.g. loan guarantees); (ii) government revenue that is otherwise due is foregone or not collected (e.g. fiscal incentives such as tax credits);[. . .] (iii) a government provides goods or services other than general infrastructure, or purchases goods; (iv) a government makes payments to a funding mechanism, or entrusts or directs a private body to carry out one or more of the type of functions illustrated in (i) to (iii) above which would normally be vested in the government and the practice, in no real sense, differs from practices normally followed by governments[.]87

Article 107(1) TFEU views state aid in similarly broad terms: ‘any aid granted by a Member State or through State resources in any form whatsoever which distorts or threatens to distort competition by favouring certain undertakings or the production of certain goods shall, in so far as it affects trade between Member States, be incompatible with the internal market.’88

86

Rodi (2000), pp. 41 ff. For a concise introduction to the WTO subsidy system, see Sykes (2010), pp. 479 ff. 88 For a concise introduction to the EU state aid system, see Sykes (2010), pp. 486 ff., and Kassim and Lyons (2013), pp. 3 ff. 87

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Fig. 6.1 Types of subsidies

Despite some variation in details, all of these definitions assume a broad definition of subsidy. Because subsidies can take such different forms, it is useful to divide them into smaller groups based on the legal and economic problems associated with them (and the approaches that can be used to solve these problems). A common (and logical) categorisation distinguishes between non-repayable grants, loans, loan guarantees and advantages integrated into other contracts or instruments (see Fig. 6.1). The framework has enabled the Commission to identify even implicit subsidy elements, including those related to tax credits, public contracts, shares in companies or other contractual relationships governed by private law.89 This is not a trivial concept: before the elements of subsidy distribution can be identified, there must be some way to measure deviations from normal market conditions. The detection of tax subsidies is especially difficult.90 The main challenge here is to determine whether isolated rules provide favourable treatment, even if the tax regime as a whole imposes a significant tax burden. In making this determination, it is crucial to distinguish any such rules from elements that are formally presented as tax breaks but actually represent structural elements of the tax regime.91 For example, the basic personal allowance is in line with the logic of the ‘ability to pay’, not a tax break (and thus not a subsidy). But electricity tax relief for companies with a high energy consumption has nothing to do with the basic idea of consumption taxes and thus qualifies as a tax subsidy.92 6.2.2.3.2 Justification for Subsidies The justification for subsidies, like the justification for state functions in general, is an important topic of economic analysis because it can determine the ‘legitimate’

89

Rodi (2000), pp. 152 ff. Listokin (2019), pp. 42 ff. 91 Cf. Rodi (1994), pp. 204 ff. 92 For further detail, see Micheau (2014), § 3.02. 90

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applications of subsidies. From an economic point of view, the concept of market failure plays a key role in this determination.93 It can also be useful to identify circumstances in which subsidies are not justified. For example, subsidies are not justified when they interfere in a functioning market.94 This would lead to a suboptimal allocation of resources and cause inefficiencies. In addition, there is an obvious risk that subsidies will finance actions that companies would have taken even without public support, which would enable freeriding. Subsidies also tend to crowd out private money.95 Market distortions may alter these general calculations. For example, if there is only one player in the market (e.g. Boeing in the aircraft market), subsidies granted to an incumbent (EADS/Airbus) may be justified as an effort to create competition. By the same logic, subsidies for start-ups can be justified as necessary to incentivise learning effects and economies of scale.96 They may also encourage companies to outperform minimum legal requirements.97 Subsidies primarily serve as tools to internalise positive external effects.98 In such cases, the actual level of activity falls below the socially optimal level, because a certain portion of the activity’s positive effects benefit parties other than the actors themselves. Subsidies can adjust the level of activity to align with a socially efficient outcome. Farmers, for example, produce positive external effects if their activity sustains or increases biodiversity, beautifies the landscape or prevents erosion in mountainous regions. The same is true for research and innovation (R&D) that is not protected by patents. Positive external effects are often associated with the provision of collective goods. If the state does not wish to produce these goods on its own, subsidies can facilitate production by private parties.99 First, however, decision-makers must consider whether and to what extent a price can be imposed on those who benefit from the public good (e.g. toll roads or the use of association with mandatory membership to provide a public good, such as a dike). Still, this option may have undesirable distributive effects. As in the case of (pure) public goods, subsidies can be used to influence preferences regarding merit goods,100 such as healthcare and education. In theory, subsidies can also prevent negative external effects.101 The

93

Hildebrand (2014); WTO (2006), pp. 55 ff.; Roberts (2020), pp. 200 ff. WTO (2006), pp. 58 ff. 95 Gustafsson (2018), p. 11, in reference to empirical studies. 96 WTO (2006), pp. 58 ff. 97 Regarding EU state aid control, see, e.g., European Commission, Communication from the Commision: Guidelines on State aid for environmental protection and energy 2014–2020, OJ 2014 C 200/1, 3.2.1.2. 98 WTO (2006), pp. 61 ff.; Roberts (2000), pp. 200 ff. 99 Roberts (2000), pp. 202 f. 100 See Sects. 2.3.2.1 and 2.3.2.5 above. 101 European Commission, Communication from the Commision: Guidelines on State aid for environmental protection and energy 2014–2020, OJ 2014 C 200/1, 3.2.2.1. 94

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appropriate course of action in this case is to impose a burden (e.g. a tax) that will internalise externalities by compensating for damage. If a countervailing incentive is implemented instead (in form of a subsidy to avoid negative external effects), it provides a ‘reward’ that is undesirable from the perspective of redistributive policy.102 Finally, information asymmetries can justify subsidies. This justification plays an important role in the field of innovation, especially in the context of start-ups and venture capital.103 Because it is difficult for banks to obtain adequate information on innovations when making financing decisions, they tend to be risk averse and charge high interest. The state can intervene here, especially because innovations are also often accompanied by positive externalities. Subsidies created to correct distributive failures are justified differently from those designed to mitigate the allocative inefficiencies described above. Subsidies used to correct distributive failures aim to address the failure to obtain socially desirable market outcomes, not the failure to achieve efficient market outcomes. Direct social transfers, however, should not be categorised as a form of subsidy, however, because such payments do not entail the behavioural obligation typically associated with subsidies. Incidentally, it has been rightly observed that the justification for those subsidies correcting distributive market failure is unspecific and provides no basis for limiting the subsidy system.104 6.2.2.3.3 Positive Analysis of Subsidy Implementation For policymakers, subsidies represent a (central) control mechanism. As a result, it is crucial to analyse the impacts of subsidies. Despite their considerable popularity as policy instruments, however, many subsidy programmes have proved to be incorrectly or inefficiently designed. 6.2.2.3.3.1 Incidence Analysis and Inefficiencies in Subsidy Policy

Impact analysis is an essential step in the process of evaluating subsidies.105 The analysis of subsidy incidence is no less challenging than that of tax incidence.106 In both cases, the technique incorporates microeconomic analysis (reactions of subsidy recipients and their competitors) and macroeconomic analysis (effects on the economy as a whole). The task is made even more difficult by the fact that subsidies are typically applied in combination with other economic-policy measures and interact with these in various ways.107 Over the past decade, the EU Commission has

102

Roberts (2000), p. 204. Gustafsson (2018), pp. 5 ff. 104 For a critical perspective, see Nieder-Eichholz (1995), pp. 89 ff. 105 See Staiger (2009), 2.1.4.5. 106 See Sect. 5.3.1.1.2 above. 107 For a literature review on this topic, see Buts and Jegers (2014), pp. 36 f. 103

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actively promoted the systematic implementation of ex-post evaluations as an additional procedure.108 In this context, economic analyses focus mainly on inefficiencies in subsidy policy.109 Politicians often lack sufficient knowledge to assess market failures and the potential for subsidy programmes to overcome them.110 In addition, inefficiencies in formulating objectives have a negative impact on economic analysis and on the implementation of a legal framework. In particular, the secondary purposes—that is, the purposes beyond the behavioural objective (i.e. the purpose ‘in the public interest’)—are often identified inadequately or not at all.111 First, subsidies are known to have significant distorting effects on competition and to hamper international trade (this is, after all, the basis for the WTO subsidy scheme and key features of EU rules on State aid).112 Although subsidies often appear to be implemented to benefit employment policy, their actual impact on employment is generally negative.113 They deliberately privilege and discriminate and are only ostensibly a ‘market-oriented’ instrument; in reality, they substantially restrict the freedom of economic actors. Subsidies can solidify existing structures and slow necessary structural change. They can also have effects that are undesirable in terms of redistributional policy (as, for example, when large-scale farms profit more from agricultural subsidies than do family farms). They can promote a ‘subsidy mentality’ and induce additional subsidies. In addition, inefficiencies can result from deadweight losses and—in federal structures—from multiple subsidies and undesirable ‘subsidy races’ between subsidy-granting authorities. All of these effects (unduly) limit the fiscal flexibility that the subsidising parties can exercise. The fiscal aspects of subsidy allocation exacerbate the negative effects. An inefficient application of subsidies reduces the budget resources available for other economic policy instruments. When subsidies are financed by taxes, inefficiencies in tax collection will augment the ineffiencies associated with subsidy allocation. 6.2.2.3.3.2 The Political Market for Subsidies

Studies on the political economy of subsidies analyse the behaviour of the actors involved in allocating subsidies.114 This topic of analysis can be referred to as the ‘political market for subsidies’.115

See, e.g., European Commission (2014), ‘You can’t improve what you can’t measure: State aid evaluation’, Competition Policy Brief, issue 7. 109 See Brüggemann and Proeger (2017), pp. 4 ff., for a literature review (with mixed results). 110 Roberts (2000), p. 205. 111 Gustafsson (2018), p. 12. On the purposes of subsidies and their functions for system-building, see Rodi (2000), pp. 57 ff. 112 Roberts (2000), pp. 206 ff. 113 See Brüggemann and Proeger (2017), pp. 4 ff. 114 Nieder-Eichholz (1995), chap. VII. 115 Cf. Staiger (2009), 2.2. 108

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Research in this field focuses on the behaviour of politicians and bureaucrats and examines why subsidies are such a popular tool for realising state objectives.116 These actors can gain positive publicity as benefactors, while the burdens of subsidy allocation remain well-concealed (‘fiscal illusion’) and fall to subsequent generations of politicians to resolve. This process is facilitated by the subsidymaximising strategies of subsidy recipients and the passivity of third parties that incur damages (a passivity due mainly to a lack of legal means). Finally, interest groups and unions typically have significant informational advantages over politicians and voters and are thus able to mount successful campaigns lobbying for subsidy programs.117 The ‘rent seeking’ associated with this practice leads to a welfare loss for society as a whole.118 Adjustment assistance provides one example to illustrate the interplay between self-interested actors and the negative consequences of their actions.119 Subsidies for this assistance may be justified as a means to cushion the social impact of structural crises. In fact, even the mere anticipation and/or announcement of these subsidies eliminates incentives to resolve the structural problem. Wage reductions are avoided, and employers and employees join forces to fight for (more) subsidies. There are many other reasons why unions are particularly successful within ailing or declining industries (the ‘loser’s paradox’).120 In expanding industries, profits signal that market entry is worthwhile, while incumbents within declining sectors ‘invest’ in lobbying activities instead. Politicians have considerable leeway in their decisions on subsidies. Voters are seldom aware of the financial impact (e.g. taxes), but those who receive subsidies or are favoured by them will be grateful towards politicians.121 As a result, politicians tend to use subsidies as an instrument in the political business cycle. 6.2.2.3.4 Recommendations to Improve the Subsidy System It is interesting to consider the coordination of international subsidy reductions in the context of public goods. One way out of the ‘subsidy jungle’ is for nations to establish supranational restrictions—to bind themselves, like Odysseus, to the mast in order to avoid succumbing to the Sirens’ song. The success of EU policies on state aid supervision can be viewed in this light.122

116

On the role of politicians in subsidy allocation, see Gustafsson (2018), pp. 14 ff.; Roberts (2000), pp. 204 ff. 117 On the ‘rational ignorance’ of voters regarding subsidy policy, see Claßen (2001), pp. 111 ff. 118 Cf. Gustafsson (2018), pp. 15 ff. On the experience of lobbying for subsidies in the US, see Roginska-Green (2018), pp. 146 ff. 119 Cf. Staiger (2009), 2.1.4.4.3. 120 Ibid., Sect. 2.2.3.2. 121 On the role of voters, see Gustafsson (2018), pp. 17 ff. 122 Staiger (2009), Chap. 3.

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Many ideas have been proposed to improve the system of subsidy legislation.123 One option is to introduce a qualified majority requirement into the constitution for subsidies; but this requirement would infringe on the principle of democracy.124 Quantitative limits (e.g. long-term ‘subsidy caps’) pose practical problems.125 It is certainly worthwhile to consider enacting a general law on subsidies, but a law of this kind is unlikely to generate any great improvement.126

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6.3.1

Basic Principles

Thus far, the discussion has focused on competition policy, with a particular emphasis on the role of the state—specifically, its responsibility to preserve undistorted competition, its intervention in competition, and the limits to that intervention (public enterprises, public contracts and subsidies). The analysis will now turn to the governance of the economy and the regulation of markets to achieve the state’s public-interest objectives.127 Before examining traditional economic governance and regulation (see Sect. 6.3.4 below), we will consider two aspects of these issues: first, the overall management of the economy, which can be analysed using key macroeconomic indicators like inflation or unemployment (business cycle or economic stabilisation policy); and, second, the regulation of markets (‘natural monopolies’) that once operated as private monopolies or state-owned enterprises (e.g. telecommunications, railroads and utilities). An analysis of each of these areas can also reveal the antagonism between ‘economic’ and ‘social’ regulation that has emerged in Anglo-American literature.128 In this context, economic regulation refers to direct market intervention in cases of ‘market failure’129 or the creation of markets where they do not exist (‘missing markets’); it includes any situation in which a state limits market mechanisms or assumes market functions (production and distribution) in the absence of a market to pursue its economic policy agenda. Social regulation refers to the controls implemented to achieve broader behavioural adjustments that benefit the public good (e.g. environmental protection, consumer protection or employee protection).

123

Addressed extensively in Claßen (2001), E.I. See, e.g., Claßen (2001), E.I. 125 See, e.g., Claßen (2001), F.I. 126 Claßen (2001); Rodi (2000), pp. 368 f. 127 On issues of economic policy, see Coyle (2020), Chaps. 1 and 2. 128 On the related concepts of ‘economic regulation’ and ‘social regulation’, see Ogus (1994), pp. 4 ff. 129 See, e.g., Coyle (2020), pp. 64 ff., and Stiglitz and Rosengard (2015), Chap. 4. 124

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Macroeconomic Policies (Business Cycle or Economic Stabilisation Policy)

6.3.2.1 Overview Economists evaluate the need for economic policy action based on the principle of stability (equilibrium), a concept imported from the study of mechanics. In economics, equilibrium is a situation in which economic plans are coordinated in the best possible way in a given market (sectoral or microeconomic equilibrium) or in the economy as a whole (general or macroeconomic equilibrium). General equilibrium is achieved when macroeconomic data recorded in national accounts (e.g. economic growth, inflation, utilisation of overall productive capacity, or the trade balance) reflect an ideal or at least adequate relationship. The analysis of macroeconomic equilibrium is the main focus of business cycle theory. The concept of equilibrium is, of course, purely theoretical for two reasons. First, equilibrium achieved through economic processes is never static; it can only be dynamic (i.e. adjustment processes after disturbances). Second, the point at which disequilibrium (i.e. disturbance) signals the need for economic policy action is determined based on subjective criteria. The goal of stabilisation policy is to restore equilibrium through state intervention. This policy can target individual markets, such as when states fix prices; the common market for agricultural products in the EU is an important (and controversial) example. Stabilisation policy can also target the overall economy, such as through the introduction of stimulus packages. 6.3.2.2 Macroeconomic Equilibrium and Business Cycle Policy State macroeconomic policies are based on the phenomenon of the business cycle. The production capacity utilisation rate is subject to constant fluctuations associated with two critical phenomena: (1) a decline in capacity utilisation and an underutilisation of capacity (a recession, resulting in unemployment) and (2) an overutilisation of capacity (an overheating of the economy, resulting in high inflation). In general, there is little dispute that markets cannot establish a stable equilibrium in the context of this macroeconomic phenomenon. This situation thus represents a form of market failure, and the state has a mandate to intervene. Economists disagree on the correct analysis (business cycle theory) and on the most suitable prescriptive measures (stabilisation policy). In response to the economic crises of the first half of the twentieth century, the prevailing perspective was initially based on the theory of John Maynard Keynes.130 This led to a widespread belief that intervention was necessary, specifically in the form of counter-cyclical stabilisation policies. Still, theoretical economic approaches have varied significantly over time, ranging from neoclassical to monetaristic, supply-side and neo-Keynesian theories.131 William Nordhaus (1975) was the first to apply insight 130 131

See, e.g., Dow et al. (2018). Listokin (2019), pp. 25 ff.

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from the New Political Economy (NPE) to explain fluctuations in the business cycle.132 This approach broke new ground by considering the utility-maximising behaviour of economic policymakers.133 From this perspective, it is highly problematic that politicians have such broad leeway, especially in fiscal policy, because the substance and timing of government spending can vary dramatically.134 There is reason to doubt that politicians have sufficient (economic) knowledge to use such tools efficiently135 or to implement measures at the appropriate times to prevent response gaps.136 Politicians also tend to pursue too many objectives at one time, combining the policy instrument with various political goals (e.g. social or environmental); in the resulting complexity, it can be easy to lose sight of the economic rationale.137 The main problem is that utility-maximising politicians can exploit their discretionary leeway to engage in opportunistic behaviour: they may exercise their spending power strategically over the course of the political business cycle to increase their chances of reelection (e.g. through visible spending before elections or support for specific voters).138 The excessive fiscal policy implemented under such circumstances is one explanation for rising government debt. The situation is further complicated by the fact that fiscal policies are handled by multiple state actors, whose individual interests hamper necessary coordination. Spillover effects of spending policies could lead to freerider behaviour. Due to the criticism of discretionary fiscal policy, monetary policies have become more accepted, both in theory and in practice. Such policies transfer competences to independent central banks or independent agencies and are thus a powerful tool for combating political opportunism. However, the key instrument of monetary policy, the interest rate, becomes a less effective tool when interest rates are extremely low, as they have been for a long time (a trend that is only beginning to change now, in 2022). Unconventional monetary policies have not yet proved to be an adequate substitute.139

6.3.2.3 Recommendations for the Legislature In general, governments can exercise considerable discretion in their decisions on macroeconomic policies. Constitutions seldom contain specific rules to govern these decisions. More recent constitutions may provide some legal guidance but tend to remain vague. According to Article 109(2) of the German Constitution, the Federation and the Länder ‘shall. . .give due regard to the requirements of overall economic

132

See Sect. 2.2.3.2.3 above. Listokin (2019), pp. 38 ff., 149 ff. 134 This idea has been transferred to other policy areas as the ‘political business cycle’; see Sect. 4. 1.1 above. 135 Ibid., 36 f. 136 Ibid., 37 f. 137 Ibid., 38 f. 138 Ibid., 38 ff., 149 ff. 139 See Listokin (2019), pp. 25 ff., 54 ff. 133

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equilibrium’ within the framework of EU law. Section 131(2) of the Constitution of Spain is hardly more specific: The State shall be empowered to plan general economic activity by an act in order to meet collective needs, to balance and harmonize regional and sectorial development and to stimulate the growth of income and wealth and their more equitable distribution.140

It is difficult to imagine, however, how constitutions could regulate macroeconomic policies more precisely. Constitutions also play a role in such policies to the extent that they explicitly or implicitly entrust monetary policy to an independent central bank.141 Article 99(2) of the Swiss Constitution is explicit in this respect: ‘The Swiss National Bank, as an independent central bank, shall pursue a monetary policy that serves the overall interests of the country. . .’ Regarding sub-consitutional legal acts, the legislature has two basic options to increase the rationality and efficiency of macroeconomic policies. One option is to develop a legal framework for discretionary leeway on fiscal policies. The second option is to introduce legislation implementing automatic fiscal mechanisms. Effective fiscal policy depends on flexible decisions about targets and the timing of spending. It is therefore challenging to regulate discretionary leeway without restricting political actors in ways that could endanger the efficiency of the measures. Clearly, however, the central legislature can establish a framework coordinating fiscal policies among various actors, especially in federal states. Automatic fiscal policies are a second option for the legislature.142 The income tax is a classic example of an automatic macroeconomic stabiliser: taxes are lower in times of economic crisis, leaving taxpayers with more money and automatically incentivising private spending (and vice versa in a booming economy). In this case, no specific policy decisions are necessary, which means that no time is lost. As Yair Listokin has demonstrated convincingly, regulations designed for other purposes can be used as macroeconomic stabilisers, and this concept that can be extended to other areas of law.143 The law of debitors and creditors—especially bankruptcy regulations—is one example of a law that can support countercyclical efforts. Of course, this option should not be expected to fully substitute for discretionary fiscal policies.

See also Article 100(4) of the Swiss Constitution: ‘The Confederation, the Cantons and the communes shall take account of the economic situation in their revenue and expenditure policies.’ 141 See, e.g., Article 282 TFEU on the European Central Bank and Article 88 of the German Constitution on the German Central Bank. 142 Ibid., 41 ff. 143 Ibid., 175 ff. 140

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Natural Monopolies and Options for State Regulation

Natural monopolies present some of the greatest challenges for economic regulation. Efforts to regulate natural monopolies are often controversial.144

6.3.3.1 Basic Principles The concept of functioning competition assumes the existence of a model of perfect competition, in which all goods and production factors are perfectly divisible. Indivisible goods limit the number of suppliers, increasing market power; this constitutes a case of market failure.145 Indivisibilities primarily arise in situations in which the productive capacity for certain resources (e.g. power plants, roads and railways) can vary only by large increments due to technical constraints. The presence of indivisibilities generally decreases the average cost (unit cost) of producing a good because of the economies of scale obtained from delivering the good; this increases the returns to scale. In some cases, of course, the total cost of producing partial quantities exceeds the costs of production at a single firm due to high fixed costs (the subaddivity of cost functions). In extreme cases, it is not economically efficient or technically feasible for more than one supplier to meet demand (e.g. grid-based supply systems). This situation is referred to as a natural monopoly. Natural monopolies can also occur when irreversible expenditures (‘sunk costs’) make it difficult to enter or exit the market. For example, market entry is more difficult if expenses have already been written off (as is typical for nuclear power plants). This situation can prevent market entry in extreme cases (as frequently occurs for infrastructure networks, such as rail networks).146 Until the late 1970s, there was widespread consensus that natural monopolies represented an important case of market failure. As a result, state action was considered justified to prevent welfare losses from monopolistic pricing.147 When natural monopolies develop and there is no way to address the cause of the indivisibility, it is necessary to consider which measures the state can employ to eliminate, or at least limit, the ‘room for exploitation’ available to monopolists. Richard A. Posner demonstrated that deficiencies in competition can lead to various other failures,148 such as internal inefficiencies (without competition to drive down costs), unresponsiveness towards consumer desires and a lack of incentives for innovation. These problems do not only emerge in the case of ‘private’ monopolists; the 144

On the long history of the concept, see Mosca (2008). On the conceptual framework, see Posner (1968) and Joskow (2007). 145 See Sect. 1.2.3.6 above. 146 Definitions of natural monopolies vary widely to emphasise different aspects of the concept; there is no generally accepted definition. See Posner (2008), p. 548: ‘aggegated demand can be satisfied with lowest costs from one (or two) firms’. Mosca (2008), p. 317: ‘a market, in which for structural reasons only one firm finds it profitable to produce. . .’ 147 See, e.g., Posner (1968), pp. 550 ff. 148 Posner (1968), pp. 573 ff.

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participation of the state does not in itself guarantee that the public interest will be served (especially because, in federal systems, an enterprise may operate at a level that does not carry out regulatory tasks, as in the case of municipal enterprises). Regulation is therefore also necessary in the case of public enterprises acting under the conditions of a natural monopoly. 149 Since the late 1970s, the concept of natural monopolies has become increasingly controversial.150 Some economists haved argue that so-called natural monopolies have existed for a long time without causing serious problems and are now being used to justify state intervention.151 The Austrian School, in particular, has even denied that monopolies are problematic.152 Regardless of any particular viewpoint on natural monopolies, the number of such monopolies falls as competition increases.153 In situations where natural monopolies are (still) considered to exist, they constitute a market failure and justify state intervention.154 Typically the state will restrict market entry into industries with natural monopolies in order to prevent price increases and the risk of ruinous competition. Under these circumstances, however, it is appropriate to limit the price-setting ability of monopolists (or oligopolies) by introducing cost- or profit-based pricing regulation.155 This practice could even have an incentivising effect (cost reductions, innovations, etc.).156 Such regulations are extremely demanding, however, especially because they require authorities to remain so well-informed. This task becomes even more complex when the framework of the regulation is also intended to provide dynamic incentives for cost-saving innovations. All of these approaches suffer from ‘regulatory lacks’.157 Finally, states can create or promote countervailing power in the marketplace, which allows them to indirectly restrict the freedom of monopolists and oligopolies to set prices. As mentioned above, however, public enterprises are affected by many of the same problems caused by private actors in natural monopolies. It is often difficult for the state to control the other side of the market, and there is a risk that ‘power spirals’ will develop. As an alternative to price regulation, enterprises can compete for the monopoly position (or network). A tendering process can allocate or auction off the supplier position (generally for a limited period of time) with sealed bids. This format was used to auction off Universal Mobile Telecommunications System (UMTS) licences

149

Ibid., 626 ff. For an overview of the literature, see Mosca (2008), pp. 317 ff. 151 DiLorenzo (1996), p. 43 152 Mosca (2008), p. 319 and further reference. 153 DiLorenzo (1996), pp. 52 ff. 154 Posner (1968), pp. 592 ff.; Mosca (2008), p. 318. 155 Cf. Posner (1968), pp. 593 ff. 156 Ibid., 627 ff. 157 Cf. Posner (1968), pp. 593 ff. 150

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in Germany. Price regulation reduces prices; in an auction, the state can extract the monopoly profits. Recent policy discussions have focused on the role of regulation that is designed to limit the activity of a natural monopoly by restricting it to one stage of the valueadded chain. A monopolistic bottleneck in the energy supply, railway or telecommunications sectors (among others) is typically limited to the specific infrastructure (energy networks, rail networks, telecommunications networks).158 As a countermeasure, network access obligations can be imposed at non-discriminatory prices (as in the regulation of rail transport or grid-based power supply systems).159 Unbundling these business operations from activities in upstream or downstream markets (e.g. energy production or energy service) can prevent monopoly profits from hindering competition in these markets as well.160 Recent efforts to unbundle railway or energy companies in the EU provide one example. This offers important context for the debate on whether or not infrastructure should be operated as an independent public enterprise. The creation of competition to guarantee cost-efficient service is only one aspect of regulated competition. The primary purpose of such regulation is to create ‘competition in the common good’. It aims to create free competition within former monopoly structures, while at the same time ensuring the continued supply of the ‘services of general interest’ traditionally provided by these entities. Regulatory law is thus intended to create competition that is conditioned by social, ecological, economic, technological and territorial considerations. Where price regulations are concerned, it is crucial to prevent regulated enterprises from attempting to increase profits by reducing quality and performance levels. To guard against such risks, price regulations are typically linked to specific requirements for service quality and/or business practices.161 Instruments employed in this context include redistributive pricing programmes, for example in the provision of basic services of general interest. ‘Universal services’ are guaranteed.162

6.3.3.2 Regulatory Challenges in Select Network Industries The following discussion highlights individual regulatory issues associated with specific examples of network-based industries, including telecommunications, railways and grid-based power supply systems.163 6.3.3.2.1 Market Failures Telecommunications markets exhibit a significant subadditivity of costs: due to network economic effects, the value of the network is largely a function of the

158

Bender et al. (2011). See Sect. 6.3.3.2.2 below. 160 On the telecommunications market, see Spulber and Yoo (2009), pp. 132 ff. 161 Fritsch (2018), 8.3.5. 162 See Sect. 6.3.3.2.3 below. 163 For an introduction, see Bender et al. (2011). 159

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number of users connected to it.164 The total costs of producing partial quanitites of a good are thus significantly higher than the costs of production by a single source. As a result, natural monopolies tend to form in these industries (especially in the case of local access networks), even when innovations revolutionise existing technology.165 Network externalities can arise, in particular because the utility of the network increases for all users as new users are added. This creates incentives to offer prices below cost during the network’s earlier phases of development (at the risk of ruinous competition), and then set prices above cost once expansion is complete. There is also a risk that the market will not guarantee benefits that are important in terms of destributive policy, such as full coverage. Before discussing potential market failures in the provision of rail transport services, it is necessary to differentiate between two different markets.166 One market is for the provision of railway infrastructure (including railway stations); the other is for transport services, specifically the transport of goods and people by train. The system for rail traffic management falls somewhere between these two markets and essentially serves as a system for coordinating and monitoring trains. Railroad infrastructure (like rail traffic management) clearly has the characteristics of a natural monopoly. Due to the enormously high fixed costs, a parallel rail link would not be economically feasible; and in any case, such links would be undesirable from the perspective of the state. In the field of rail transport services, functioning competition is only possible if non-discriminatory access to the rail network is guaranteed.167 Analyses of energy market failures must also distinguish between different energy supply markets.168 One of these is the market for power generation. The other encompasses network infrastructure for the provision of electricity and gas and thus the grid-based power industry; here, too, there are significant differences between the roles of tansmission lines and distribution grids in the energy supply system. Although the topic is discussed here in the context of the power supply, similar issues apply to the gas supply system. The transmission network and the distribution grid are both examples of natural monopolies, which indicates the need for price regulation, at least in these areas. As in the case of telecommunications and railway industries, non-discriminatory access is also a concern for electricity supply systems. For historical reasons, unbundling is also an important issue here, because electric companies have traditionally been integrated into all submarkets. Economic policy measures can be used to respond to this situation.

164

Spulber and Yoo (2009), p. 4 and further reference. Ibid., 119 ff., 135 ff. 166 For an introduction to the economic analysis of rail regulation, see Finger and Messulam (2015). 167 On the EU regulatory approach, see Finger and Messulam (2015), pp. 2 ff. 168 See, e.g., Mulder (2020). 165

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6.3.3.2.2 Enabling Competition In many countries, the state once provided basic services, at least in the areas of railways and telecommunications; this was less often the case for grid-based energy supply. Since the 1990s, however, such arrangements have undergone dramatic changes, especially as a result of global trends towards privatisation. It is clear that fair competition to provide network-based services is nearly impossible if state enterprises are privatised without further action; such enterprises will be reluctant to allow competitors to offer services using their infrastructure. In this situation, one option for the state is to transfer the infrastructure (e.g. railway network or energy grids) to a state-owned company (e.g. Deutsche Bahn in Germany). Another option is to ‘unbundle’ the companies, at least with regard to infrastructure and services. EU law allows for both options: Member States can decide to establish public ownership of railway and energy infrastructure. In either case, regulation by the States must ensure that infrastructure management is independent of the actual (energy or rail) transport services. (In railway systems, this responsibility falls to the ‘independent infrastructure manager’;169 in electricity networks, it is the task of the ‘transmission system operator’ and ‘distribution system operator’170). This ‘legal’ unbundling is less stringent than strict ownership unbundling, which Member States are permitted—but not obligated—to introduce. Member States are required to establish a regulatory body to ensure non-discriminatory access to infrastructure within this institutional framework. These entities are typically independent sector regulators.171 In both energy grids and railway networks, there was only a negotiated access at the beginning, which proved insufficient to overcome the interests of infrastructure companies. The development of new telecommunications technologies has led to a situation in which there is no single infrastructure system for telecommunications, and resources like frequencies are limited. This might change in the future (e.g. due to internet-based telecommunication systems or telecommunication via electricity grids). For now, states use licensing mechanisms to ensure that scarce infrastructure resources are allocated fairly.172 In any case, former natural monopolies will have monopolistic features (or one supplier of services with considerable market power), at least during a transition period. As a result, price regulation will be necessary in many cases.

169

Finger and Messulam (2015), pp. 7 ff. Article 30 ff. (DSO) and 40 ff. (TSO) of Directive 2019/944 of 5 June 2019 on common rules for the internal market for electricity, OJ L 158/125. 171 OECD, Directorate for Financial and Enterprise Affairs Competition Committee, Working Party No. 2 on Competition and Regulation, Independent Sector Regulators, DAF/COMP/WP2(2019) 3. 172 Regarding the development of EU regulation for telecommunication markets over the last 25 years (compared to development in the US), see Cave et al. (2019). 170

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6.3.3.2.3 Universal Services Telecommunications, railway services and energy supply networks fulfil basic needs of modern societies. This issue was largely unproblematic—provided that the state supplied these services. As privatisation in these sectors increased, it became necessary to establish regulations defining the scope of universal services and the ways and means to finance them.173 Universal services in the telecommunications sector have traditionally centred around telephone access; more recently, debate has focused on whether states should also be responsible for guaranteeing access to new technologies.174 At least in Europe, universal services in the railway sector are strongly oriented towards public passenger transport at the local or regional level.175 In terms of the energy supply, access to electricity is typically considered a universal service; for this reason, European regulation provides for the appointment of a ‘supplier of last resort’.176 From an economic perspective, it is important to clarify the definition of ‘universal services’ as well as the method of financing them. One traditional approach is mandatory service obligations, combined with the possibility of cross-subsidising. Because universal services are related to public tasks, public subsidies appear to be more appropriate. To boost the efficiency of service provision, tendering has become an increasingly popular approach.177 With regard to financing universal services, funds are considered to be the best solution, as they allow the state greater flexibility in determining the details of burden sharing (i.e. by the state, companies and/or customers).

6.3.4

Traditional Economic Oversight and Regulation

Traditional economic regulations (beyond general competition laws) functioned mainly as protective measures. Today, regulatory objectives are much broader, especially with regard to the inclusion of environmental protection. Regulatory instruments (e.g. approval provisions or requirements to engage or not engage in certain activities) served as the principal basis for traditional economic regulation. As in environmental law, there are now calls for regulations that are more effective and more efficient (i.e. with lower transaction or avoidance costs). Regulation of the sexual services market provides an interesting example for an analysis of various interests, including those of politicians. Although this market has always been economically important and in great need of regulation (e.g. related to

173

Regarding public services in EU law see Sauter (2014). See for that Blackman and Srivastava (2011), pp. 153 ff. 175 Regulation (EC) 1370/2007 of 23 October 2007 on public passenger transport services by rail and by road, OJ L 315/1; Article 4 of proposed Regulation 2013/28 on competitive tendering of public service contracts. 176 See Talus (2013), 3.4.1. 177 Jaag and Trinkner (2009). 174

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health problems, crime prevention or social security for suppliers), legislators have responded almost exclusively by issuing prohibitions and imposing criminal sanctions.178 Politicians are motivated to support such measures because they fear the reactions of conservative voters and the damage to their own reputation that may result from a nonpunitive approach to the issue. In Germany, as in several other countries, prostitution has been legalised179 but remains highly underregulated.

6.4

International Economic Relations and the Global Economic Constitution

6.4.1

Basic Principles

6.4.1.1 The Global Economic Constitution and International Economic Law Globalisation has led to a dramatic increase in the importance of international economic relations. A global economic constitution establishes the rules, coordination mechanisms and institutions governing these relations.180 Its provisions apply to cross-border trade in goods and services, the international movement of capital, and cross-border investment. International economic law provides the regulatory framework for the global economic constitution. This body of law encompasses all norms that specifically refer to the production, trade or distribution of goods and services, provided that these norms pertain in some way to cross-border activity. Specific topics in international economic law include: (1) laws governing the movement of goods and services (including international contract and sales laws); (2) international business law (international corporate, competition and tax laws); (3) international property and investment law, such as investment protection agreements; and (4) international currency law (e.g. Bretton Woods) and international financial law (e.g. International Monetary Fund, World Bank). In addition to sector-specific regulations, various influential and effective principles of international economic law have emerged over time. These include non-discrimination, the most-favoured-nation principle and the principle of reciprocity, which ensures that obligations are balanced.

178

See Della Guista (2010), pp. 1 ff. Act Regulating the Legal Situation of Prostitutes (Prostitution Act) [Gesetz zur Regelung der Rechtsverhältnisse der Prostituierten (Prostitutionsgesetz)] of 20 Dec. 2001, BGBl. I, 3983. 180 On the global economic constitution as a regulatory concept see Tully et al. (2016), Afilalo and Patterson (2019), pp. 330 ff. 179

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The following section examines the laws related to the exchange of goods and services (excluding international contract and sales laws). It focuses in particular on regulatory instruments employed in the cross-border trade of goods and services.

6.4.1.2 Economic Perspectives From an economic standpoint, the global economic constitution and international economic law can be viewed as a public good: much like the the design of national economic law determines the economic welfare of citizens, international economic law significantly influences wealth and its distribution.181 In an economic analysis, the central question is which forces and factors contribute to the development of this public good. Let us assume, somewhat simplistically, that nation-states participate in developing international economic law, because this is the only efficient way to conduct cross-border trade in goods and services (in which virtually all states have an interest). This assumption fails to consider the free-rider problem. It also fails to account for the fact that the interests of states vary depending on economic situations—and that ‘the’ interest of a state actually consists of many different interests (e.g. the interests of exporting companies and domestic industries or the economic, social, and ecological interests of individuals). One factor motivating states to create international economic law is the desire of each state to develop a system closely resembling its own national laws, which can benefit its domestic economy. State efforts to influence the design can lead to an international competition between systems of economic law.182 Individual interests also encourage the creation of international competition law, because interests favouring its development (e.g. export industries and companies operating internationally) are generally better organised than interests favouring protectionism. In addition, politicians have broad leeway to champion the interests of those supporting the law, because most voters are less interested in or knowledgeable of issues related to foreign trade.183 Another crucial explanation for the emergence of certain rules within international economic law is the ‘constitutional function’ of such rules.184 Politicians and governments enter into international commitments so that they can refer to them later in interactions with citizens and lobby groups (or voters).185 This is particularly evident during the subsidy allocation process, during which politicians find it difficult to reject subsidy requests.186

181

Meessen (2009). See, e.g., Kerber (2009). 183 Behrens (2010), pp. 15 f. 184 Cf. Petersmann (1991); Cottier (2009), pp. 318 ff. 185 Cottier (2009), p. 322. 186 On the reasons for this, see Sect. 6.2.2.3.3.2 above. 182

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6.4.2

259

International Trade Law

State restrictions on cross-border trade through customs duties, quantitative restrictions or other regulations have a long tradition in the history of economic policy. During the mercantilist period, such restrictions became a central mechanism for state intervention. Attempts to dismantle trade regulations through bilateral or multilateral agreements between states date back nearly as far as the restrictions themselves. The international trade law that has emerged from these agreements is an important area of economic research.187

6.4.2.1 Theoretical Foundations of Trade Liberalisation Within positive economics, two important questions are why nations institute trade restrictions and why they enter into agreements liberalising trade.188 The tendency for states to embrace protectionism (‘protectionist bias’) is generally attributed to the influence of national stakeholders and interest groups (e.g. businesses or unions). If there were a national ‘market for protectionism’, a well-organised demand for protectionism would far outmatch the demand for trade liberalisation. Where there is interest in liberalisation (for example, among consumers interested in price reductions), efforts to achieve this objective are not rational, because trade liberalisation represents a public good. The argument that states have an interest in restricting trade—especially in order to increase national prosperity—has lost much of its influence. In recent years, however, this perspective appears to have regained ground.189 Why, then, do states agree to reduce trade restrictions and liberalise trade? One driving force is the lobbying by interest groups discussed above: a growing number of businesses rely on cross-border economic activity and favour trade liberalisation. This is why industry groups and business associations in the US engaged in lobbying activities to influence negotiations on the Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS) in the mid-1980s.190 Constitutional economics suggests that trade agreements offer one way to counter national interests in protectionism. In this sense, an international trade regime serves both domestic economic and domestic policy functions.191 Thus far, there has been insufficient empirical research into economic explanations for the implementation of trade restrictions and the development of agreements liberalising trade. But because a positive correlation is generally

187

Cf. Sykes (2007), pp. 786 ff. Cf. Sawyer (2014), pp. 1044 ff. 189 Afafilo and Patterson (2019) argue that the traditional global economic constitution (GEC 2.0) is crumbling and a period of protectionism is beginning, referred to as GEC 3.0. 190 Krajewski (2003), p. 15. 191 Petersmann (1991). 188

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assumed to exist between liberalisation and growth,192 the main motivation is likely economic. Within normative economics, a key question is whether parties should enter into agreements to liberalise trade. The traditional argument in welfare economics is that the international division of labour can increase prosperity (the ‘theory of comparative advantage’). Conversely, action taken without restraints (e.g. the initiation of trade wars) leads to a decline in prosperity (‘beggar-thy-neighbour’ policy). There is no question that rules are necessary for cross-border trade. It is viewed as a typical dilemma structure that must be resolved through a legal framework. This idea193 originated with Adam Smith, was applied to foreign trade by David Ricardo and John Stuart Mill and led to a far-reaching liberalisation of international trade in the twentieth century.194 Growing evidence of globalisation’s negative effects has tempered this basic consensus, at least to some degree. It is becoming increasingly clear that the liberalisation of world trade is associated with negative phenomena, such as environmental degradation and global economic crises. Hopes that liberalising world trade could help enforce human rights or fight poverty remain largely unfulfilled. The least developed countries are among the clearest ‘losers’ of globalisation. There is an obvious need to fundamentally reassess the objectives of international economic policy.195

6.4.2.2 General Agreement on Tariffs and Trade (GATT)/World Trade Organisation (WTO) Modern international trade law began with the Atlantic Charter of 1941, which expressed a commitment to a liberal expansion of international economic relations. The Havana Charter achieved this objective in 1947, although the only aspect of its complex regulations that entered into force was the GATT (other provisions would have created an International Trade Organization (ITO)). In order to establish the principles of free trade, the contracting parties held a series of trade rounds. Geneva was the primary location of these events, serving as the site of negotiations in 1947 and for the 1961–1962 Dillon Round, the 1964–1967 Kennedy Round and the 1973–1976 Tokyo Round. Negotiations focused mainly on reducing tariffs. In the Tokyo Round, the emphasis was on developing additional agreements (‘GATT codes’) addressing non-tariff barriers to trade, such as quantitative restrictions, export restrictions and subsidies. Because amendments to the GATT required a 2/3 majority, each of these agreements was formed between a specific group of Contracting States. The Uruguay Round in the early 1990s refined and enhanced international trade law. It officially established the WTO and introduced an

192

For a historical overview, see, e.g., Hallaert (2006). Cf. Maneschi (2013); Sawyer (2014), pp. 1037 ff. 194 Cf. Afilao and Patterson (2019), pp. 334 ffq. 195 See also Cottier (2009), p. 327. Afilao and Patterson (2019) argues that these developments led to changing employment structures and a decline in the middle class. 193

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obligatory dispute settlement procedure; it also extended rules governing trade in goods to include trade in services (General Agreement on Trade in Services (GATS)) and protection of intellectual property (TRIPS Agreement).196 The international trade system had great initial success in liberalising trade and in solidifying and codifying an organisational structure. More recently, however, the development of the trade system seems to have stalled. This is reflected in the fact that the latest round of trade negotiations (Doha Round), which began in 2001, remained largely unsuccessful, particularly regarding the liberalisation of agricultural markets.197

6.4.2.3 Investment Protection Law Investment protection law198 primarily applies to direct investments, a term designating long-term capital flows for the acquisition of assets. (These are separate from portfolio flows, which involve receivables). Foreign direct investment has increased rapidly in the course of globalisation. The ostensible purpose of these investments is to serve the needs of the population of the host country. In practice, their main function is to increase sales; direct investment makes it possible to gain shares in markets that would otherwise be difficult to access due to trade barriers or logistical problems. Direct investment has always been politically controversial. On the one hand, it is important for the economic development of host countries (particularly for developing countries); on the other hand, it poses a threat to domestic production and cultural identity and creates the risk of dependence on transnational corporations. For these and other reasons, states have developed a range of instruments to regulate foreign direct investment.199 Market access is subject to certain conditions, which may apply to the constitution or management of the company, the use of domestic primary products or the employment of host-country nationals. Specific restrictions also apply to sectors that are regarded as sensitive or important for strategic reasons (e.g. armaments or media). Under international law, the primary objective of investment protection law is to provide legal certainty for direct investments. Bilateral investment treaties have traditionally been created for this purpose. These treaties include national treatment provisions and most-favoured-nation clauses for investors, as well as terms related to profit transfer, compensation for exproprations and dispute resolution. Thus far, efforts to create a multilateral investment regime have been unsuccessful. Failed proposals include the Multilateral Agreement on Investment (MAI),

196

On the historical origins of GATT and WTO, see Posner and Sykes (2013), pp. 263 ff.; Trommer (2020). 197 On the reasons for this failure, see Stephen (2019). 198 For an overview of international investment law, see, e.g., Subedi (2020). On the economic analysis of international investment protection law, see Sykes (2007), pp. 810 ff.; Posner and Sykes (2013), pp. 238 ff.; Bonnichta et al. (2017). 199 On the political economy of international investment agreements, see Bonnichta et al. (2017).

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developed under the auspices of the OECD.200 The draft interpreted investment broadly (including portfolio investment) and granted virtually unlimited market access. Developing countries, which had little influence over the contents of the proposal, expressed concerns that the agreement would encroach on their sovereignty; like a number of others states, they also feared that it would have negative effects on environmental policy and labour rights. WTO law, on the other hand, includes specific multilateral agreements related to investment protection, including the TRIPS Agreement201 and the Agreement on Trade-Related Investment Measures (TRIMs). TRIMs is significantly more restrained than the draft MAI proposal; it contains prohibitions on certain conditions for direct investors but no criteria for market access. As a result, it serves less as an agreement on investment protection than as a legitimisation of restrictive investment measures in trade policies.202 The Doha Declaration mandated an analysis of key issues relevant to a comprehensive investment agreement under the WTO; however, these efforts, too, were shelved.

6.4.2.4 Intellectual Property The protection of intangible property rights—above all, intellectual property rights—is an important subject in law and economics.203 Intellectual property protection mainly applies to patents and copyrights. Patents protect inventions in the field of technology; copyrights protect creative, intellectual or artistic works. This section focuses primarily on technological innovations and the instrument of patents.204 6.4.2.4.1 Market Failures and Instruments (Especially Patents) Intellectual property (IP) is often used to demonstrate the theory of market failure.205 In general, IP refers to innovations that are resource-intensive (costly) to produce. The costs of providing these innovations to customers are lower, with marginal costs sometimes near zero (e.g. in the case of computer software). On the other hand, people using the IP of others do not need to recoup the upfront (‘sunk’) costs of production. As a result, innovations and IP are usually regarded as public goods; their production generates positive external effects. Companies typically find themselves in a prisoner’s dilemma with regard to innovation: if they invest in the creation of IP while other companies do not, these other companies will still benefit from its use. These concerns tend to reduce the level of innovative activity, resulting

200

OECD-Doc. DAFFE/MAI/NM(98)2/REV1. See Sect. 6.4.2.4.3 below. 202 Michaelis and Salomon (2010), Rn. 19. 203 Cf. Menell and Scotchmer (2007). 204 With an emphasis on copyright law, see, e.g., Posner (2005). 205 See Sect. 1.2.3 above. 201

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in a sub-optimal outcome. In the context of this prisoner’s dilemma, non-investment indicates ‘defection’.206 There are two main options for states to internalise these positive externalities. First, they can directly or indirectly subsidise innovation; financing basic research at universities is a prominent method of indirect support. Second, they can ‘propertise’ intellectual goods by granting exclusive rights (e.g. copyrights or patents) that restrict access to these materials. The goal of patent protection is to internalise external effects in order to stimulate innovation and creativity. Proponents of the ‘public good’ approach argue that inventions and innovations are by nature common resources and should retain this role. Joseph Stiglitz, for example, states that ‘efficiency in use means that knowledge should be freely available. The problem is that IP rights circumscribe the use of knowledge and thus, almost necessarily, cause inefficencies.’207 Supporters of this argument dispute the notion that IP protection maximises overall social welfare.208 Recent studies indicate that the positive correlation between strong protection of IP and economic growth is weaker than was previously believed; this effect is observable within relatively closed markets but is much more apparent in the context of cross-border relations.209 Finally, advocates of the ‘public good’ perspective argue that internalising (positive) external effects through exclusive rights of use creates (temporary) monopolies, leading to specific adverse effects. Patents and the prohibition of imitations result in a ‘monopoly of knowledge’ that increases prices for consumers (sometimes making the patented products, e.g. medications, unaffordable) and prevents other companies from refining these achievements and developing additional innovations. Against this background, companies in possession of patents can strategically exploit the resulting market power. There is also a risk that a licence will not be usable to its fullest extent, especially if its use is subject to conditions and restrictions.210 Thus, the risk that a patent will be ‘underutilised’211 exists alongside the risk that there will be a patent race, which would generate excessively high overall economic costs.212 Finally, a patent does not prevent others from exploiting an innovation; it simply increases the costs associated with doing so by an amount that depends on the effectiveness of the sanctioning mechanism. As discussed in the next section, it is especially challenging to establish an effective regime for patent

206

Engel (2011), p. 279. Stiglitz (2008), p. 1700. 208 On doubts and objections, see, e.g., Ostergard (2003), pp. 13 f. 209 Ostergard (2003), pp. 33 ff. 210 Engel (2011), p. 290. 211 Colangelo (2012), pp. 17 f., discusses this situation in the context of the ‘tragedy of the anticommons’ (see Sect. 2.3.2.3 above), a metaphor for a coordination breakdown that results from an excessive division of rights of use and exclusion over property. 212 Cf. Colangelo (2012), p. 9. 207

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protection in an international context, because interests in such protection vary between states. The arguments outlined above are strongly contested by those who view patents as an instrument to internalise external costs.213 Patent proponents claim that patents should be regarded not as rewards for past achievements (inventions), but as tools to create a market for inventions. Patents make innovations available to the public—at least in the long run—by requiring a full disclosure of the details of the invention; without the patent, the inventor could keep the work a trade secret. When supplemented by the principles of exclusion, transferability, certification and standardisation, patent law creates a functioning market for inventions. This market provides appropriate incentives for an efficient use of inventions, which in turn stimulates innovation and economic growth. The market also enables targeted financing mechanisms and allows even small companies to specialise in the market of innovations. Without patents, inventions might be kept secret, leading to closed R&D alliances and/or vertically integrated company structures. 6.4.2.4.2 The Challenge of Efficient Intellectual Property Regulation: The Case of Patents The above discussion portrayed the issue of patents in relatively black-and-white terms. Intellectual property—especially patents—has the potential to help create an efficient market for innovations, while exclusive rights can have significant negative effects. The legislature must therefore carefully weigh advantages and disadvantages. In particular, it is crucial to restrict disincentives to innovation and to ensure that property rights are granted only to the extent necessary to internalise external effects. In the process of considering the advantages and disadvantages of such protection, the legislature must first assess whether there is in fact a disincentive to innovation. Take, for example, a painting signed by the artist and a copy of that painting; the value and price of the copy will not be comparable to that of the painting. Open platforms, like those used for shared software, apparently function without the protection of property rights; the very essence of such systems is that contributors cannot claim property rights for their contributions. The legislature must also carefully examine the scope of protection that is required (and justified). For reasons that are more or less intuitive, IP rights—unlike rights to tangible property—have never been granted without time limits. This indicates that state practice does not align with the view of IP rights as property per se which states must acknowledge. Instead, states take an instrumental approach,

213

For an excellent overview of the arguments, see Spulber (2015).

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employing IP rights as a tool to achieve objectives and increase social welfare.214 In some states, this principle is even enshrined in the constitution.215 Rules regarding the scope of IP rights vary widely between states. Because the state is responsible for creating property rights, it is largely free to determine the scope of such rights. As a result, there is no generally accepted criteria for what qualifies as a patentable ‘invention’.216 Finally, state practice has developed instruments to limit the risk that exclusive intellectual property rights will be misused. Central among these are rules on compulsory licences that address various public needs like public health.217 6.4.2.4.3 International Protection of IP Rights IP rights are traditionally protected in accordance with the territoriality principle (‘principle of national treatment’).218 The level of protection varies considerably depending on the interests involved. Countries with relatively high value creation through innovation (primarily developed countries) tend to institute comprehensive and long-term protection, while other countries (primarily developing countries and emerging countries) tend to adopt lower standards of protection. Empirical evidence demonstrates that developing countries derive virtually no practical economic advantage from a strong IP protection regime.219 Conversely, the countries that advocate for the stronger protection of intellectual property rights are typically those in which international companies with innovative products represent a powerful lobby group.220 Tensions over this issue will inevitably escalate as the process of globalisation continues. To address these issues, states have formed numerous international conventions on IP since the end of the nineteenth century, such as the Paris Convention on the Protection of Industrial Property (1883).221 The TRIPS Agreement, signed in 1994, became a historic milestone in this process by establishing worldwide minimum standards (combined with strong WTO enforcement procedures). In formalising this agreement, developed countries succeeded in significantly increasing the level of international protection in WTO policy. (Multinational corporations, especially those in US, had a clear influence on its design.)222 In return, the agreement took

214

Correa (2013), pp. 172 ff. For example, Article I (8) of the US Constitution states that ‘the Congress shall have the power. . .to promote the progress of science and useful arts, by securing for limited times to authors and inventors the exclusive right to their respective writings and discoveries.’ 216 For further detail, see Correa (2013), pp. 178 ff. 217 Correa (2013), pp. 202 ff. 218 On the political economy of intellectual property rights, see Granstand (2003); on the economics of the international system of intellectual property rights, see Ostergard (2003). 219 Ostergard (2003), pp. 61 ff. 220 Ibid., 3 ff. 221 For an overview, see Correa (2013), pp. 207 ff. 222 Archibugi and Filippetti (2010), pp. 143 ff. 215

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initial steps towards liberalising the textile and agricultural sectors of developing countries. The TRIPS Agreement now contains provisions establishing non-discrimination obligations, minimum standards for the protection of specific IP rights, regulations on anti-competitive licensing practices, parameters for the enforcement of rights, and mechanisms for resolving disputes. The purpose of strengthening international IP protection is to dismantle trade barriers and encourage the development and distribution of technological innovations. Industrialised countries, however, are urging the adoption of even broader standards of protection: the US and the EU are pressing countries outside of the WTO to accept ‘TRIPS-plus’ standards in the context of bilateral or regional trade agreements.223 Outside the WTO agreement, the draft of an international treaty to combat piracy (AntiCounterfeiting Trade Agreement (ACTA)) was released in 2010. In 2012, after the eruption of massive international protests, the ratification process was terminated in many countries; the treaty was also rejected by the European Parliament.

6.5

Summary

Economic law is not only a state regulatory tool; for the social subsystem of the economy, it also represents a public good. The purpose of economic law is to enable functioning competition between private economic actors and to limit the state activity that can influence competition. From an economic and legal perspective, the economic activity of the state (‘public enterprises’) requires a justification, as does the allocation of subsidies. It is becoming increasingly common to use public contracts (and the associated mechanisms of public procurement) to achieve purposes unrelated to public procurement. These areas of law are governed by a fragmentary legal framework, which belies the enormous significance of these fields for policy decisions on economy and competition. The meaning of ‘economic regulation’ is no longer limited to classic economic governance and overall control of the economy (‘macroeconomic equilibrium’); it now also refers to the regulation of markets that were once structured as monopolies. Based on the theory of natural monopoly, the development of regulatory structures is partly general and partly specific to the grid-based sectors of the economy – specifically, the telecommunications, railway and energy industries. As globalisation has increased, issues related to international economic relations and the global economic constitution have taken on particular importance. In the context of international trade law, the earlier emphasis on trade liberalisation is now being put to the test, both economically and legally. More nuanced perspectives have also emerged on the protection of international investments and IP—and on the market failure associated with them. These analyses have identified a clear need for reform.

223

Correa (2013), pp. 212 ff.

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Dabbah MM (2010) International and comparative competition law. Cambridge University Press, Cambridge Della Guista M (2010) Simulating the impact of regulation changes on the market of prostitution services. Eur J Law Econ 29:1–14 DiLorenzo TJ (1996) The myth of natural monopoly. Rev Aust Econ 9:43–58 Dow S, Jespersen J, Tily G (eds) (2018) The general theory and keynes for the 21st century. Edward Elgar Publishing, Cheltenham Engel C (2011) When is intellectual property needed as a carrot for innovators? J Compet Law Econ 7:277–299 Eucken W (1950) Grundlagen der Nationalökonomie. Fischer, Berlin, Jena 1940; Springer, Berlin European Commission (2003) Commission Directive 2006/111/EC of 16 November 2006 on the transparency of financial relations between Member States and public undertakings as well as on financial transparency within certain undertakings Finger M, Messulam P (2015) Rail economics and regulation. In: Finger M, Messulam P (eds) Rail economics and regulation in Europa. Edward Elgar Publishing, Cheltenham/Northampton, pp 1–21 Fritsch M (2018) Marktversagen und Wirtschaftspolitik - Mikroökonomische Grundlagen staatlichen Handelns, 10th edn. Vahlen, München Froufe PM (2019) Economic Constitution of the European Union, before and after Lisbon (between the principle of Competition and the “Social Market Economy”). UNIO – EU Law J 3:109–122 Grandia J, Meehan J (2017) Public procurement as a policy tool: using procurement to reach desired outcomes in society. Int J Sector Manage 20:302–309 Granstand O (2003) Economies, law, and intellectual property: seeking strategies for research and teaching in a developing field. Kluwer, Boston, MA Guangdong X (2014) Does law matter for economic growth? A Re-examination of the ‘Legal Origin’ hypothesis. Intersentia, Cambridge/Antwerp/Portland Gustafsson A (2018) Industrial policy: political considerations, payoffs, and peculiar incentives. Jönköping International Business School Jönköping JIBS Dissertation Series No. 125 Hallaert J-J (2006) A history of empirical literature on the relationship between trade and growth. Mondes en Développement 135:63–77 Heimler A (2012) Cartels in public procurement. J Compet Law Econ 2012:1–14 Hildebrand D (2014) Modernisation of state aid rules in the European Union. Application of economic concepts and principles. In: Schoenmaekers S, Devroe W, Philipsen N (eds) State aid and public procurement in the European Union. Cambridge/Antwerp/Portland, Intersentia, pp 1–18 Hofmann HCH, Pantazatou K (2019) The transformation of the European economic constitution. In: Hofmann HCH, Pantazatou K, Zaccaroni G (eds) The metamorphosis of the European economic constitution. Edward Elgar Publishing, Cheltenham, pp 2–24 Hong H, Shum M (2002) Increasing competition and the winner’s curse: evidence from procurement. Rev Econ Stud 69:871–898 Howlett M, Ramesh M (2020) State-owned enterprises as policy tools. In: Bernier L, Florio M, Bance P (eds) The Routledge handbook of state-owned enterprises. Routledge, New York, pp 553–567 Jaag C, Trinkner U (2009) Tendering universal service obligations in liberalized network industries. Compet Regul Netw Ind 10:313–333 Joskow PL (2007) Regulation of natural monopoly. In: Polinsky AM, Shavell S (eds) Handbook of law and economics, vol 2. Elsevier, North Holland, pp 1227–1348 Kaplow L, Shapiro C (2007) Antitrust. In: Polinsky AM, Shavell S (eds) Handbook of law and economics, vol 2. Elsevier, Amsterdam, pp 1073–1225 Kassim H, Lyons B (2013) The new political economy of EU state aid policy. J Ind Compet Trade 13:1–21 Kerber W (2009) The theory of regulatory competition and competition law. In: Meessen KM, Bungenberg M, Puttler A (eds) Economic law as an economic good. Sellier, Munich, pp 27–44

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Kim B-Y (2012) The studies of economic systems and institutions: some views on future directions. J Comp Econ Stud 7:11–21 Kirchgässner G (2008) Homo oeconomicus. The economic model of behavior and its applications in economics and other social sciences. Springer, New York Kirchner C (2010) Zur Ökonomik des Vergaberechts. VergabeR:725–735 Krajewski M (2003) Konstitutionelle Ökonomie des GATT/WTO-Rechts. In: van Aaken A, Schmid-Lübbert S (eds) Beiträge zur ökonomischen Theorie im Öffentlichen Recht. Deutscher Universitäts-Verlag, Wiesbaden, pp 1–24 Leaman J (1988) The political economy of West Germany, 1945–85. Palgrave Macmillan, London Listokin Y (2019) Law and macroeconomics. Legal remedies to recessions. Harvard University Press, Cambridge Maneschi A (2013) International trade theory and comparative advantage. In: Linarelli J (ed) Research handbook on global justice and international economic law. Edward Elgar Publishing, Cheltenham, pp 274–300 Meessen KM (2009) Economic law as an economic good. Its rule function and its tool function in the competition of systems. In: Meessen KM, Bungenberg M, Puttler A (eds) Economic law as an economic good. Munich, Sellier, pp 3–26 Menell PS, Scotchmer S (2007) Intellectual property. In: Polinsky AM, Shavell S (eds) Handbook of law and economics, vol 2. Elsevier, Amsterdam, pp 1473–1570 Mercuro N, Medema SG (1997) Economics and the law. From posner to post-modernism. Princeton University Press, Princeton Michaelis M, Salomon T-R (2010) Handelsbezogene Investitionsmaßnahmen. In: Hilf M, Oeter S (eds) WTO-Recht. Rechtsordnung des Welthandels, 2nd edn. Nomos, Baden-Baden, pp 336–351 Micheau C (2014). State Aid, subsidy and tax incentives under EU and WTO law. Wolters Kluwer, Alphen aan den Rijn Morgan B, Yeung K (2007) An introduction to law and regulation. Text and materials. Cambridge University Press, Cambridge Mosca M (2008) On the origins of the concept of natural monopoly: economies of scale and competition. Eur J Hist Econ Thought 15:317–353 Mulder M (2020) Regulation in energy markets. Economic mechanisms and policy evaluation. Springer International Publishing, Heidelberg Nieder-Eichholz M (1995) Subventionsordnung. Ein Beitrag zur wirtschaftlichen Ordnungspolitik. Duncker & Humblot, Berlin North DC (1990) Institutions, institutional change and economic performance. Cambridge University Press, Cambridge OECD (2015) OECD guidelines on corporate governance of state-owned enterprises. OECD Publishing, Paris OECD (2017) The size and sectoral distribution of state-owned enterprises. OECD Publishing, Paris OECD (2018) Ownership and governance of state-owned enterprises: a compendium of national practices. OECD Publishing, Paris Ogus A (1994) Regulation - legal form and economic theory. Hart, Oxford Ostergard RL (2003) The development Dilemma. The political economy of intellectual property rights in the international system. LFB Scholarly Publishing LLC, New York Papenfuß U (2020) Corporate governance of state-owned enterprises: conceptualization, challenges and perspectives for the public corporate governance field. In: Bernier L, Florio M, Bance P (eds) The Routledge handbook of state-owned enterprises. Routledge, New York, pp 433–444 Peters A (2010) Wettbewerb von Rechtsordnungen. VVDStRL 69:7–53 Petersmann E-U (1991) Constitutional functions and constitutional problems of international economic law: international and domestic foreign trade law and foreign trade policy in the United States, the European Community and Switzerland. University Press Fribourg, Fribourg

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Piga G, Thai KV (2007) The economics of public procurement. In: Piga G, Thai KV (eds) The economics of public procurement. Palgrave Macmillan, Houndmill, pp 1–10 Pircher B (2020) EU public procurement policy: the economic crisis as trigger for enhanced harmonization. J Eur Integr 42:509–525 Posner EA, Sykes AO (2013) Economic foundations of international law. The Belknap Press of Harvard University Press, Cambridge Posner RA (1968) Natural monopoly and its regulation. Stanford Law Rev 21:548–643 Posner RA (2005) Intellectual property: the law and economics approach. J Econ Persp 19:57–73 Prosser T (2014) The economic constitution. Oxford University Press, Oxford Putniņš T (2020) Economics of state-owned enterprises. In: Bernier L, Florio M, Bance P (eds) The Routledge handbook of state-owned enterprises. Routledge, London, pp 215–238 Raitt G (2019) The metamorphosis of market power. The Zero-Sum competition and market manipulation approach. Hart Publishing, Oxford Roberts TM (2020) Subsidies and the environment. In: Richards KR, van Zeben J (eds) Policy instruments in environmental law. Edward Elgar Publishing, Cheltenham, pp 199–211 Rodi M (1994) Steuervergünstigungen als Instrument der Umweltpolitik. StuW: 204–213 Rodi M (2000) Die Subventionsrechtsordnung. Die Subvention als Instrument öffentlicher Zweckverwirklichung nach Völkerrecht, Europarecht und deutschem innerstaatlichen Recht. Mohr Siebeck, Tübingen Roginska-Green I (2018) Subsidies in the US and the EU. control or free provision? Nova Science Publishers, New York Sánchez Graells A (2015) Public procurement and the EU competition rules, 2nd edn. Hart Publishing, Oxford Sauter W (2014) Public services in EU law. Cambridge University Press, Cambridge Sawyer WC (2014) International trade policies. In: Payson S (ed) Public economics in the United States. How the federal government analyzes and influences the economy, vol 3. Praeger, Santa Barbara, pp 1033–1059 Schanze E (2009) Assessing the impact of economic law. In: Meessen KM (ed) Economic law as an economic good. Sellier European Law Publishers, Munich, pp 65–74 Schebesta H (2014) EU Green procurement policy modernisation package, eco-labelling and framing measures. In: Schoenmaekers S, Devroe W, Philipsen N (eds) State Aid and public procurement in the European Union. Insentia, Cambridge, pp 129–141 Spagnolo G, Castellani L (2018) Introduction – vendor rating, performance and entry in public procurement. In: Piga G, Tátrai T (eds) Law and economics of public procurement reforms. Routledge, London, pp 1–11 Spulber DF (2015) How patents provide the foundation of the market of innovation. J Compet Law Econ 11:271–316 Spulber DF, Yoo CS (2009) Networks in telecommunications. Economics and law. Cambridge University Press, Cambridge Staiger B (2009) Die Kontrolle staatlicher Beihilfen in der Europäischen Union. Eine ökonomische Analyse der Kompetenzallokation. Kovac, Hamburg Stephen MD (2019) Contestation overshoot. Rising powers, NGOs, and the failure of the WTO Doha Round. In: Stephen MD, Zürn M (eds) Contested world orders: rising powers, non-governmental organizations, and the politics of authority beyond the nations-State. Oxford University Press, Oxford, pp 39–81 Stiglitz JE (2008) Economic foundations of intellectual property rights. Duke Law J 57:1693–1724 Stiglitz JE, Rosengard JK (2015) Economics of the public sector, 4th edn. W. W. Norton, New York Subedi SP (2020) International investment law. Reconciling policy and principle. Hart Publishing, Oxford Sykes AO (2010) The questionable case for subsidies regulation: a comparative perspective. J Legal Anal 2:473–523 Sykes AO (2007) International law. In: Polinsky AM, Shavell S (eds) Handbook of law and economics, vol 1. North Holland, Amsterdam, pp 757–826

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Talus K (2013) EU energy law and policy. A critical account. Oxford University Press, Oxford Trommer S (2020) The evolution of the global trade regime. In: Ravenhill J (ed) Global political economy, 6th edn. Oxford University Press, Oxford, Ch. 5, pp 111–139 Tully J, Dunoff JL, Lang AF, Kumm M, Antje W (2016) Introducing global integral constitutionalism. Global Const 5:1–15 Voigt S (2009) Institutionenökonomik, 2nd edn. Fink, Paderborn Weishaar SE (2014) Procurement reforms and bid rigging: mixed blessings or our happily Ever after? In: Schoenmaekers S, Devroe W, Philipsen N (eds) State aid and public procurement in the European Union. Intersentia, Cambridge, pp 101–114 Willemyns I (2016) Disciplines on state-owned enterprises in international economic law: are we moving in the right direction? J Int Econ Law 19:657–680 Windholz EL (2017) Governing through regulation: public policy, regulation and the law. Routledge, London WTO (2006) World Trade Report 2006. Exploring the links between subsidies, trade and the WTO (https://www.wto.org/english/res_e/booksp_e/world_tradereport06_e.pdf) Yakovlev AA, Tkachenko AV, Balaeva ON, Rodionova YD (2020) The Russian system of public procurements: context of legislative changes. Probl Econ Transit 3:214–230

7

Environmental Economics

Of the many fields of economics, environmental economics has arguably had the greatest influence on legal practice in recent decades.1

7.1

Principles of Environmental Economics

7.1.1

Market Failures in an Environmental Context

Environmental economics builds on and further elaborates classical microeconomic theory. This field of economics primarily examines preferences and needs in the presence of constraints. Particularly in the context of environmental policy, the market mechanism often fails to produce the conditions that are generally considered optimal. The problem of ‘market failure’ plays a significant role here: the market for environmental goods either does not exist or does not yield the preferred outcome. A clean and intact environment is widely considered a desirable public good.2 Nevertheless, significant dilemma structures emerge in its provision, because actors display strong tendencies towards non-cooperation and often exploit the cooperative efforts of others. The concept of dilemma structures can explain why gains from cooperation can only be obtained through institutions; however, it does not indicate what form these institutions should take. (One approach to achieve cooperation, for example, is to make non-cooperation a punishable offence.) The neoclassical approach to environmental economics uses the theory of external effects to analyse the challenges associated with environmental public goods.3 In

1

For an introduction to environmental economics, see Field and Field (2021). For greater depth, see Buchholz and Rübbelke (2019) and Lewis and Tietenberg (2019). On environmental law and economics, see Faure and Partain (2019). 2 See Uitto (2016). 3 For research on externalities, see, e.g., Preiss (2012). # Springer-Verlag GmbH Germany, part of Springer Nature 2022 M. Rodi, Economic Analysis of Public Law, Springer Textbooks in Law, https://doi.org/10.1007/978-3-662-66089-8_7

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an environmental context, this theory suggests that the market rarely takes negative or positive externalities into account—especially in the case of negative externalities, such as environmental damage. Positive externalities can be produced, for example, when new environmental technologies are not patented; in this situation, subsidies can be granted as compensation. Negative externalities occur when a decision is made that has no repercussions for the decision-maker but adversely affects a third party. This is where the ‘polluter pays’ principle of environmental policy comes into play: because the market does not ensure that externalities will be internalised, policy interventions are necessary.4 Environmental problems are also typically associated with information asymmetries.5 This is evident, for example, in the relationship between environmental authorities and the private actors whose behavior has caused the environmental problems. Relationships between private parties can also involve information asymmetries concerning environmental effects: for example, the manufacturer knows more about the environmental compatibility of a product than do buyers or consumers. Finally, the New Political Economy (NPE) suggests that state failure can explain certain deficiencies, especially in the context of environmental policy.6 For example, massive limitations in the implementation of environmental regulations can be attributed to an alignment of interests between businesses (polluters) and local environmental authorities, which leads to illegal practices in the enforcement of environmental law.7 The goal of energy efficiency can be used to demonstrate the existence of multiple market failures. Energy efficiency policies are intended to conserve resources, secure the energy supply and mitigate climate change. Markets fail with regard to resource conservation because the calculations of actors today do not adequately account for the future benefits of (increasingly scarce) resources; prices do not sufficiently reflect future scarcity. From an economic perspective, the security of supply can be interpreted as a standard insurance problem because it concerns the economic costs that (may) result from shortage-induced price fluctuations.8 At least where payment must be made at their own expense, however, utility-maximising actors are unwilling to pay individually (at their own expense) to combat a risk that affects everyone; this produces a dilemma situation. Finally, market failure can occur as a result of information asymmetries, especially with regard to energy efficiency. This is because actors often lack the information needed to make (relatively expensive) investments, even though these investments would pay off in the long run because of the energy efficiency of the capital goods. In many cases, the process of collecting

4

On the available environmental policy instruments, see Sect. 7.2 below. Cf. Laffont (1994). 6 See, e.g., Hepburn (2011), pp. 127 ff. 7 For greater detail, see Sect. 7.2.1.2 below. 8 Sturm and Mennel (2009), pp. 15 f. and further reference. 5

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information would be so time-consuming that the transaction costs would be high. In addition, actors often simply fail to give future benefits sufficient thought.9

7.1.2

The Coase Theorem (Exchange and Negotiated Solutions)

A central topic in debates on environmental policy is the Coase Theorem, which was introduced by British economist Ronald H. Coase in the 1960 essay ‘The Problem of Social Cost’.10 In essence, the theorem challenges the assumption that the state should implement policy instruments (e.g. environmental taxes) to internalise (negative) externalities when they occur. Coase theorised that the problem of market failure would cease to exist if private property rights were allocated for public goods; this logic is consistent with the creation of individual usage rights to resolve the ‘tragedy of the commons’.11 The state defines the (generally transferable) rights of use (‘property rights’) for resources (e.g. air) that are affected by externalities. Directly converting the environmental resource into a marketable good can eliminate the ‘market failure’; external effects can then be internalised through negotiation.12 Property rights cannot be granted for certain environmental goods (e.g. air); a modified version of the Coase Theorem addresses these situations by equating ‘property rights’ with rights to cause a certain amount of environmental damage (e.g. the emission of a specific amount of air pollution) that will negatively affect the relevant environmental good. Coase questioned whether the state could achieve its environmental objectives simply by influencing the emissions behaviour of the alleged polluter. He argued that, after the state reaches a basic regulatory decision, any misallocation can be remedied through interactions between affected parties, who negotiate with one another to establish the ‘optimal’ (‘Pareto-efficient’) level of emissions/external effects. In a world without transaction costs, resources will be utilised where they are most valued, provided only that the rights of use are clearly defined. For an efficient allocation of resources, it is irrelevant who is assigned the rights of use; in a sense, this argument also challenges the ‘polluter pays’ principle in environmental policy. The Coase Theorem is best illustrated by an example.13 A power plant is situated at the headwaters of a river, and wastewater from the plant damages a fishery located downstream. If the state grants the fishery the property rights (or rights of use) for the Dawnay and Shah (2011), pp. 88 ff.: ‘People are bad at computation.’ Coase (1960); for an introduction, see Parisi (2005); Hazlett (2009); Polinsky (2011), Chap. 3. For greater depth, see Coase (1993), pp. 129 ff.; Faure and Skogh (2003), pp. 151 ff. (with concrete examples taken from the waste and recycling industries, among others). 11 See Ostrom (1990/1999). 12 Congdon et al. (2011), pp. 130 f. 13 See Ostrom (1990/1999). In the main example used by Coase to illustrate his theorem, a conflict develops between a farmer and a rancher when the rancher’s cattle wander onto the farmer’s land and destroy crops; see Coase (1960), pp. 838 ff. 9

10

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resource (river water), the power plant will negotiate with the fishery to determine how much wastewater it can continue to discharge and how much it must pay to do so. If the rights of use are instead allocated to the power plant, the fishery can pay the power plant to reduce the amount of wastewater discharged. Theoretically, the outcome of the negotiations will be the same in each case; that is, the socially optimal level of pollution will be reached. At this level, the marginal benefit to the power plant equals the marginal cost to the fishery. The Coase Theorem has generated a great deal of criticism, especially with regard to its practicality.14 This criticism is often unjustified, however, because the theorem was intended to serve as a conceptual model that holds only if certain restrictive assumptions are met. A frequent objection is that the Coase Theorem is ideologically charged and promotes market liberalism.15 This is a surprising critique, especially because Coase was heavily influenced by socialist ideas as a young man.16 It is also inaccurate in terms of the content of the theorem: the conceptual model is associated with positive economics and only aims to estimate the effects of state action.17 This is relevant to the argument that information and transaction costs are particularly high in the environmental sector and can prevent negotiated solutions.18 Coase recognised this problem; the need to take positive transaction costs into account is, of course, a political reality. Only after this is accomplished can meaningful decisions be reached on the use of negotiated solutions or interventionist measures to internalise effects. Another common objection to the theorem is that the potential for negotiations to produce an optimal outcome depends on the bargaining position, the regulatory framework for the negotiations and the abilities of the actors. According to this view, Coase’s theoretical framework fails to account for the possibility of strategic behaviour:19 actors perform (or merely threaten to perform) a harmful activity only with the goal of being paid to terminate it. An even more serious objection is that there are generally information asymmetries between actors; therefore, the injured party knows its own marginal damage costs but can only roughly estimate the marginal abatement costs of the injuring party (and vice versa).20 It could be argued that the avoidance of strategic behaviour is ultimately included in the transaction costs, but this explanation is not yet entirely satisfactory.21 Critics of the theorem also point out that the model presupposes few actors (in extreme cases, only two). This is problematic for two reasons. First, if many

14

See, e.g., Arcuri (2005). See, e.g., Hazlett (2009), pp. 37 f. and further reference. 16 Hazlett (2009), pp. 2 ff. 17 Relatedly, Arcuri (2005), p. 227. 18 Polinsky (2011), pp. 14 f., on the problem of transaction costs; Hahnel and Sheeran (2009) regarding information problems. 19 Voigt (2009), 2.2 (pp. 59 f.). 20 Hahnel and Sheeran (2009). 21 Medema (1999), pp. 140 and 146. 15

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parties are involved, their interests must be aggregated (which generates transaction costs). Second, the fact that the injuring and injured parties are generally heterogenous groups also creates the risk that free riders will attempt to profit from the negotiations and agreements of others. The resulting prisoner’s dilemma can make negotiations difficult or impossible.22 Finally, negotiations may not produce optimal outcomes because success ultimately depends on whether the parties are both willing and able to pay.23 If, for instance, Farmer A is granted rights of use for the commons, negotiations may be impossible if Farmer B does not have the financial means necessary to acquire the rights to use it. The most significant challenge to the Coase Theorem and its ‘invariance hypothesis’ may be that the initial allocation of rights of use has a number of practical consequences. Empirical evidence indicates, for example, that there is a difference between the willingness to pay to acquire property rights and the willingness to relinquish them; initial allocations thus alter preferences.24 In addition, the policy decisions on this topic have significant distributional effects (with implications for distributive justice). Finally, there may be reasons for the state to reduce environmental damage even further; in such cases, the environmental policy ‘bargaining equilibrium’ is considered insufficient. In summary, the Coase Theorem alone is not a ‘silver bullet’ that can solve every environmental problem. It is, however, an important analytical tool (among others) that can help structure pathways to a solution. This tool is especially useful in situations without a central authority, such as international climate change negotiations. Using this approach led participants to conclude that industrialised countries should share in the responsibility of reducing emissions in developing countries (e.g. within the framework of the Clean Development Mechanism).25

7.1.3

Valuation of Environmental Damage

7.1.3.1 Basic Principles Identifying deviations of a market outcome from an environmental ‘ideal state’ is a central problem in environmental economics. It is important to distinguish this ideal from the state of the environment that environmental policy aims to achieve—that is, to establish the valid environmental quality standards. A rational environmental policy does not pursue environmental objectives ‘at any price’. Instead, it balances the costs and benefits of implementing environmental policy instruments. Costs are evaluated and assessed relative to an evaluation of

22

Guerra-Pujol and Martinez-García (2014). Cf. Arcuri (2005), pp. 229 ff. 24 Arcuri (2005), pp. 225 ff. For relevant empirical research and a discussion of the ‘behavioural economic’ perspective and the underlying ‘endowment effect’, see Jolls (2007), 116 ff. (pp. 4.2). 25 See Sect. 7.4.4.3 below. 23

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benefits. The main benefit lies in preventing environmental damage. This process assumes, however, that the damage to the environment (and the corresponding benefits of avoiding it) can be evaluated using a comparable technique.26 Before this question can be discussed in greater detail, it is necessary to clarify the meaning of cost-benefit analyses in general. Discussion: Rational Cost-Benefit Analysis

Cost-benefit analysis (CBA) is an important economic tool for evaluating policy instruments.27 It is always necessary when market prices do not accurately reflect the scarcity of resources or the preferences of market participants, as in all cases of market failure. This analysis tests the rationality of potential state actions; for example, it can be used to determine whether the state should plan an infrastructure project like a new railway line or a motorway. A CBA is generally carried out in five steps: (1) Identify actual or potential negative environmental damage and measures to remedy or prevent the damage. A CBA in environmental policy begins with the specification of a (present or future) environmental problem and a proposed solution that would involve the use of policy instruments. (2) Conduct an impact assessment. What (undesirable) consequences would occur if the measure were not taken? (Stated differently, what consequences can the measure prevent?) A discussion of a proposed general speed limit, for example, should consider factors such as reductions in traffic accidents, exhaust emissions, and potential delays. The difficult probability questions that emerge at this stage must be incorporated into the assessment.28 (3) Conduct a cost assessment. What (governmental, social and individual) costs would the measure impose?29 A cost-effectiveness analysis should also be performed at this point to evaluate whether the goal can be reached at a lower cost. (4) Estimate benefits. The most difficult step is determining the benefits associated with achieving the objective. These benefits should also be compared with the benefits that would be obtained if the same resources were used to meet other objectives. This can only be evaluated on the basis of a common unit of account, which is generally monetary (monetisation).

26

For an introduction to the valuation of environmental damage, see Hanley and Barbier (2009), pp. 15 ff. 27 See also Faure and Skogh (2003), Chap. 10 (pp. 165 ff.); Revesz and Stavins (2007), pp. 508 ff.; Moosa and Ramiah (2014), Chaps. 5 (pp. 85 ff.) and 6 (pp. 111 ff.); Hussen (2019), Chap. 8 (pp. 172 ff.). 28 On the issues of risk assessment and probability of occurrence (especially regarding the problem of risk aversion), see Ricci (2006), pp. 15 ff. 29 Regarding individual cost categories, see Moosa and Ramiah (2014), 5.3 (pp. 93 ff.).

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(5) Compare costs and benefits. In the final step, total estimated costs are compared to total estimated benefits. Because a one-to-one comparison of present and future costs and benefits is impossible, problems may arise at this stage.30 The costs and benefits of environmental protection measures are generally not apparent at the same time: the immediate costs of abatement must be weighed against the prevention of future environmental damage (which, in the case of climate change and many other environmental problems, will not be evident for many years). There is general agreement on the merits of discounting under these circumstances, with the interest rate used as a benchmark.31 Other issues are more contentious. Some authors have identified ethical concerns associated with discounting32 and, citing the need for intergenerational equity, have proposed zero or even negative discount rates.33 Although there is at least a broad consensus on the need for a ‘social’ discount rate lower than private rates,34 the future of this proposal remains uncertain. The ‘proper’ discount rate is a normative question, and opinions on it vary considerably. (The German Federal Environmental Agency, for example, suggests a rate of 3% for short periods up to 20 years and a rate of 1.5% for longer periods in the interest of intergenerational equity).35 In the context of climate change valuation, however, Stern proposes a discount rate of up to 0.1% for good reason: the current benefits of climate change measures are correspondingly high.36 The valuation results are as varied as the valuations themselves.

◄

7.1.3.2 Advantages of a Monetised Environmental Valuation For obvious reasons, CBA is relevant to the development of rational environmental policy. It can be used in a comparison of damage and avoidance costs to assess the efficiency of environmental policy measures. In addition, CBA makes it possible to compare various types of damage (e.g. air pollution or species loss); the results can define priority-setting criteria for environmental policy. Finally, CBA can evaluate the benefits of environmental policy (i.e. damage avoided) relative to other economic indicators (especially GDP). The results can inform an analysis of the relationship between GDP growth and an increase in social welfare.37

30

See Rao (2002), 3.6. For further details on this benchmark, including problems associated with it, see Heesterman (2004). 32 See, e.g., Rao (2002), 3.6. 33 Hussen (2019), Chap. 8.5 (pp. 184 ff.) provides an overview of authors and arguments. 34 Hussen (2019), pp. 182 ff. and further reference. 35 Umweltbundesamt (2007), p. 39. 36 Stern (1997), pp. 49 ff. For a critical perspective, see Nordhaus (2007). 37 On ‘integrated environmental and economic accounting’, see Bartelmus (2014). 31

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7.1.3.3 Problems with a Monetised Environmental Valuation In the environmental policy field, a monetised assessment of benefits poses significant problems. CBA in environmental policy is problematic because of the many uncertainties involved in assessing costs and benefits. Economic dilemmas (such as determining the correct discount rate, as discussed above) are compounded by enormous scientific challenges. One such challenge could involve determining how much atmospheric temperature will rise due to emissions of a fixed amount of greenhouse gases, as well as the weather effects and other consequences that may result. Another difficult consideration is the basis that should be used for valuations of the environment. This highlights the broader philosophical debate between ecocentric and anthropocentric perspectives on the environment.38 If the environment is considered intrinsically valuable (and there are many reasons why this should be the case), it is hardly possible to assess environmental policies with a rational CBA. Economists, however, adopt an anthropocentric perspective because they presuppose the existence of consumer sovereignty. The underlying question thus becomes: what benefit does the consumer attach to environmental quality? The measurable indicator of environmental quality is ‘willingness to pay’, which is used to estimate an individual demand curve for environmental quality. The ‘consumer surplus’ is then determined to assess the benefit derived from a concrete improvement in environmental quality; this value tends to decrease as environmental quality increases. Because environmental policy instruments are typically associated with the production of public goods, the non-market value of such goods is problematic; it must therefore be quantified in a different way. This raises the issue of relevant value categories.39 The monetary valuation of environmental conditions is based on the value attributed to the actual use of a specific environmental good (‘use value’), which is indicated by the willingness to pay for the good. Other categories of value supplement (or substitute for) this value. ‘Option-to-use value’, or simply ‘option value’, indicates the potential to use a certain good, regardless of the actual demand for that good. For example, individuals may value the existence of a local recreation area, even if they never have time to use it. ‘Existence value’ refers to the welfare effect of the mere existence of certain environmental attributes. For example, individuals benefit from biodiversity, even though they may not know whether the existence of a certain species will improve their lives directly in some way. (The discovery of penicillin from the fungus Penicillium in 1928 is a remarkable example of the potential benefit of a species.)40 ‘Bequest value’, a special case of existence value, refers to the satisfaction that people derive today from the expectation that a natural resource will be preserved for future generations. This can also be interpreted as an aspect of option value that reflects intergenerational equity concerns. 38

On this controversy, see, e.g., Kopnina et al. (2018). For a comprehensive overview, see Willis and Garrod (2012). 40 See, e.g., Rao (2002), pp. 180 f., 184 f. 39

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Appraising the value of nature and the environment (including lives of plants, animals, and human beings) raises significant ethical questions. From a moral standpoint, placing a monetary value on human life or human health is clearly problematic. There are, however, two arguments in favour of monetary evaluations of this kind. First, they are necessary because they make it possible to perform a monetary valuation or CBA in the environmental policy field. Second, the value is that of a statistical life, not the life of an individual person: strictly speaking, the monetised value refers to the risk of death.41 However, the approach raises a related question: are there any rational criteria for valuations of death? One possible basis for such calculations is the willingness of individuals to accept a greater risk of dying at work in exchange for higher (hazard) pay;42 another option would be to calculate the ‘value’ of a life in terms of an individual’s productivity or expected lifetime earnings. It is hardly surprising that the value attributed to human life varies significantly across studies.43 A second moral problem arises from the potential association between the ‘price’ assigned to human lives and the background of the individuals in question (e.g. region of origin, social status, age or education). The discussion of discount rates has already revealed one crucial issue related to justice: intergenerational equity. Monetised CBA also raises questions of distributive justice. By aggregating costs and benefits at the society level, CBA fails to consider how individuals will be affected by the measures in question. The critique of utilitarianism thus applies in this context:44 is a measure really preferable if it leads to huge benefits for a small group (e.g. wealthy individuals) while adversely affecting the majority? Such measures would have little chance of success in elections or polls.45 If willingness to pay were the only criteria for political decisions, new parks would be planned for wealthy areas and waste disposal plants would be located in areas with poorer populations.46

7.1.3.4 Methods of Valuation In valuations of public goods, one of the most difficult questions to resolve is which method should be used. Because there are no real markets for nature or the environment, artificial prices must be determined on the basis of ‘revealed preferences’. Valuation methods fall into two basic categories: direct methods, which are based on surveys (the ‘stated preference approach’), and indirect methods, which are used to infer individual preferences from other (market) data.

41

Ackerman and Heinzerling (2002), pp. 1564 ff. For further detail, see Graves (2014), pp. 157 ff. 43 Studies have shown that a human life is generally valued at €3–7 million; €7 million, the value calculated in studies in the US, is based on wage premiums for occupational fatality risk. See Umweltbundesamt (2007), pp. 71 f.; Kochi et al. (2006); Viscusi and Aldy (2003). 44 See Sect. 1.2.1.3 above. 45 For a discussion of the relationship between CBA and democracy, see Graves (2014), pp. 135 ff. 46 For these examples, see Ackerman and Heinzerling (2002), pp. 1573 ff. 42

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7.1.3.4.1 Direct Method (Stated Preference Approach) The direct method employs surveys to assess individual willingness to pay (e.g. the estimated value of environmental quality).47 These surveys can refer to the concrete environmental improvements that could result from targeted measures. The survey method can also be used to evaluate preferences for environmental goods (or changes to these goods, for better or worse) under hypothetical environmental conditions (contingent valuation method (CVM)).48 Preferences are expressed in two forms. ‘Willingness to pay’ indicates the amount that an individual is willing to pay to attain a particular environmental condition, and ‘willingness to accept’ indicates the minimum monetary amount for which an individual would be willing to accept a deterioration of environmental quality. Unfortunately, these values do not coincide, as is well documented in behavioural economics.49 Apart from the disparities in these values (and the general costliness of such interviews), there are other challenges associated with direct valuation methods; these challenges are typically consistent with the effects observed in behavioural economics. Stated preference methods for environmental valuation share all of the problems that are associated with the interview methods used in empirical social research. The quality of results depends largely on the information available and is therefore vulnerable to ‘information bias’. A direct survey demands that respondents have a high level of information (e.g. with regard to links between environmental pollution and health problems) or between emissions (e.g. of CO2) and their actual consequences. It is striking that the existence value of endangered species is more closely related to their aesthetic appeal than to their ecological role.50 To mitigate the effects of insufficient information, respondents are provided with some details during the survey; survey results will of course depend on the kind of information given. ‘Hypothetical bias’ presents another problem.51 Because respondents are not making ‘real’ transactions, they are not required to bear the consequences of their choices. Several studies have suggested that mean hypothetical values reported to researchers can be up to three times greater than the value of actual cash payments.52 This effect is linked to the free-rider problem or the risk of strategic behaviour (‘strategic bias’).53 Respondents may try to guess how the information will be used and provide answers that distort the expected outcome to align with their individual preferences. If they perceive that the value they report could serve as the basis for

47

For a detailed explanation of the survey process, see Graves (2014), pp. 144 ff.; for practical examples, see Hussen (2019), pp. 153 ff. 48 For an overview of this method, see Venkatachalam (2004). 49 Horowitz et al. (2013), pp. 116 ff.; for empirical evidence, see Knetsch (2013). For a general discussion, see Sect. 1.2.2.2.3.3. 50 Hussen (2019), p. 153. 51 Horowitz et al. (2013), pp. 119 ff. 52 Hussen (2019), p. 153. 53 Ibid., pp. 135 f.

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actual payment obligations, they have an incentive to understate their willingness to pay. All other insights from behavioural economics also apply.54 For example, in classical risk assessments (extent of loss/probability of occurrence), people tend to be risk averse. Individual risk assessments are influenced by examples that immediately come to mind, such as an oil spill that has just occurred (‘availability heuristic’). 7.1.3.4.2 Indirect Methods (Revealed Preference Approaches) It is no less challenging to draw accurate conclusions about individual willingness to pay from observed behaviour patterns or measurable data obtained using indirect methods. Various approaches are suitable for this purpose. These are not mutually exclusive; they can be combined, like the pieces of a mosaic. In many cases, environmental damage leads to differences in inputs and outputs that have a market price (‘market-pricing approach’).55 ‘Value-added methods’ are used when businesses experience identifiable utility losses as a result of environmental damage (higher production costs or lower yields). Examples include crop damage from climate change or fuel replacement costs resulting from the lack of available woodfuel following deforestation. Environmental measures can increase yields in such cases (e.g. a larger fish harvest due to the implementation of a new water-pollution control technology). Environmental damage can also be calculated by measuring the costs of reversing environmental deterioration that has already occurred (‘sum of specific damages approach’56 or ‘replacement cost approach’).57 These costs may be reflected in the costs of renovating house façades that were blackened by air combustion or in the costs of medical expenses to treat health issues. The problem with this approach, of course, is that some damage is irreversible. It may also cost less to prevent damage than to repair it. Another group of methods evaluates the household costs resulting from environmental damage (‘household production function approaches’).58 The ‘preventive expenditure method’ is used to assess changes in spending on goods and services that substitute for environmental quality (e.g. the purchase of water filters to reduce the risk of drinking contaminated water or the installation of noise-proof windows to reduce noise pollution). Such costs are substantial: estimates of ‘defensive environmental expenditures’ in the US range from 5–10% of GDP.59 A particularly wellknown subcategory is the ‘travel cost approach’.60 This method can be used to 54

See Kuenzler and Kysar (2014), 2.2 (pp. 752 ff.). See Hussen (2019), pp. 143 ff. 56 Graves (2014), Chap. 13 (pp. 151 ff.). 57 Hussen (2019), pp. 150 f. 58 Hussen (2019), pp. 150 ff. 59 Hussen (2019), p. 151. 60 Graves (2014), Chap. 15 (pp. 177 ff.); Hussen (2019), p. 151 ff. 55

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measure the benefits of recreation and leisure derived from intact local recreation areas, forests and bodies of water. The costs that individuals incur to visit these destinations (travel expenses, time investment and possible admission fees) are used to indicate the value attributed to such locations.61 This method can be applied to evaluate the (planned) elimination of a recreational site, the creation of a new site or a change in the environmental quality of an existing site. This method has several apparent drawbacks. For example, visitors to recreational sites will have varying motives for travel, and costs may be reduced if households relocate to a town closer to the recreational area. Finally, the travel cost method does not account for the existence value of the site. Methods to determine hedonic prices examine the effects of alternative environmental conditions on the market price of certain goods (or services).62 This approach is mainly applied in the context of real estate based on the assumption that environmental conditions (e.g. road noise) are among the criteria evaluated in price assessments (property value method). Wages are an important hedonic price indicator, because the conditions of the physical work environment (e.g. air or noise pollution and other risks to life or health) have a measurable impact on negotiated pay. This, of course, presupposes that the relevant markets are functioning and that prices are not altered through state intervention (as in the case of rent control) or collective agreements (e.g. wage agreements). In addition, it is generally difficult to isolate the impact of environmental pollution from other factors. For example, worsening environmental conditions may reduce real estate prices, but prices may fall even further as lower costs draw socially underprivileged groups to the area. 7.1.3.4.3 Valuation of Environmental Degradation: Unavoidable but Problematic Overall, the valuation of environmental damage can be problematic and has many limitations. As a result, it is hardly surprising that there is significant variation between valuations. Assessments of the climate change costs incurred from one ton of CO2, for example, range from €14–300.63 Still, there is no alternative to the valuation process, and researchers must make the best of what they have. It is important to note that the values obtained are generally only realistic when a strategic combination of multiple methods is used to obtain data for calculations. This suggests another practical problem with valuation procedures: designing reliable studies is associated with considerable (financial) expense. This problem is, of course, particularly pronounced for direct methods. Data from prior assessments are used in new studies to mitigate the deterrent effect of this expense on environmental policy actors. Experts assist in applying the ‘willingness to pay’ from

61

For studies on Lumpinee Park in Bangkok and the Great Barrier Reef off the coast of Australia, see Hussen (2019), pp. 151 f. 62 Cf. Graves (2014), pp. 160 ff.; Hussen (2019), pp. 146 ff. 63 See Umweltbundesamt (2007), pp. 67 ff., in which the German Federal Environmental Agency advocates a value of €70. Stern (1997), p. 322, recommends a similar value (€85).

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previous evaluations to new problem areas and new projects. Considering the many factors influencing the willingness to pay for environmental goods, however, this ‘value transfer technique’ is far from a perfect solution.64

7.1.4

Evaluation Criteria for Environmental Policy

Environmental targets (and the best instruments to achieve them) cannot be determined scientifically. Such targets are ultimately political decisions that are reached after various factors have been taken into account. The decision-making process is primarily guided by two considerations: the internalisation of external costs and a CBA comparing the imminent costs of environmental damage with those of avoidance.65 These concepts are still too abstract to be applied to the creation of concrete environmental legislation. This has played a role in the evolution of environmental policy principles: as soon as environmental policy is incorporated into legislation, these principles serve as its systematic and teleological foundation and are given greater weight in the interpretation of the law. Economic arguments have been particularly influential in this regard. In many cases, however, policy principles have roots in multiple disciplines and include at least aspects of environmental law (or environmental constitutional law), environmental ethics and environmental policy.66 First, it is important to discuss the considerable discretion granted to the legislature in the context of policy design. It is not unthinkable that the legislature could recommend environmental policy instruments that violate constitutional or European law. But the implementation of such recommendations would require a revision of higher-level law and thus lead to considerable transaction costs, even if the necessary majorities can be organised. In practice, of course, it is possible for the legislature to knowingly defy higher-level law and wait to discover whether there will be any (legal) consequences, such as a court ruling. In evaluations of environmental policy instruments, however, definitive statements on legal compatibility are often not possible. Clear constitutionality can be considered advantageous, while concerns based on European and/or constitutional law present legal risks and disadvantages. In addition to these questions of higher-level law, specific environmental policy criteria play a crucial role in evaluations of environmental policy instruments. The ‘polluter pays’ principle and the precautionary principle have been established elements of formal law for decades. They represent important structural elements of existing environmental law and are therefore important in interpreting it properly.

64

For an illustration and critical analysis, see, e.g., Brouwer (2000). See Sect. 7.1.3.1 above. 66 Recommendations on this topic made some 20 years ago have remained essentially unchanged. See Rodi (1993), pp. 43 ff.; Rogge and Reichardt (2016). 65

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The ‘polluter pays’ principle links the actions and obligations imposed under environmental policy (abatement or payment obligations) with the adverse effect on the environment; economists typically have a favourable view of this principle because it leads to an internalisation of external costs. Recently, the role of the precautionary principle in environmental policy has become the focus of intense debate.67 The principle suggests that environmental policy action should be taken against environmentally harmful practices immediately and to the greatest extent possible, even when there is no definitive scientific proof that the practices will have serious consequences. The precautionary principle adheres to the economic rule of thumb that ‘prevention is better than cure’, because abatement costs are generally lower than the costs of repair. The principle is also rational because of the many uncertainties (e.g. the role of causality) that preclude an exact internalisation of costs. Its main function is to prevent irreversible consequences or severe limitations on the options available to future generations. From an economic perspective, the precautionary principle has significant drawbacks, because it treats environmental policy action as an absolute principle and disregards enormous potential costs; this contradicts the rationale for the CBA. One way out of this dilemma is to apply the CBA and the precautionary principle in a parallel and coordinated way. After all, both the ‘polluter pays’ principle and the precautionary principle have been incorporated into higher-level legislation.68 Other (more formal) principles have also been established to guide the legislature as it develops environmental policies. The environmental impact assessment (EIA) or environmental risk assessment and risk management play an important role in the design process.69 These instruments should be designed not only to minimise administrative costs (which are already included in the CBA) but also to ensure a smooth implementation (administrative practicability). This goal is closely associated with the aim of securing sufficient acceptance of the measures: acceptance lowers implementation costs and improves effectiveness. Finally, the environmental policy instruments created should be able to accommodate new developments (variability) and avoid instrumental lock-in. The issue of (cost-)effectiveness is likely the most significant principle within environmental economics.70 As a general rule, environmental protection creates costs, not only for the state but also for private actors (businesses) and thus for the national economy. The desirable environmental impact (target) therefore cannot be evaluated in isolation; it is always crucial to achieve targets as cost-effectively as possible. The cost-effectiveness test can be considered the ‘little brother’ of CBA; it also has the benefit of being far easier and less expensive.

67

See, e.g., Hussen (2019), pp. 187 f.; Kuenzler and Kysar (2014), pp. 759 ff. In the context of EU law, see Article 191(2)(1)(2) TFEU. 69 See Hussen (2019), pp. 188 f. 70 For a discussion of this topic in the context of induced technological change, see Rosendahl (2004). 68

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Cost-effectiveness is the central factor evaluated in CBA. Environmental economics has shown a growing acknowledgement of this principle as it relates to the concept of dynamic efficiency. Realistically, environmental policy goals will be accomplished less through ‘doing without’ (sufficiency) than through technological efficiency. This will require greater use of dynamic instrument comparison. In determining which environmental policy instruments should be implemented, the potential of each instrument to facilitate innovation is becoming an increasingly important consideration. This property is referred to as ‘innovation efficiency’. The classical hypothesis on environmental policy suggests that, on balance, measures to protect the environment impose costs (on individuals, firms and society as a whole). However, the Porter hypothesis, which emerged from discussions of innovation efficiency, has recently called this assumption into question.71 Porter and van der Linde pointed out that environmental regulation typically induces innovations, the advantages of which partly or fully compensate—or exceed—the costs. Many studies have since investigated whether the relationship between environmental regulation and economic growth (or competitiveness) is negative or positive. The results are mixed, with evidence suggesting that the relationship typically depends on the design of environmental regulation. Well-designed regulation, at least, has been found to have largely positive effects on economic development.72 Finally, environmental policy tools can be evaluated in terms of their usefulness in advancing other state objectives. Examples of such objectives include principles of legal policy (i.e. consistency throughout the legal system; simplicity and comprehensibility), financial policy (i.e. stability of public finance; revenue neutrality), economic policy (i.e. overall economic equilibrium, market conformity, and competitive neutrality) and international aspects (international alignment of policy and law). Above all, social policy goals—especially distributive justice, including intergenerational equity—must be considered when designing environmental law and policy measures.73 The concept of sustainability was first used in reference to the balance that must be struck between economic, ecological and social needs of present and future generations.74

7.2

Environmental Policy Measures

Environmental economics has made a decisive contribution to the development and advancement of environmental policy instrumentation. It emerged from criticism of classical instruments of environmental regulatory law. The field focused first on the 71

See Moosa and Ramiah (2014), Chap. 9, Sec. 4 (pp. 208 ff.). See Moosa and Ramiah (2014), pp. 76 ff. and 219 ff, for an overview of relevant studies. 73 See Hussen (2019), pp. 190 ff. 74 Ibid., Chap. 13 (pp. 289 ff.). 72

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design of economic instruments of environmental policy and ultimately made these politically acceptable.75

7.2.1

Environmental Regulatory Law (‘Direct Regulation’, ‘Command-and-Control Law’)

Historically, environmental regulatory law has been the most dominant and influential environmental policy instrument.76 Its consistent implementation in Western democracies since the 1960–1970s has played a significant role in improving environmental conditions.

7.2.1.1 Method of Operation Environmental regulatory law mainly operates by establishing specific activities by private actors to be illegal. This represents the ‘command’ portion of ‘commandand-control law’. (‘Control’ refers to implementation and enforcement.) Environmental regulatory law establishes binding guidelines for the conduct of individuals (permissions and prohibitions), which are implemented by force if necessary (through administrative enforcement and sanctions). The behaviour of individuals is not an end in itself, however; the focus is on environmental quality objectives or emission standards, which are established by the legislature and initially addressed to the environmental authorities. At this stage, the standards are not directly enforceable; they must first be ‘translated’ into concrete measures. For environmental law on power plants, this ‘translation work’ is carried out through performance standards, which generally fall into two categories. Emission standards set limits on the amount of pollution released by individual plants; they are generally practical measures that permit some flexibility for the addressee. For technology or performance standards, on the other hand, the state prescribes the specific measures and techniques that will be used to limit emissions.77 Despite the justified criticism it has received (see below), environmental regulatory law is likely to remain the foundation of environmental law.78 This area of law must guarantee a minimum standard of health and property protection. One benefit of environmental regulatory law is that it can address specific environmental problems and address them in targeted ways.79

75

For an overview of environmental policy instrumentation, see Revesz and Stavins (2007), pp. 534 ff. On its use as part of a programmatic approach, see European Commission (2007). 76 There are plausible reasons for this from an economic perspective. See, e.g., Revesz and Stavins (2007), pp. 558 ff. 77 For a typology of standards, see Faure and Partain (2019), pp. 64 ff. 78 See Faure and Skogh (2003), pp. 188 ff. 79 See Moosa and Ramiah (2014), pp. 13 f.

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7.2.1.2 Criticism In its earliest stages, environmental economics focused intensively on criticism of environmental regulatory law. One influential line of criticism challenged the argument that regulatory law could quickly and accurately induce desired behavioural changes. Since the 1970s, numerous studies have demonstrated that environmental regulatory law has suffered from a lack of enforcement.80 This is partly explained by its relative inflexibility and its failure to incorporate the interests of relevant actors and stakeholders.81 The implementation of such laws is also made more difficult by the risk of collusion between lower-level environmental authorities and entities affected by the regulations; this may occur, for example, when a polluting business is a vital source of local jobs. In addition, the relationships between relevant actors and stakeholders are characterised by significant information asymmetries.82 Another reason for existing deficiencies in enforcement is that the sanctions provided for by environmental regulatory law are often suboptimal. In certain cases, it may make more sense to impose higher sanctions in order to spend less on monitoring efforts and save money on enforcement.83 The design of environmental regulatory law actually often hinders enforcement. Another criticism of environmental regulatory law is that it is prone to regulatory capture. Lobbying efforts that target regulatory standards are often successful.84 At the same time, regulators are dependent on information from the regulated entities (an ‘information asymmetry’).85 The fact that experienced employees of the regulating agencies often ‘switch sides’ only strengthens concerns about regulatory capture.86 With regard to cost-effectiveness, regulatory law has clear disadvantages.87 Today, the presence of these disadvantages is widely regarded as inescapable, even by policymakers. Regulatory law may initially be effective in ‘harvesting the low-hanging fruit’, but the overall costs of regulation often rise exponentially as stricter standards are introduced.88 Direct regulation does not account for the significant variation between abatement costs for different plants. As a result, overall costs are higher for such instruments than for other instruments that provide stronger incentives for actors with lower abatement costs (e.g. taxes or emissions trading).89

80

For an overview of studies, see Heyes (2000), pp. 121 ff.; Faure and Weishaar (2012), pp. 406 f. For further discussion and suggestions for reform, see Huppes and Simonis (2009). 82 See Laffont (1994). 83 See, e.g., Polinsky and Shavell (2007). 84 See Moosa and Ramiah (2014), p. 13; Faure and Partain (2019), pp. 191 ff. 85 Press (2015), pp. 8 ff. 86 Ibid. 87 See, e.g., Faure and Partain (2019), pp. 191 ff. 88 Press (2015), pp. 5 ff. 89 See Moosa and Ramiah (2014), pp. 13 ff. 81

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There are also reasons to doubt the ecological effectiveness of environmental regulatory law. It offers no incentives to introduce further-reaching environmental protections (i.e. a dynamic incentive effect) and favours ‘end-of-pipe technology’.90 Once a regulated actor fulfils the legal requirements, they have no incentive to improve their performance, even if it would be possible (though perhaps more difficult) to implement better measures. At the same time, there is no push to develop more advanced abatement technology. It is therefore unlikely that the commandand-control ‘toolkit’ is sufficient to bring about technological advancements (e.g. in the area of climate change policy).91 There is another reason for this lack of dynamic efficiency in innovation. Under environmental regulatory law, a central concern is that legislation regulating technology (‘best available technology’) creates an agency problem. Businesses (as agents) have knowledge of possible innovations but have no incentive to share this knowledge with the regulator (the principal); in fact, they have an incentive to avoid doing so in order to avoid eliciting stricter regulation. Overall, environmental regulatory law provides too few incentives for technological innovation.

7.2.1.3 Modernisation of Environmental Regulatory Law Recently, there has been growing recognition that economic incentive instruments are not the only mechanism that can internalise external effects. The ‘polluter pays’ principle is also an integral component of environmental regulatory law, because it requires the regulated entities themselves to bear the avoidance costs necessary to comply with mandated limits.92 Modernising environmental regulatory law can also at least defuse some of the criticism levelled against it. One way to modernise environmental law is to recognise that stringent guidelines are not necessary for every single plant or entity. As an example, consider the options for compensation specified in the German Federal Immission Control Act (Bundesimmisionsschutzgesetz (BimSchG)).93 This Act permits plant operators to deviate from established limits if they submit a plan that will further reduce total emissions from multiple facilities (including those of third parties). User benefits also increase flexibility; for example, an exemption from environmental restrictions can be granted for the use of products or machines that are particularly eco-friendly (as when an especially quiet aircraft is exempted from the ban on night flights). Regulatory law can also be made more dynamic through technology-forcing policies. The Japanese Top Runner Program, launched in 1998, demonstrates the potential effectiveness of such policies. The Program uses the levels achieved by the best-performing suppliers (‘Top Runners’) as the obligatory energy efficiency standards for end-use products.94 In the decade after the initiative was introduced, 90

Press (2015), pp. 12 ff. Ibid., pp. 565 ff. 92 Hussen (2019), p. 94. 93 Sections 17(3a) and 7(3) BImSchG. 94 Osamu (2013). 91

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energy efficiency doubled in the relevant product markets. Policies like the Top Runner Program establish the most efficient technologies available on the market as the generally binding standard. The companies that introduced these technologies thus acquire a ‘first mover advantage’. The resulting competitive advantages incentivise the promotion of technological advancements and the dissemination of information on the resulting innovations.

7.2.2

Environmental Liability

Today, environmental liability law is no longer viewed only as a tool for reconciling interests. It is also increasingly regarded as an effective mechanism for pursuing environmental policy objectives.95

7.2.2.1 Basic Principles The economic analysis of law has always focused particular attention on (civil) liability law.96 The classical civil law institution of tort liability (i.e. liability for damages for a violation of third-party rights) plays an important role in environmental law and environmental liability law in particular; in this case, however, it is used as an instrument to protect the public interest in safeguarding the environment. Environmental liability applies to damage caused by environmentally harmful behaviour. Traditional tort law has often been modified for such cases and is regulated by separate laws (e.g. the EU Environmental Liability Directive or corresponding national laws). Under classical tort law, an injuring party is liable only for the damage to thirdparty legal interests that is caused by their actions (causality) and for which they are at fault; in cases of uncertainty, the injured party bears the burden of proof. The legislature can reduce these requirements in various respects, such as by introducing ‘presumption rules’ that reverse the burden of proof regarding the causal connection. Such measures address the distinctions between degrees of fault (negligence) and thus the standard of care required to avoid liability. The classical standard of liability is fault-based liability under tort law and the liability for any failure to exercise ‘due diligence’ in business activities. The specific language used in jurisprudence to formalise this ambiguous legal concept is therefore relevant to an economic analysis of law. The imposition of tort law also represents an internationalisation strategy, as it forces the party responsible for external effects to provide compensation for related damage. The allocation of property rights is therefore a fundamental question in the context of environmental liability law; if there were no liability for environmentally harmful behaviour, the polluter would be granted a comprehensive right to cause

95

On this issue, see also Kirchgässner (2008), pp. 125 ff. (4.2.2). For further detail, see Faure and Partain (2019), Chap. 8 (pp. 145–180). 96 See, e.g., Calabresi (1984), Cooter (1991) and Faure (2009).

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damage. The Coase Theorem suggests that the injuring party and the potentially injured party would theoretically negotiate possible actions to prevent damage as well. Even in the case of comprehensive and strict environmental liability, in situations with ‘bilateral externalities’, the injuring party will seek to compel the potentially injured party to undertake activities for damage avoidance or reduction (which may be less costly than preventive actions by the injuring party).97 Negotiations are, of course, not feasible in cases of ‘pure’ environmental damage that do not involve private rights. While discussions of jurisprudence tend to focus on the implications of such policies for distributional effects, economists are more interested in advance effects—that is, in the preventive effects of liability law.98 As the threat of liability grows, parties that are (potentially) responsible for environmental damage will intensify their efforts to prevent it (avoidance costs will increase accordingly). The stricter the environmental liability law, the greater the efforts at prevention. This results in an individually optimal level of due diligence. An interesting question for legislators is whether and to what extent this level is also optimal for society as a whole. In many states, the role of classical tort law has been expanded in two respects in order to strengthen its function as an environmental policy instrument.99 First, stricter liability has been imposed in cases of third-party damages arising from environmentally harmful behaviour (e.g. strict liability or the elimination of the need to prove causation). Strict liability falls at the opposite end of the spectrum from standard liability.100 A party found strictly liable must provide compensation for any damage attributable to its actions; this incentivises action to prevent emissions until the marginal costs of additional abatement efforts equal the anticipated damages (the amount multiplied by the probability). The legislature may also add clauses on contributory negligence to relevant laws in order to provide incentives for victims to avoid damages.101 One special effect of strict liability is its influence on the activities of the potential injuring party: if the party cannot avoid liability by conducting business in accordance with ‘due diligence’ requirements, it may consider reducing any activity that could lead to liability.102 Second, liability that once applied only to personal damage (e.g. damage to property, health or life) has been extended to include environmental damage. In the US, this policy was introduced in the Compensation and Liability Act of 1980

97

On the differences between negotiated solutions in environmental liability and Coase’s classical property rights approach, see Faure (2009). 98 See Faure and Partain (2019), pp. 146 ff. 99 For an overview, see Faure and Partain (2019), pp. 158 ff. 100 For examples (e.g. in the context of nuclear plants or oil pollution), see Faure and Partain (2019), pp. 159 ff. 101 See Faure and Partain (2019), pp. 151 ff. 102 Ibid., pp. 152 ff.

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and the Superfund Amendments of 1986; the EU took a similar approach103 with the Directive on Environmental Liability of 2004.104

7.2.2.2 Environmental Liability Law in National Legal Systems, with a Focus on Germany Of course, the distinction between negligence and strict liability is not the only factor influencing the impact of the respective liability act. Other important aspects include the definition and assessment of causality between activity and damage, as well as liability caps and insurance options or obligations. Thus, in practice, liability law tends to be quite hybrid. An interesting example is the German Environmental Liability Act (Umwelthaftungsgestez (UmweltHG)) of 1991. In Section 1 of the German Environmental Liability Act, the legislature established strict liability for effects on the environment (as defined in Section 3 (1) UmweltHG). Under Section 6(1) UmweltHG, causation is presumed if a facility is likely to cause the damage under the circumstances of the individual case. According to Section 6(2), however, the presumption of causation does not apply if the facility is operated in accordance with its intended purpose (particularly if it has complied with the legally established emission limits); this, of course, significantly restricts the presumption of causation. One specific question facing the legislature is how it should handle situations in which there are multiple causes (‘multiple causation’).105 Under German environmental liability law, the presumption of causation is excluded if multiple facilities are capable of causing the damage, in accordance with Section 7 UmweltHG. This further limits environmental liability. Another problematic aspect of environmental liability is that the scope of liability is, by nature, limited by the assets and other financial resources of the company causing the damage. In addition, the legislature frequently establishes maximum limits on liability, as in Section 15 UmweltHG (maximum liability of €85 million for damage to persons and €85 million for property damage).106 These upper limits are intended to ensure that activities that may cause damage do not cease because of potentially high liability costs; they should at least be insurable under reasonable conditions. 7.2.2.3 Specific Questions in Law and Economics As noted above, a key focus in economics is on whether damage prevention balances out to a level that is efficient for society as a whole. Environmental liability law, like liability law in general, is intended to prevent damage, though not at all costs: the

103

On related legislation in the US and the EU, see Faure and Partain (2019), pp. 158 ff. EU Directive 2004/35/EU of 21 April 2004 on environmental liability with regard to the prevention and remedying of environmental damage, OJ L 143, 30 April 2004, 56. 105 On options of joint and several liability, see, e.g., Faure and Partain (2019), pp. 171 ff. 106 On the economic effects of maximum liability limits (‘caps’), see, e.g., Faure and Partain (2019), pp. 165 ff. 104

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costs of avoiding harm must remain reasonable. It is important to consider that the redistribution of damages from the injured to the injuring party is only a means by which to optimise overall social efficiency.107 As shown above, many features of environmental liability influence the probability of liability, and there is no one-sizefits-all solution. In any case, the legislature must account for the fact that measures strengthening liability will lead to rising avoidance costs; and these are opportunity costs that could be used for other environmental instead of for precautionary measures.108 Limitations for liability (‘caps’) are one specific topic to be addressed here.109 An argument in favour of limitations is that such caps ensure that the relevant business activities are insurable and prevent insolvencies. Faure and Partain rightly reject these arguments,110 maintaining that such caps contradict basic rationales for environmental liability, especially the internalisation of consequences of risky activity. In addition, the insurance industry has developed innovative instruments to cope with extremely high risks. These limitations are ultimately subsidies, and there is clear evidence that the potentially liable industry is lobbying for these in a profitmaximising strategy. Still, the question of (voluntary or mandatory) insurance is per se an interesting topic in an economic analysis of law. As indicated above, the German Environmental Liability Act presupposes that environmental risks can be insured (an outcome that the law is designed to facilitate). In this sense, the question is how (voluntary or mandatory) insurance coverage for environmental risks affects internalisation and prevention and what the allocation effects of environmental risk insurance will be.111 One conceivable negative effect could be that efforts to prevent damage and observe the duty of care will be reduced to the level at which the insurer (still) pays. There is also a risk that insured parties will exploit the frequent information deficits that generally exist on the part of insurance companies (principal-agent situation).112 One argument in favour of integrating insurance companies into environmental liability insurance regimes is that they have considerable expertise in damage calculations and damage avoidance strategies. They will attempt to create incentives for prevention measures, for example by differentiating insurance premiums or setting requirements that parties must meet to qualify for insurance. Insurance companies have tried-and-tested strategies for doing so, such as deductibles and tools for risk analysis and risk assessment.113

107

Faure and Partain (2019), pp. 148 ff. Ibid., pp. 147 f. 109 Ibid., pp. 164 ff. 110 Ibid. 111 For further detail, see Faure and Skogh (2003), pp. 263 ff. 112 Cf. Endres (2013), part 2, sec. B.IV.4. 113 On the effect of deductibles on an insured party’s level of care, see Endres (2013), part 2, section B.IV.5. 108

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7.2.2.4 Empirical Studies on the Impact of Environmental Liability Empirical studies114 provide evidence that environmental liability has a deterrent effect and influences the behaviour of potential polluters. On the other hand, such studies show that environmental liability has serious trade-offs, especially including high transaction costs. One interesting finding is that companies try to reduce assets exposed to liability, e.g. by splitting them among a greater number of smaller companies. Another factor influencing the efficiency of liability schemes is the tendency for parties to systematically underestimate the risk of incurring environmental liability.115 It is of course interesting to consider the preventive effects of the German Environmental Liability Act and their implications for strict liability on one hand and clear limitations of liability on the other. In a study for the Enquete Commission of the German Parliament, Schwarze concluded that accidents involving environmentally hazardous facilities fell by 12% annually between 1993 and 1997; however, he could not confirm these findings in subsequent research that incorporated the results of other studies.116 Likewise, the presumption that the Environmental Liability Act could have a beneficial impact on compliance with regulatory requirements could not be substantiated.

7.2.3

Environmental Taxes and Charges

7.2.3.1 Basic Principles Environmental taxes and charges are forms of state financing instruments and give these instruments a role in influencing environmental policy.117 Strictly speaking, taxes and charges finance state tasks by linking the financing of such tasks to the general financial responsibility of citizens (in the case of taxes) or specific financial responsibilities (in the case of charges). However, state financial instruments do not only have financing (and thus revenue) effects. The imposition of taxes and charges also has general ‘steering effects’, because affected parties organise their behaviour around the obligation to pay—above all, of course, to avoid or reduce tax burdens. The state exploits this steering effect when it imposes taxes and charges in a deliberate attempt to modify behaviour (incentive taxes).118 Arthur Cecil Pigou, a professor of political economy at the University of Cambridge, developed a theoretical framework for this mechanism that has been highly influential ever since its introduction in the 1920s.119 Pigou argued that taxes and charges were appropriate measures for internalising external effects and 114

For an overview, see Faure and Partain (2019), pp. 176 ff. On this ‘optimism bias’, see, e.g., Jolls (2007), pp. 127 ff. 116 See Schwarze (2004). On related issues, see Hapke and Japp (2001). 117 See Määttä (2006) and, more recently, the commentary in Milne and Andersen (2012). 118 See Rodi (1994), pp. 82 ff., and Sect. 5.3.1.1.2 above. 119 Pigou (1920); see also, e.g., Milne and Andersen (2012). 115

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regarded subsidies as ‘negative taxes’ that could internalise positive externalities. Taxes and subsidies should therefore be imposed in such a way that parties responsible for externalities adjust their activity to a socially optimal level.120 Since the introduction of this concept, environmental taxes have often been referred to as ‘Pigouvian taxes’. In the course of further debate, however, it became clear that an optimal internalisation of external effects through taxes and charges would be virtually impossible to achieve in practice, since this would require the state to know the exact marginal damage and abatement cost functions. As a result, an ‘optimal tax rate’ that leads to an exact internalisation is a fantasy. For a Pigouvian tax, marginal external costs would need to be evaluated from the perspective of the affected parties; the external costs would be relevant not in the initial state, but in the final equilibrium, after adjustments had been made. Because the market does not provide this information, the evaluation problem is ultimately left to the state. A more realistic alternative, the ‘pricing and standards’ approach, was developed by Baumol and Oates (1971).121 This approach replaces the goal of achieving an exact internalisation of external effects with a more modest one: reducing concrete emissions to a politically defined level. The method minimises the costs of reaching the target environmental status, because companies adjust activities in accordance with their individual costs of preventing emissions. Companies with relatively low abatement costs will contribute more to achieving the standard in an effort to avoid paying taxes, while companies with higher abatement costs will be more inclined to pay the tax.

7.2.3.2 Types of Environmental Taxes and Charges Environmental taxes and charges are as varied as the systems of state taxes and charges themselves.122 The following paragraphs introduce several basic types from a legal perspective (i.e. without regard to their concrete areas of application), along with the advantages and disadvantages of each.123 Taxes and charges can serve as environmental policy instruments. A tax is generally defined as a payment made to a branch of government without reference to individual payment responsibilities and without provision of services for individual payers in return. Charges, on the other hand, are based on an individual payment responsibility. They are generally payments made in exchange for a service, with charges levied in proportion to the scope of service received. The following discussion focuses on environmental taxes, which currently dominate the general tax discourse and political practice.

120

Pigou (1932), p. 224. Baumol and Oates (1971). 122 On the historical evolution of the multiple-tax system, see Sect. 5.3.1.2 above. 123 For an attempt to define and classify environmental taxes, see Milne and Andersen (2012), pp. 20 ff. 121

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It is first useful to differentiate between environmental taxes (and charges) in a broader and narrower sense. ‘True’ environmental taxes are those which directly apply to the undesirable environmental behaviour as a taxable item and are based on aspects like the type, scale and harmfulness of emissions (e.g. wastewater tax) or the use of environmentally hazardous products (e.g. pesticides).124 The imposition of emission taxes is associated with all of the familiar problems that arise from monitoring compliance with thresholds under environmental regulatory law. Environmental taxes in a broader sense are levied in connection with behaviour that is neutral in itself; any environmental effect is achieved indirectly (e.g. through a tax on electricity use). If the legislature intends to apply taxes and charges as an environmental policy instrument, it should ground these in a broad concept of environmental taxes and charges, which can be understood as all obligatory unilateral payments to the state—as well as all those provided to the state with no service rendered in return. These instruments are likely to have a noticeable ‘steering’ effect on behaviour that affects the environment.125 In the context of the tax system, it is also necessary and logical to distinguish ‘true’ environmental regulatory taxes (and charges) from fiscally justified taxes that also have a desirable effect on the environment. The latter category primarily includes excise taxes (such as the tax on energy consumption) that are constitutionally justified in their own right as fiscal taxes. ‘True’ environmental regulatory taxes, on the other hand, have an additional objective: to influence behaviour. Because this deviates from the ability-to-pay principle, it must be justified under constitutional law (especially with regard to basic rights). This indicates the considerable difficulties that arise in connection with the legal system.126 Taxable events must be further distinguished from tax concessions and tax differentiation in the context of environmental policy-related fiscal taxes and environmental incentive taxes.127 Environmental taxes are primarily intended to serve as charges for environmentally undesirable behavior. Tax incentives, on the other hand, are designed to provide relief for environmentally desirable behaviour (for example, through the ability to deduct expenses for investments in environmental protection from income taxes); such ‘tax expenditures’128 function as subsidies and are governed by European law on state aid.129 Tax differentiation introduces varying tax rates (e.g. the mineral oil tax on lead and sulfur content) to achieve environmental policy objectives.

124

Herrera Molina (2012), pp. 90 f. On this issue, see Rodi (2012b), pp. 60 ff, with reference to the approaches of the OECD. 126 For further detail, see Rodi (1994), pp. 52 ff. and 194 f. 127 See Rodi (1994), pp. 204 ff. 128 For a discussion of this general concept, see Herrera Molina (2012), pp. 96 ff. 129 On the distinction between tax concessions as subsidies and other tax standards, see Sect. 6.2.2. 3.1 above. 125

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7.2.3.3 Relevant Issues in an Economic Analysis of Tax Law Several issues that are relevant to an economic analysis of tax law have been addressed in the above pages, which introduced various categories of environmental taxes and charges. Several more important issues related to this topic are discussed below. One problem with the use of taxes as an instrument of environmental policy is that it is often difficult to determine or estimate the effects of taxes in advance. As a result, it is difficult to identify the ecological effect of environmental taxes (‘ecological accuracy’ or ‘ecological effectiveness’) or their efficacy in internalising external costs. These difficulties are especially pronounced in the (frequent) cases in which several taxes are introduced for the purpose of internalising externalities. Measures internalising the external costs of street traffic provide one example: relevant charges include road user charges as well as the mineral oil tax, electricity tax and vehicle tax. This problem is exacerbated by the combination of these measures with non-tax instruments.130 Recent debate has focused on the static and dynamic efficiency of environmental taxes.131 How efficiently environmental taxes facilitate technological change is, of course, an especially relevant question for research subsidies.132 Studies have shown that also (burdening) environmental taxes can encourage innovation, but it is important to note that this effect depends on the design of the specific taxes.133 As discussed above, environmental taxes are often imposed as excise taxes. It can therefore be extremely difficult to determine who ultimately bears the tax burden and what effects these taxes have on income in individual cases. This issue is crucial to the successful implementation of environmental tax reform.134 Environmental taxes are generally ‘suspected’ of disproportionately burdening lower- and middle-income brackets and thus having a regressive effect. Existing studies show that this effect is overestimated and depends on the type and design of the specific tax.135 A lack of transparency regarding tax effects can lead to an additional problem: price signals may not always have their desired effect.136 In the context of environmental taxes—and energy taxes in particular—there is intense debate over the competitiveness of (domestic) industry. Unsurprisingly, the industry lobby pursues this issue as a priority (and does so successfully).137 Tax 130

For empirical evidence, see Faure and Weishaar (2012), p. 408. See Barde and Godard (2012). On the use of this criterion to evaluate environmental policy instruments, see Sect. 7.1.4 above. 132 See the discussion in Vollebergh (2012), which includes a note on the unsatisfactory state of current research. 133 See Braathen (2009) for an overview of the research situation. 134 On the background of this reform and its distributional effects in Vietnam, see Rodi et al. (2012), pp. 134 ff. 135 For an overview of existing studies, see Kosonen (2012). 136 On problematic aspects of ‘bounded rationality’ in the context of environmental taxation, with a focus on issues related to motivation and attention, see Ørsted Nielsen (2012), pp. 448 ff. 137 See Braathen (2009), pp. 231 ff. 131

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relief (especially energy tax relief) is common in order to maintain and ensure the competitiveness of energy-intensive enterprises. In principle, of course, this applies to other environmental policy instruments that impose financial burdens on domestic industry, such as emissions trading. In recent years, there has been renewed discussion on whether and to what degree a border tax adjustment (BTA) can eliminate this problem.138 Relatively low transaction costs have traditionally been regarded as a key advantage of environmental taxes. The use of carbon tax and emissions trading as policy instruments for climate protection can illustrate this benefit.139 This advantage can quickly become a disadvantage if, for example, direct emissions taxes are introduced instead of excise taxes and have transaction costs similar to those of regulatory law. The existence of this advantage thus depends on the individual design.140 When the advantages of environmental taxes are discussed, the concept of the ‘double dividend’ is cited repeatedly.141 Environmental charges can and should be designed in such a way that they achieve both the specific environmental policy objective and other public-interest goals. Above all, they should contribute to a reduction of unemployment, primarily through an appropriate allocation of revenue (as occurred in the Ecological Tax Reform in Germany). This should be reflected in the tax design (i.e. by penalising environmentally harmful activities rather than burdening workers with taxes and social security contributions). The ‘double dividend’ concept is closely associated with the principle of revenue-neutral environmental taxation. In practice, the ‘revenue-neutral’ requirement has become more political than theoretical.142 In the political sphere, this principle is considered a necessary factor in increasing acceptance of environmental taxes, because it can counter the suspicion that these taxes are merely tax hikes ‘cloaked in green’.143 This necessarily raises the question of how ‘revenue recycling’ can be carried out in a way that provides the greatest benefit to society as a whole. Especially in the context of environmental taxes and charges, intense debate has focused on how taxes and charges differ from other instruments of environmental policy and how appropriate combinations of instruments should be designed.144

138

See Sect. 7.4.2 below. See Crals and Vereeck (2005). 140 Further research is needed in this area. See Pavel and Vitek (2012) and further reference. 141 This concept can be traced back to Pearce (1991). Barker et al. (2009), pp. 83 ff. 142 Ibid., pp. 83 ff. 143 On the significance of this topic, for example in the realisation of comprehensive ecological tax reform in Vietnam, see Rodi et al. (2012), pp. 133 f. 144 Faure and Weishaar (2012); for a general discussion, see Sect. 7.3 below. 139

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Financial Support Programmes

7.2.4.1 Basic Principles The rationale for financial support programmes is simple: the state provides private parties with monetary advantages in order to encourage them to act in the public interest. The reasons for the popularity of support schemes were outlined in the earlier discussion of subsidy use as an economic policy tool;145 the state gains the favour of the beneficiaries and then ‘preaches to the choir’. The general public feels the resulting burdens only indirectly through taxes and charges. 7.2.4.2 Subsidies Subsidies play a key role in economic policy, as discussed above.146 They are also an important tool in the environmental policy toolbox. Environmental subsidies refer to the monetary advantage that the state grants to individuals or enterprises without market remuneration in order to motivate them to adopt an environmentally desirable behaviour. Another key topic in environmental law and policy analysis is the elimination and reform of environmentally harmful subsidies.147 In OECD research, ‘environmentally harmful subsidies’ are defined as subsidies that discriminate against sound environmental policies.148 Because environmental subsidies lead to distortions in competition, they require justification. The internalisation of positive externalities is a primary justification for environmental subsidies (e.g. in the field of basic research on environmental protection). This justification can also apply to subsidies for new, environmentally friendly products that are not yet able to compete in the market.149 Adjustment assistance for adaptations to changes in technological or legal conditions (e.g. adaptation to new, stricter environmental regulations) is another well-established justification for environmental subsidies, at least in Europe. The above discussion noted that subsidies can, and often do, have undesirable side effects: for example, they may pose an obstacle to necessary structural change and can give rise to a ‘subsidy mentality’, deadweight loss and subsidy competition. Despite these negative effects, such subsidies are typically popular, even in the field of environmental policy; the reasons for this popularity were explained above from the perspective of an economic analysis of law.150

145

See Sect. 6.2.2.3 above. See Sect. 6.2.2.3 above. 147 See Oosterhuis and ten Brink (2014). 148 See OECD (2005), pp. 33 ff. 149 See, e.g., the eco-car subsidy programme and the eco-point programmes for appliances and houses in Japan; Matsumoto (2016), pp. 16 ff. 150 See Sect. 6.2.2.3.3.1 above. 146

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7.2.4.3 Support Through Price and Quantity Controls Most countries support investments in renewable energies.151 But more recently, there has been a clear tendency to avoid using classic subsidies for this purpose. Special funding instruments were developed to facilitate the expansion of renewable energies. There are two basic approaches to accomplish this objective: quota models and feed-in systems. Thus far, the EU Renewable Energy Directive has failed to harmonise policies across Europe and has permitted competition between the policies of the Member States.152 Under the quota system, electricity suppliers and consumers are obligated to obtain a certain percentage of the supplied (or consumed) electricity from renewable energy sources. Tradable certificates are also often used to fulfil this obligation. In systems based on feed-in tariffs (FITs), energy suppliers are required to purchase electricity from renewable energy sources (‘obligation to purchase’) and to pay a predetermined price above the market price (‘obligation to pay’). The use of tendering systems to fix prices is becoming more common. This links FITs more closely to the fixed quantities of renewable energy sources supported. From an economic and legal perspective, both of these approaches are associated with clear and roughly equivalent advantages and disadvantages. This equivalence, as well as the ‘lock-in’ of specific instruments in each state, makes it unlikely that policies will be harmonised across Europe in the foreseeable future. One advantage of the quota system is that it can be used to achieve clearly defined goals. The fact that this system establishes a basic ‘market price’ for the renewable energy supply initially appears advantageous; however, it is problematic that the prices cannot be readily predicted and may prove to be too high from an economic perspective, especially in transitional phases. In addition, unless the legislature institutes quotas for individual energy sources, this policy promotes the ‘cheapest’ renewable energy source, regardless of its environmental or other advantages (e.g. its implications for land use or ecological balance). The respective markets may thus be too small for optimal results. Because they do not require quantity restrictions, systems based on FITs have proved to be dynamic and successful; however, in Germany, they demonstrated a major disadvantage in the field of photovoltaics in the early years of the scheme. The principle of legal certainty requires the purchase price to be guaranteed for years; if the price is set too high, however, the economic costs of individual energy sources may become untenable. As noted above, there is a tendency to incorporate tendering into FIT systems. This combines central advantages of quota systems (i.e. fixed quantities of supported investments and a market system to fix support levels) with those of FIT systems (i.e. investment certainty). There is no such thing as a ‘silver bullet’, however, and this approach has its own disadvantages: tenders increase the costs and administrative burdens for companies and are thus particularly detrimental to small investors.

151

See Renewable Energy Policy Network (2021). On the content and historical evolution of the Renewable Energy Directives, see Calliess and Hey (2012), pp. 237 ff. 152

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Recent debate among policymakers has focused on the question of whether it makes sense to advance a targeted promotion of renewable energy alongside the existing emissions trading system. This issue will be addressed in greater detail below in the context of combined policies.153 A closely related question is how financial support can be justified, both legally and economically. Interestingly, legal and economic perspectives diverge on this issue. Economists view support for renewable energy as subsidies that require justification.154 Lawyers hold divergent opinions regarding whether renewable support schemes qualify as general price regulations. The European Court of Justice established a sophisticated jurisprudence to distinguish between the two schemes.155 Under Article 107 TFEU, aid granted by a Member State or through State resources requires a certain level of state involvement, which is clear in the case of renewable energy legislation. In addition, resources from the support schemes are required to remain under public control and have direct links to the state budget—through a reduction of the state budget or at least the creation of a concrete economic risk associated with such support. The states can therefore construct the support schemes in a way that does not fall under state aid control.

7.2.5

Environmental Certificate Trading

Environmental certificate trading has long been a topic of discussion in environmental economics.156 In recent decades, it has had a significant influence on European policy.157

7.2.5.1 Basic Principles While ecotaxes and subsidies influence behaviour towards the environment through price control, environmental certificates are used for quantity control (‘fixed target policy’).158 The basic idea behind this system is to grant rights of disposal over scarce public resources and goods. This underlying concept can also be applied to transmission frequencies in telecommunications legislation159 and airport landing rights,160 as well as to milk quotas in agricultural law.161 At present, however, its

153

See Sect. 7.3 below. See, e.g., Lehmann (2010). 155 For a detailed discussion, see, e.g., in Vasbeck (2019). 156 For an introduction to certificate trading, see Faure and Skogh (2003), pp. 226 ff.; Woerdman (2020). 157 On the EU emissions trading scheme, see Gronwald and Hinterman (2015), Weishaar (2016) and Verbruggen et al. (2019). 158 Hepburn (2006). 159 Colangelo (2012), pp. 33 ff. 160 Ibid., pp. 67 ff. 161 Ibid., pp. 105 ff. 154

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main application is in the field of environmental law: the use of environmental goods is allocated to private parties by means of transferable and tradable rights of use. This instrument is implemented by setting limits on the quantity of harmful emissions or the scope of environmentally harmful activities in a certain region (‘cap’). The upper limit may refer to specific emissions (e.g. carbon dioxide (CO2) or sulfur dioxide (SO2)) or to the use or consumption of certain objects or products (e.g. the number of disposable bottles or permitted quantity of fish). Certificates or licences (or rights of use) issued for these activities (‘permits’ or ‘allowances’) entitle the holder to engage in relevant activities in accordance with predefined targets, such as by emitting one tonne of the regulated pollutant or capturing one tonne of the regulated species of fish. The certificates, licences and rights of use are tradable, with market prices determined by supply and demand (‘cap and trade’). Under the alternative ‘baseline-and-credit’ (or credit-trading) scheme, allowances are issued if performance surpasses a fixed standard; in this case, companies must offset any deficits by purchasing additional allowances.162 Policymakers then reduce the upper limit (cap) over time, for example through devaluation. The establishment of a legal regime required for certificate trading is not a trivial matter.163 First, the basic parameters must be set, such as ‘cap and trade’ rather than ‘baseline and credit’ or a mixed model. Another basic question concerns the relevant parties in the trade and supply chain: these may be ‘upstream’ (which, in greenhouse gas emissions trading schemes, may include the suppliers or importers of fossil fuels) or ‘downstream’ (e.g. individual plants emitting greenhouse gases). The scope of the certificate programme—that is, which sectors and pollutants or activities are included—must be determined. There are also more technical aspects. For example, the legislature must set trading periods, specify terms for transferring allowances between periods (‘banking’ and ‘borrowing’) and establish procedures in the event of changes to company or plant assets (closures or expansions for new operators (‘newcomers’)). In addition, rules must be developed to govern the issuance of allowances (allocation), which can be auctioned or issued in relation to a ‘baseline’ or previous use (‘grandfathering’).164 Combining environmental trading schemes with other environmental policy instruments is particularly challenging; for example, reductions resulting from subsidy programmes must be taken into account. It is equally difficult to combine these with international systems based on economic incentives (e.g. the flexible mechanisms of the Kyoto Protocol) or link these with other (national or international) schemes to design larger and better-functioning trading markets.165 The legislature must resolve technical legal questions, such as the legal status of allowances (in terms of property rights, accounting and tax law) and the organisation of trade (e.g. through exchanges). Finally, of course, it is

162

On these two models, see the detailed discussion in Nentjes (2016). For a systematic overview of design options, see, e.g., Verbruggen et al. (2019). 164 Verbruggen et al. (2019), p. 13. 165 On the challenge of linking emissions trading schemes, see, e.g., Mehling (2016) or Türk and Gubina (2016). 163

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necessary to monitor whether the actors possess (or relinquish) the proper number of allowances for the activity (‘monitoring’) and to establish and implement sanctions. In the case of regulated emissions (e.g. of SO2), additional regulations are necessary to prevent potential overloads in certain areas (‘hot spots’). Last but not least, measures are needed to counter the threat of anticompetitive practices like market manipulation.166

7.2.5.2 Historical Development and Types of Trading Schemes The practice of trading certificates is considerably younger than the concept on which it is based: the internalisation of external costs, which was first applied by Arthur Cecil Pigou (1920) in the context of taxes and fees. This idea was further developed in the late 1960s by political economists Thomas D. Crocker and John H. Dales167 and subsequently implemented in the US in several environmental policies (i.e. leaded fuel substitutes, trade in CFCs, and regulations on water quality and SO2 emissions). A first limited—though successful—application of the concept was in the use of certificate trading to restrict the use of leaded fuel (1982–1987). Larger refineries had the opportunity to trade rights to add lead to gasoline. Refineries that produced gasoline with a lower lead content could obtain lead credits and then sell them to other companies. More than half of US refineries participated in the programme. This instrument achieved the environmental objective of reducing lead content in gasoline by the 1987 deadline. The use of this approach in place of regulatory mechanisms saved roughly $200 million per year.168 The Acid Rain Program (1990 Amendment to the Clean Air Act) introduced trading in SO2 emissions rights.169 The objective was to reduce emissions by over 50% (relative to 1980 levels) by 2010; the number of issued allowances was determined accordingly. Certificates were issued to companies annually (through ‘grandfathering’) via operating permits. Each year, a small fraction (2.8%) was deducted from the emissions rights allocated to each company. The rights were issued for a certain calendar year, with unused rights carried over to the next year (‘banking’). New emitters were permitted to enter the market by auctioning off certain quantities of emissions at a national auction. Emission caps set for a given plant (and thus the number of certificates allocated) were based on the actual emission values of the plant per unit of energy generated. As a result, older plants received a higher allocation per unit of energy generated than did newer plants. Power plants whose capacity surpassed a certain limit were required to participate in certificate trading; other companies outside of the energy sector could participate voluntarily (‘opt-in’). Monitoring was conducted by continuous emission monitoring (CEM) systems that took continuous measurements at all plants. Exceeding the

166

See, e.g., Hintermann (2016). See Cole (2016), p. 10; Crocker (1966); Dales (1968). 168 For details of this programme, see Cole (2016), pp. 20 ff. 169 For a detailed discussion, see Ellerman et al. (2000). 167

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permitted emission cap would result in a penalty of $2000/tonne and a loss of emission rights corresponding to the amount of the excess. The RECLAIM (Regional Clean Air Incentives Market) programme is a regional initiative in California that began operation in early 1994.170 The initiative was designed to lower the levels of nitric oxide (NOx) and SO2 by 2010 and, in particular, to reduce ozone depletion in Greater Los Angeles. Only major emitters were allowed to participate. The licences were valid for one year; annual licences for every year through 2010 were issued at the beginning of the programme in 1994. In order to prevent ozone hot spots, banking was not permitted. In the EU, climate change policy has shifted from ecotaxes to emission certificate trading.171 This transition was logical, because emissions trading has been regarded as particularly compatible with the mechanisms detailed in the Rio Process and especially in the Kyoto Protocol. In addition, due to the need for unanimous agreement, the Commission reached only a minimal consensus after a 10-year attempt to harmonise ecotaxes. One substantive advantage of greenhouse reduction through emissions trading systems is that such systems prevent the occurrence of localised environmental damage (hot spots). Certificate trading has also been implemented in some US and EU states with tradable energy-saving certificates, also called white certificates.172 In some trading systems, certain companies—typically energy suppliers—are required to introduce energy-saving measures but can generally choose whether to achieve this goal through measures targeting production or consumption. Participating companies can fulfil the energy-saving requirements themselves or acquire energy savings certificates on the market. The introduction of these certificates at an EU level is controversial. In particular, there are no easy answers to questions on the specific methods by which energy efficiency measures should be determined, evaluated and monitored.

7.2.5.3 Legal Framework, Specifically in the Context of European Certificate Trading The EU achieved a major legal policy breakthrough with Directive 2003/96/EC,173 which established and implemented a legal framework for emission certificate trading. This framework was subsequently revised and amended174 by Directive 2009/29/EC175 and Directive 2018/410/EU.176 This directive established a ‘cap-and-trade’ system for trade in greenhouse gas emissions certificates (initially only for CO2, but since 2013 also for 170

For further details, see the analysis by Fromm and Hansjürgens (1996). For further detail, see Sect. 7.2.5.3 below. 172 Cf. Bertoldi et al. (2005). 173 Of 27 October 2003, OJ L 283/51. 174 On the history of this development, see Grubb (2014), 7.3 (pp. 240 ff). 175 Of 23 April 2009, OJ L 140/63. 176 Of 19 March 2018, OJ L 76/3. 171

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perfluorocarbons (PFC) and nitrous oxide (N2O)). It uses a ‘downstream’ approach (not ‘upstream’, which includes fuel suppliers and consumers) to target emitters. In addition to larger thermal power stations, the directive covers the iron and steel smelting industries, coking plants and refineries; glass, ceramic and brick manufacturers; and paper and cellulose production. Other fields were added later, most notably including the aluminium industry and air transport. Major changes since 2013 have affected the ‘cap’ (i.e. Europe-wide instead of national specifications) and the allocation procedure. Initially, allowances were primarily distributed free of charge (‘grandfathering’), but allocation has shifted to auctioning since 2013 (with a gradual transition for sectors affected by ‘carbon leakage’). One interesting feature of the system is the allocation of free allowances, which is based on EU-wide ‘top ten benchmarks’ for plants ranking among the top 10% in efficiency in each field. Trading takes place in a purely electronic system and is carried out through stock exchange, brokers or ‘over the counter’ (OTC) transactions. The 2021 proposal for a further reform177 seeks to adapt the scheme to stricter climate goals (increasing the yearly reduction factor from 2.2% to 4.2%). It also suggests a major systemic change that would integrate the sectors of shipping, traffic and transport, and buildings (which would require an upstream system to supplement the scheme).

7.2.5.4 Assessments Within an Economic Analysis of Law In the past, the instrument of environmental certificates raised ideological concerns (i.e. accusations of ‘trade in pollution rights’ or the ‘sale of indulgences’). Such criticism is unfounded. Environmental certificates are designed to set a price for environmentally undesirable activities—activities that, contrary to the intention of the ‘polluter pays’ principle, would not otherwise incur costs (at least not within the limits defined in environmental regulatory law).178 The quantity control approach ensures that the intended environmental effect will be achieved with a high degree of accuracy. Provided that an effective monitoring and sanctioning mechanism is in place, certificate trading guarantees a ‘precision landing’ for a defined objective. In the field of political economy, the assumption that such a mechanism exists (which requires a critical evaluation) is one cause for hesitation, as are several other observations. First, the influence of lobby groups was apparent in the implementation of the system, even during the initial stage of setting national caps. The risk of this influence has grown as decisions have shifted to a more European level, because lobbying activities only need to target one decision.179 Second, the potential for a real reduction in overall emissions is questionable. This is

European Commission, Proposal for a Directive . . . amending Directive 2003/87/EC as regards aviation’s contribution to the Union’s economy-wide emission reduction target and appropriately implementing a global market-based measure, COM(2021)552 final of 14 July 2021. 178 For ethical arguments against emission trading (and counterarguments), see Dirix et al. (2016). 179 On lobbying within the EU emissions trading system (ETS), see Weishaar (2014a), 5.5 (pp. 118 ff.). 177

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clear from the fact that, in areas practising emissions trading, fossil fuel consumption will decrease, possibly lowering the international market price of such fuels and encouraging increased consumption elsewhere.180 The occurrence of this process in other countries is one cause of ‘carbon leakage’, i.e. the relocation of emissionsintensive activities to countries not included in the scheme. Another primary focus in discussions of political economy is the allocation procedure itself, which refers to the process by which certificates are distributed.181 Interestingly, ‘free allocation’ appears to come at a very real cost.182 Many politicians have expressed surprise that, through ‘windfall profits’, the energy sector, in particular, profited considerably from the free distribution of emissions certificates.183 From an economic perspective, however, this was far from surprising: economic principles suggest that the redemption of certificates of monetary value will be passed on to consumers as opportunity costs.184 Free distribution also introduces a problem that is virtually impossible to solve, namely how to integrate later entrants into the market (‘newcomers’). There is a clear economic rationale for auctions. Economists, however, also recognise the problems associated with the preferred auction process. In this context, the issue is variation in the ability to pay and the distortions of competition associated with it (e.g. exercising market power by hoarding certificates).185 Another problem involves the appropriate use of proceeds. Since 2013, European law has required at least 50% of proceeds to be earmarked for climate change mitigation projects (Article 10 (3) EU ETS Directive). A largely unresolved question regarding certificate trading falls at the intersection of economics and law: how should the law define and classify these newly created goods as rights? The traditional classification of goods and property has proved to be largely inadequate for ‘new goods’, such as emissions certificates, because of its orientation towards physical goods (and claims). The theoretical debate in economics over ‘new property’ dates back to the 1960s.186 There have been demands for the creation of a new category of ‘regulatory’ property in the context of certificate trading.187 Because legislatures generally fail to meet this demand, the treatment of emissions rights under the law will continue to be fraught with significant problems under civil and tax law, leading to legal uncertainty. These problems are associated with classification as tangible or intangible assets; the transferability of rights and the granting of security interests; and accounting and tax treatment (e.g. in terms of income taxes or value-added tax).188 The legal framework for emissions trading so far answers these questions inadequately, if at all.

180

Piemonte (2010), pp. 40 ff. For greater detail, see Weishaar (2014b), 5 (pp. 99 ff.). 182 Grubb (2014), p. 254. 183 On the phenomenon of windfall profits in the EU ETS, see Gulli (2016). 184 For further detail, see, e.g., Woerdman et al. (2009). 185 For insights into trading behaviour, see Gronwald and Hintermann (2015), pp. 213 ff. 186 See, in particular, Reich (1964) and Colangelo (2012), pp. 4 ff. 187 Cf. Colangelo (2012), pp. 21 ff. 188 See Colangelo (2012), pp. 26 ff., 185 ff. 181

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Emissions trading is generally regarded positively in terms of its economic efficiency.189 This refers, in part, to its innovation efficiency, because the trade system provides technologically neutral incentives for the development of environmentally friendly technologies. Its main strength, however, lies in its cost efficiency: the principle of tradable rights of use means, at least in theory, that emissions or other activities are reduced in areas where this makes the most sense for the economy as a whole (lowest abatement costs or lowest marginal utility relative to other activities). A market price is determined for the release of one unit of a pollutant on the basis of marginal abatement costs (or for other activities based on marginal utility). Some elements of this concept are subject to criticism. For example, in individual cases, the granting of emissions rights, like that of rights of disposal in general, may lead to non-rational and thus economically inefficient use (‘underutilisation’ or the ‘tragedy of the anticommons’).190 In terms of its general effect, however, this does little to change the overall assessment of the instrument’s economic efficiency. Every environmental policy instrument, including emissions trading, leads to transaction costs. The transaction costs of certificate trading are primarily related to the complex legislative regime and demanding system of enforcement associated with it. Nevertheless, a metastudy by Crals and Vereeck has shown that the ‘natural’ environmental policy alternative to emissions trade—ecotaxes—does not in itself lead to lower transaction costs. In either case, the transaction costs depend on the design of the specific legal regime.191 Like all environmental policy instruments that drive up company costs, emissions trading can lead to problems for international competition. There is a risk that companies will transfer their production to countries with fewer environmental constraints, thus ‘exporting’ emissions (carbon leakage).192 One method of counteracting this effect is to create a ‘pricing’ offset mechanism (e.g. a borderadjustment tax) for products from countries with lower environmental standards; however, this is problematic under the terms of world trade law.193 Of necessity, many states—and the European emissions trading system itself—have taken a different approach: exempting industries at risk of carbon leakage (in particular, by allocating free emission allowances).

189

For greater detail, see Rogge (2016). Cf. Colangelo (2012), pp. 10 ff. 191 Crals and Vereeck (2005), pp. 207 ff. 192 On this issue in the context of environmental taxes, see Sect. 7.2.3.3 above; in the context of emissions trading, see, e.g., Prentice (2013), pp. 132 ff. 193 See Sect. 7.4.2 below. 190

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7.2.6

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Informal Instruments of Environmental Policy

Informal instruments of environmental policy194 can be defined best by what they do not do. They do not seek to influence behaviour towards the environment through coercion or through economic incentives; instead, they apply to the voluntary behaviour of the actors involved. The informal environmental policy instruments discussed below always presuppose state involvement and a political or legal framework. It is conceivable, of course, that the state will influence the environmental awareness of its citizens and thus alter the utility functions of individuals.195 Environmental measures taken as a result are then voluntary only in a narrower sense of the term. The discussion below focuses primarily on changing preferences and the ‘incentives’ that companies have for environmental measures that are more or less ‘voluntary’. There is, roughly speaking, a distinction between market-based and state-established incentives for voluntary action.196 The most important marketbased incentive is, of course, consumer demand for environmentally friendly practice. One problem with this incentive is that consumers often have incomplete information as a result of information asymmetry.197 Market-based incentives are also visible in cost savings from improved environmental performance (e.g. lower energy costs). In a broader sense, market incentives also include the competitive advantages that companies expect to gain through ‘voluntary’ environmental measures’; for example, companies that compel competitors to adopt their own environmental standards can benefit from a ‘first-mover advantage’.198 The state’s primary role in this context is to ensure that market participants comply with the basic principles of a competitive market. The state can also intervene to mitigate or eliminate information asymmetries. The state plays a much more obvious part in the creation of incentives for informal environmental measures. In this case, companies seek to achieve a ‘regulatory advantage’.199 Such advantages can arise, for example, when the state threatens to impose intrusive regulatory measures (e.g. regulatory limits) if certain ‘voluntary’ environmental objectives are not met. Companies can also gain regulatory advantages if the state discloses specific strategies for ‘voluntary’ measures and thus boosts company credibility (‘operational environmental management’), or if the state introduces product labelling systems to improve consumer information. Finally, the state can induce companies to adopt environmental measures by offering

194

On the economic analysis of voluntary environmental policy instruments, see Brau and Carraro (2006), pp. 593 ff. 195 For a general discussion of this topic, see Sect. 1.2.2.2.3.3 above. 196 See, e.g., Alberini and Segerson (2002). For an overview of relevant literature, see Brau and Carraro (2006), which proposes a distinction between supply- and demand-side incentives. 197 Cf. Brau and Carraro (2006), pp. 596 ff. 198 Ibid., pp. 618 ff. 199 Ibid., pp. 605 ff.

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subsidies and other benefits. (Here, too, ‘voluntary’ is a relative term; there is also not a clear distinction between these forms of aid and more narrowly defined environmental subsidies).

7.2.6.1 Voluntary Agreements Voluntary agreements200 are one category of voluntary and cooperative policy instruments. They can be formed between individual companies (as in the case of monopolies), groups of companies or business associations with government agencies (typically the government or individual ministries). Similar results can be achieved with unilateral commitments.201 Parties may enter into these arrangements to achieve a variety of environmental objectives, such as the reduction of harmful emissions, the adoption of clean technologies or processes, or the introduction of more environmentally friendly products. Neoclassical economic theory cannot explain the creation of voluntary agreements, because parties typically incur costs in order to fulfil their obligations. Nevertheless, companies (or affiliated associations) can have various motivations for entering into such agreements.202 These may include a desire to avoid (or delay) stricter regulations, obtain greater flexibility regarding compliance with regulations, induce public authorities to adopt stricter regulations (and thus gain a competitive advantage), cut costs by reducing pollution (through direct or indirect access to certain technologies), gain access to credit for profitable investments, receive tax exemptions or incentives, or improve their reputation. Because they are the product of a cooperative bargaining process, voluntary agreements are flexible and can be adapted to specific locations and sites. An interactive approach of this kind can provide relevant parties with information on available options for environmental policy and technology. At the same time, however, these agreements are associated with clear disadvantages. For example, like command-and-control instruments, these arrangements typically involve an information asymmetry between the private sector and the state.203 It is easier for the private sector to judge whether the targets set are significantly more strict than the results of ‘business as usual’ and/or whether more ambitious objectives could be achieved with different technologies. To the extent that voluntary agreements are motivated by competitive advantages, they may also be exploited in oligopolistic structures. In addition, the transaction costs of voluntary agreements are generally high due to the resources required to draft and negotiate the

200

See Brau and Carraro (2006), pp. 593 ff. On voluntary environmental engagement and the ‘crowding-out’ effect, see Grepperud (2007). 201 On the distinction between ‘unilateral commitments’ and ‘negotiated agreements’, see Brau and Carraro (2006), p. 594. 202 For further detail, see Croci (2005), pp. 11 ff. 203 For evidence from UK climate change agreements, see Adetutu and Stathopoulos (2021), pp. 644 ff.

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content, monitor the process, revise and adapt the agreement and impose sanctions for inadequate progress.204 Voluntary agreements are often non-binding, in the sense that the law does not impose a sanction for non-compliance. As a result, there is a risk that the parties will not adhere to the terms of the agreement, in which case the state will only have lost time for the necessary regulation.205 In group agreements, there is also a danger that the parties will not have the legal tools needed to realise goals with member companies and will instead rely on ‘soft’ sanctions, such as group pressure and reputational damage.206 In some cases, voluntary commitments can be a positive addition to the environmental policy mix.207 In general, however, they are not suitable tools for internalising external effects.

7.2.6.2 Environmental Management Environmental management systems are intended to develop a reliable and legally sound framework for operational measures that companies can implement voluntarily.208 The objective is to create and release a statement explaining how a given company will improve its environmental performance in the future. This declaration is evaluated in accordance with established legal criteria, and compliance is assessed by independent auditors. For this reason, the process is sometimes referred to as an environmental audit procedure. Companies can publicise their commitment for advertising purposes; they occasionally receive benefits from the state in return, like subsidies or relief in the enforcement of environmental law. The corresponding auditing system is based on criteria in the industry standard ISO 14001, which is recognised worldwide. A comparable framework in the EU, the Eco-Management and Audit Scheme (EMAS), has been in place since 1993.209 After taking stock of its performance in environmental protection, a company in the industrial sector develops an environmental programme. This programme defines the objectives of the company’s environmental policy and outlines concrete measures and timeframes for achieving these targets. After its performance is assessed by external environmental auditors and sites are registered, the company is authorised to prepare a statement of participation and use it for promotional purposes (though not

204

On these risks, see Croci (2005), pp. 23 ff. For a discussion of ‘cheap talk’ in game theory, see, e.g., Durlauf and Blume (2010). 206 On problems associated with the implementation of voluntary agreements, see McEvoy and Stranlund (2010), pp. 45 ff. 207 For a detailed examination of the role of voluntary agreements in the environmental policy mix, see Braathen (2005). 208 On the economic analysis of environmental management from a comparative perspective, see, e.g., Watson and Emery (2004). 209 See Regulation (EC) No 1221/2009 on the Voluntary Participation by Organisations in a Community Eco-Management and Audit System (EMAS), 22 December 2009, OJ L 342, 1; for an overview of the EMAS scheme and its history, see Wenk (2005). 205

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on products); marketing materials can include the logo specified under the ordinance with the addendum ‘verified environmental management’. It is not easy to determine how effective the Eco-Management and Audit Scheme (EMAS) has been as an European environmental management system. Between 2005 and 2021, the number of participating organisations largely stagnated at roughly 4000, even decreasing slightly, while the number of sites rose from around 4000 to around 10,000.210 However, the participating companies have shown clear progress towards the primary objectives of EMAS: improvements in environmental management and performance, as well as technical and organisational innovations.211 It is also difficult to assess the allocative efficiency of the system, because this approach does not pursue specific environmental goals in the conventional sense. Still, allocative efficiency is typically achieved for society as a whole, because the total costs of the specified improvements are low.212 From a business perspective, however, it is problematic that such improvements are generally associated with positive externalities. This explains why organisations may be reluctant to participate and why policymakers search for ways to incentivise company participation, for example by awarding subsidies.213 The practice of granting participating companies relief from the regulatory requirements of environmental legislation is the subject of intensive debate.214 A particularly controversial question is whether the deregulated and privatised monitoring system EMAS is functionally equivalent to a governmental monitoring system.215

7.2.6.3 Product Information As an environmental policy instrument, product information is generally discussed in the context of environmental labelling (or eco-labelling).216 Under such schemes, a logo or mark is placed on a product so that consumers will know that it meets higher environmental standards or was produced more sustainably than similar products.217 In practice, there is a wide variety of labelling programmes: for example, labels can be mandatory or voluntary and can refer to a single aspect or to multiple criteria.218

210

Official statistics from the European Commission are available at https://ec.europa.eu/ environment/emas/emas_registrations/statistics_graphs_en.htm. 211 For empirical data, see, e.g., Iraldo et al. (2009). 212 On the topic of allocative efficiency, see Bültmann and Wätzold (2002), pp. 217 ff. 213 Daddi et al. (2017) analyse the decrease in interest in EMAS and identify a lack of financial and human resources and market and stakeholder recognition. 214 See Adam (2011), pp. 75 ff. 215 On relevant arguments, see Bültmann and Wätzold (2002), pp. 59 ff. 216 See, e.g., Martinez Gándara (2013) and Kroll et al. (2013). 217 Martinez Gándara (2013), pp. 24 f. 218 For an overview of labelling practices, see OECD (2016).

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7.2.6.3.1 Market Failures and Corrections Like product information in general, eco-labelling addresses a primary form of market failure: information asymmetry.219 The producer clearly knows more about the environmental impact of the product; the informational advantage is even greater regarding production methods. In general, labelling schemes play a significant role in communicating ‘credence attributes’ that cannot be assessed by consumers themselves (e.g. labels for genetically modified food). Labelling schemes provide consumers with information that they might be looking for before making their purchasing decision; this helps to reduce transaction costs. The purpose of standardised labelling requirements is to allow consumers to select more environmentally friendly products. The selection may be motivated entirely by the economic interest of the consumer, for example, if the purchase of specific energy-saving products will reduce energy costs. On the other hand, these features may be intrinsic attributes that align with consumer preferences for environmentally friendly products.220 For businesses, participation in labelling schemes can be strategic, because they can integrate it into an overall strategy to demonstrate corporate social responsibility, build their reputation or create marketing materials. Of course, here, too, the motivation may in fact stem from environmental concerns.221 In order for eco-labelling to be successful in the long term, it must be based on a sound certification system.222 The selection and supervision of (typically private) certifiers is a crucial aspect of a well-functioning labelling schemes. In the EU, the introduction of an energy pass system for apartments and buildings in 2002 addressed a specific form of information asymmetry (‘user/owner’ or ‘landlord/tenant dilemma’).223 Because parties interested in renting or purchasing a residence are informed of the energy efficiency of the space, there is a corresponding pressure on the rental or purchase price; this provides an incentive for property owners to upgrade the energy efficiency of their buildings. 7.2.6.3.2 Opportunities and Challenges ‘Green markets’ have grown tremendously in recent years, far surpassing $100 billion in sales and contributing more than 50% of market growth.224 There is a huge incentive for companies to take advantage of green consumer interests—by any and all means necessary. As a result, alongside honest advertisements on environmental performance, there is a great deal of promotional material that strategically misleads

219

See, e.g., Martinez Gándara (2013), pp. 64 ff. For a detailed discussion of the motivations of consumers, see Martinez Gándara (2013), Chap. 4 (pp. 173 ff.). 221 On business motivations, see the detailed discussion in Martinez Gándara (2013), Chap. 3 (pp. 173 ff.). 222 See Martinez Gándara (2013), pp. 241 ff., and the results of the meta-study by Potter et al. (2021). 223 On the 50-year history of energy efficiency policies for buildings, see Economidou et al. (2020). 224 Kronthal-Sacco et al. (2020). 220

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consumers (‘greenwashing’). In economic terms, companies can engage in this opportunistic behaviour due to information failure; ‘greenwashers’ are free riders on the environmental market. One greenwashing strategy is to display misleading eco-labels. From the perspective of law and economics, it is clear that effective regulation is needed to protect consumer interests, maintain consumer trust and guarantee standards for eco-labelling.225 One problematic aspect of eco-labelling is the potential for such systems to introduce new market failures, especially due to information asymmetries. On one hand, there is a tendency for the variety of eco-labels to increase because private actors are interested in developing them or consumers seek information on a specific issue; this may have a positive effect by encouraging competition between eco-labelling schemes. On the other hand, there is a risk that too much information will overwhelm and disorient consumers, preventing them from differentiating between different labels and weighing the values of each.226 The result can be similar to a ‘lemon market’:227 consumers may ultimately make purchase decisions based on whether or not products display a label, regardless of type. This can lead to mediocre labelling schemes.228 Adequate (state) regulation will require the development of a robust legal framework that sets common standards for eco-labelling schemes.229 Above all, the framework must guarantee a reliable certification scheme and sufficient penalties in cases of illegal activity. Private schemes that do not harmonise standards are better than nothing, though clearly second best. This is evident at an international level, where it is often difficult to reach an understanding or agreement on common rules. The World Wildlife Foundation (WWF) has been successful in this respect, as it established sustainable forestry standards after an international forestry agreement could not be reached.230 Legislators should consider another caveat, however, especially if they intend to develop mandatory labelling schemes: such schemes are not without cost, and expenses can be considerable, depending on the circumstances.231 For example, labels for genetically modified food may require products to be kept separate and monitored throughout the entire supply chain.

7.2.6.4 Environmental Information The concept of freedom of information, which was developed in the AngloAmerican and Scandinavian sphere of law, has assumed a role as an important

225

Martinez Gándara (2013), pp. 133 ff. Ibid., pp. 261 ff. 227 See Sect. 1.2.3.5 above. 228 See Martinez Gándara (2013), pp. 272 f. and further reference. 229 See the conclusions in Martinez Gándara (2013), pp. 273 ff. 230 Martinez Gándara (2013), pp. 261 ff. 231 On the costs and benefits of labelling schemes, see Roe et al. (2014), pp. 409 ff. 226

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policy instrument.232 ‘Freedom of information’ is a mechanism intended to generate and increase civil society engagement and improve the ability of the public to monitor the activities of the state and administration.233 In 1990, a directive234 on public access to environmental information created a legal framework for the freedom of environmental information in the EU.235 This framework was further refined by the Aarhus Convention, which was implemented in 2003. Its purpose was not only to increase the transparency and legitimacy of the administration, but also to improve environmental protection. Citizens and environmental associations would thus be able to participate more effectively in environmental management procedures and become ‘advocates of the environment’, whether through public involvement or the ability to initiate legal action. Freedom of information acts have a positive environmental impact, although there has not yet been comprehensive research into how and why disclosure programmes tend to have such beneficial effects.236 As with any other instrument, however, such benefits come at a cost. Strategic behaviour can emerge on the side of agencies and on the side of private actors. Agencies may try to channel information outside traditional bureaucratic structures, thus hiding sensitive information. Private actors may try to use information strategically, for example to support their commercial objectives.237

7.3

Instrument Variety and Instrument Mix

There is an impressive variety of instruments in the environmental policy toolbox, due in no small measure to contributions from the field of economics. This diversity is associated with certain disadvantages and risks, of course, because it causes greater difficulties in assessing the (negative) side effects of these instruments and the effects of their interactions on one another. Environmental lawmakers have been likened to doctors who prescribe new medications without discontinuing or even questioning old ones. A second comparison is based on the game of billiards: although every ball (instrument) may be hit in a targeted manner, not even professionals can precisely predict its future course or effects, let alone control it. Economists must determine how to evaluate the available variety of instruments; they must also develop criteria for optimising instrument interaction to produce an

232

Lamdan (2017); for the EU, Etemire (2020). For an empirical discussion of the effects of transparency, see Grimmelikhuijsen et al. (2019). 234 RL 1990/313/EWG, OJ L 158, 56. 235 See Etemire (2020). 236 Stephan (2003). 237 See, e.g., Asheim (2010). 233

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effective and efficient combination.238 Climate change policy is an interesting reference field in this context, as will be shown in this section. Designing smart instrument mixes is particularly difficult in the field of environmental policy due to the complexity of ecological problems, time-lag effects, and unequal distribution of impacts.239 Therefore, it is not possible to design them in a static manner, and it is necessary to combine a static perspective with a process perspective.240 A good policy mix requires consistency in setting objectives and adherence to these objectives over time. Policymakers must proceed through the various stages of the policy cycle (problem identification, agenda setting, policy formulation, policy adaptation, implementation and evaluation) again and again,241 adjusting instruments accordingly. The implementation of policy instruments is guided by a basic argument from neoclassical environmental economics, which holds that a market failure should be remedied efficiently with a single instrument. The introduction of more than one instrument would be redundant and typically also inefficient, harmful to social welfare and thus counterproductive.242 Under the famous Tinbergen Rule, a certain number of independent political objectives should be pursued through an equal number of instruments; any other approach would inevitably lead to ‘instrument chaos’.243 The first candidate for the ‘claim to sole representation’ in the field of climate protection policy is emissions trading. If the emissions trading scheme were designed in such a way that it could completely internalise external effects, climate change measures would have the lowest possible (abatement) costs. The resulting certificate price would then be a realistic reflection of the abatement costs, and market forces would lead the transition to a low- or zero-carbon economy. This would automatically promote the relevant technologies; it would also provide the necessary incentives for innovation and for the development of required technologies (especially technologies for renewable energy and energy efficiency). From this perspective, the renewable energy law appears to be an environmentally useless instrument: it helps to reduce CO2, which reduces the price of CO2 certificates below a given cap, negating the instrument’s effect. This argument is correct in theory, though not in practice. In energy and environmental law, the instrument mix is a political and legislative reality. It is the result of adding new, primarily economic and information-based instruments to existing ones

238 For a general discussion of this issue, see Sect. 4.2.4.2 above; on the variety and combination of instruments in environmental law, see Rodi (2000); on the combination of instruments in energy and environmental law, Rodi (2012a), pp. 371 ff. For a discussion of the economic perspective on the instrument mix in climate protection law, Lehmann (2010). 239 Weber et al. (2014), pp. 1381 f. 240 Rogge (2016). 241 See Sect. 4.2.1.3 above. 242 Lehmann (2010), p. 66. 243 Tinbergen (1952).

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(particularly those related to regulatory law) and of using other traditional instruments (e.g. subsidies and taxes) to produce new ‘steering effects’.244 Recent evidence demonstrates convincingly that the Tinbergen Rule provides a justification for instrument variety in energy and environmental law. There are also many other arguments from the fields of policy, law and political economy to support this conclusion. In a metastudy, Paul Lehmann examined this line of argument and applied it to the instrument variety in Germany’s climate protection policies for the electricity sector.245 If the transaction costs associated with an instrument’s introduction are assessed realistically, there is reason to doubt that an instrument that is best in theory is necessarily the one most suitable in practice.246 Whenever the costs associated with the most appropriate instrument are too high, other instruments should be used in whole or in part if the internalisation of external costs will yield a positive balance.247 In addition, it is questionable whether emissions trading, even in an ‘ideal’ form, would be able to send the necessary price signals for long-term system changes and structural modifications.248 The main argument is that, because several forms of market failure are often inextricably linked in practice, multiple instruments can be justified to combat specific types of market failure. Negative external effects are thus often associated with information asymmetries and spillover effects in the field of technological development (‘technology spillovers’).249 These result from the fact that knowledge gained through innovation (or diffusion) is, to a certain extent, also available, to other market participants who do not have to pay for it. On the one hand, the introduction of new instruments that are climate-friendly can reduce costs, for example by conserving energy. On the other hand, when an actor pays the necessary costs to introduce a new technology, the resulting learning effects (‘learning-bydoing’) will benefit the other actors who later adopt the technology (‘technology spillovers’). These positive externalities slow down the desired technological change, because they lower investment in innovation (or diffusion) to suboptimal levels. The crucial point is that companies that invest in costly learning processes only consider their own benefits, not the benefits to other actors. In macroeconomic terms, individual cost-benefit calculations result in too little investment in new technologies and thus to too little learning-by-doing. A basic justification for instituting renewable energy promotion schemes alongside emissions trading is that the technological change driven by emissions trading (and ecotaxes) will lead

244

See also Rodi (2012a), pp. 373 ff. Lehmann (2010). 246 Ibid., pp. 80 ff. 247 Ibid., pp. 72 ff. 248 Görlach (2014). 249 Lehmann (2010), pp. 70 ff. 245

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to positive external effects. If these effects are not internalised, instruments aimed primarily at reducing emissions will be inefficient and thus suboptimal.250 Additional instruments may also be required to eliminate information asymmetries.251 This is clear in the context of climate policy, for example: while instruments like emissions trading or energy taxes seek to reduce certain climaterelated activities by making energy consumption more expensive, they will not achieve this goal if actors are not sufficiently informed of available alternatives, such as new energy-saving technologies. In such cases, additional informational tools, such as energy labels on products, can ensure that the affected parties react efficiently to the incentives provided in climate change policy. These economic arguments in favour of instrument variety are supported by views from the perspectives of reality and political economy. Decisions on instrumentation cannot occur ‘at the drawing board’; they must instead be based on the current political and legal situation. It is important to point out that arguments favouring the use of emissions trading as the sole instrument of climate change policy presuppose a number of preconditions. In particular, such arguments assume that it is possible to design an instrument in the context of ‘real-world’ politics in an ‘ideal’ way with respect to the requirements of climate change policy and economics. At least in the first trading periods of the EU emissions trading system, this assumption was far from satisfied, as Member States were still competent to set a (national) cap and organise the allocation of certificates. As a result, the system has been centralised considerably since 2013. Certain systematic deficits remain, however, including the fact that lobby groups can potentially influence the setting of caps; this possibility is likely no lower at a European level.252 If the ambitious targets of the European energy transition are to be achieved using only emissions trading, an ‘energy transition price of CO2’ of at least €90–100 per tonne of CO2 would be necessary in 2030; a price of up to €400 would be required in some sectors (like traffic and transport) and for some technologies (like green hydrogen).253 Currently, the certificate price is extremely volatile; prices temporarily spiked to nearly €100, leading to political debate. This indicates that a ‘decarbonising’ emissions trading system of this kind would probably entail prohibitively high political costs (e.g. opposition and resistance). Because relevant actors would anticipate this, there would be ‘regulatory uncertainty’, leading investments appropriate under emissions trading to be blocked or deferred.254

250

Ibid., pp. 80 ff. and 185 ff. Ibid., pp. 77 ff. 252 Rodi (2009), pp. 190 ff. For further discussion, including an empirical analysis, see Anger et al. (2016). 253 Cornago, The EU Emissions Trading System after the Energy Price Spike, Center for European Reform April 2022 (www.europeansources.info/record/the-eu-emissions-trading-system-after-theenergy-price-spike). 254 For a discussion of these arguments in the context of the need for complementary instruments, see, e.g., Matthes (2010), pp. 22 ff. 251

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It is also important to note that present-day decisions on the design and use of energy and climate policy instruments (and investments) have been influenced by various past decisions by the state and private sector. As a result, a change of course may be more difficult and, in some cases, even impossible. This is primarily due to the fact that certain instruments have already been introduced at considerable expense (to individuals and to society as a whole), and the legal system has been adapted to this reality in various ways. This is particularly true in the case of the CO2 emissions trading system, whose implementation represented a massive political tour de force.255 In economic terms, movement away from this instrument and towards alternative instruments like tax solutions would represent a paradigm shift or new direction that would lead to significant transaction and opportunity costs. Changes of this kind would only be possible at a European level; even there, they would likely not be politically feasible (e.g. due to the unanimity requirement concerning taxation). As discussed previously, this would be a case of instrument ‘lock-in’.256 It is important to recognise the prejudicial effects of an existing set of instruments (‘path dependency’) and of other, earlier political decisions. For example, earlier subsidies for ‘established’ technologies (e.g. coal or nuclear energy) are still distorting competition between technologies.257 From an economic perspective, other factors must be regarded as at least comparable to a subsidy, such as the extensive exemption of fossil fuels from paying external costs or of nuclear energy from a realistic accounting of external risks. The existing infrastructure (and all past investments made in it) has the same effect. This infrastructure was built to accommodate the conventional energy supply system, which is largely based on fossil fuels and nuclear energy. In concrete terms, this means that the power supply infrastructure is designed for centralised production in large plants and is thus not suitable for a decentralised energy supply from renewable sources. This ultimately leads to ‘carbon lock-in’, a structural solidification of an energy supply dependent on fossil fuels and nuclear energy.258 As a result, renewable energy does not compete on a level playing field. FITs and other schemes to promote renewable energy can also be interpreted and justified as an instrument to eliminate inequality in the competitive starting position.259 In reality, of course, existing laws typically pursue several objectives; this is a well-established legislative tradition, albeit one that economists sometimes lament.260 It is also not entirely avoidable, because, even at a theoretical stage, instruments are generally associated with a variety of effects and functions. In addition to the purely environmental policy impact of each instrument, there are important considerations related to dynamic efficiency, the promotion of

255

Rodi (2009), pp. 190 ff. See Sect. 7.1.4 above. See also Michie and Oughton (2011), pp. 62 f. 257 Lehmann (2010), p. 204. 258 Rodi (2009), pp. 190 and further reference; Rodi (2012a), pp. 376 and further reference. 259 See, e.g., Lehmann (2010), p. 194. 260 See also Rodi (2000), pp. 231 ff. 256

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innovation,261 industrial policy, security of supply, and budgetary (and thus distributive) effects. The multi-purpose nature of environmental legislation is especially apparent in renewable energy law: EU Directive 2018/2001 (RED II) explicitly states that the law serves the goals of climate and environmental protection, conservation of fossil resources, reduced dependence on energy imports, economic growth, job creation, social cohesion, and regional development on the path to a sustainable energy supply (see recitals 2–4). As Lehmann has rightly noted (in reference to the German EEG), objectives beyond ‘pure’ climate protection should also be viewed as independent justifications for renewable energy acts, even from an economic perspective.262 In addition, it is important to appreciate the fiscal policy decision implicit in these acts with respect to the emissions trading scheme: its basic structure reflects a financing decision not to burden electricity customers (at least directly, as in the case of consumer taxes) and relieves the strain on national budgets (relative to the effects of subsidies as a potential alternative). Finally, the very nature of CO2 and electricity markets suggests the need for instrument variety. Despite all efforts at liberalisation, electricity markets, in particular, are still characterised by producer oligopolies. This ‘re-feudalisation’ of energy markets leads to a significant investment of resources (through ‘rent-seeking’) in old, highly profitable structures rather than in cost-minimising, future-oriented solutions.263 Emissions trading alone cannot fundamentally change this situation, nor can regulatory or competition law. The EEG can be interpreted and justified as an accompanying measure intended to decentralise the energy system and dissolve this re-feudalisation. Systemic and structural changes are also challenging in the context of financial markets, which tend to solidify existing structures. For a variety of reasons, new technologies struggle to obtain adequate financing.264 Banks demand higher risk premiums from renewable energy producers because of the uncertainties of future development and greater exogenous risks (e.g. wind strength or hours of sunlight)— and, to a large extent, because the companies operating the plants are relatively small and have not yet developed long-term banking relationships. This has an especially harsh impact on these businesses, which are considerably more capital-intensive than fossil fuel plants. For these reasons, it is essential to implement legislative measures that will build confidence and create greater legal certainty in order to achieve the necessary capital injection. This is exactly what legislation like the EEG strives to accomplish (thus far with success).

261

See also Rodi (2009), pp. 147 ff. See Lehmann (2010), pp. 205 ff., and above regarding the Tinbergen Rule. 263 Gawel et al. (2013), pp. 7 ff. 264 See also Lehmann (2010), pp. 203 f. 262

7.4 International Aspects of Environmental Policy

7.4

321

International Aspects of Environmental Policy

International considerations have recently assumed greater importance in environmental policy. This is mainly due to globalisation and the increasingly cross-border nature of environmental problems.265

7.4.1

Dilemma Structure of Global Environmental Problems

For many environmental problems, the (negative) external effects cross the borders of states and supranational entities like the EU. Accordingly, many environmental goods represent global public goods, including the climate (the atmosphere), the ozone layer and biodiversity.266 The primary challenge stems from the fact that, unlike individual states, the global community has no central institutions that can implement legally binding instruments to internalise external effects or protect and/or (re)produce public goods. The institutions established on the basis of applicable international law (such as the United Nations and its various subsidiary bodies) are considered to be extremely weak and hardly capable of intervening effectively on behalf of a kind of global common good. Some international law experts have accurately observed that wellfunctioning institutions themselves represent a public good.267 Under current public international law, it is largely the task of the states to establish an international political and/or legal regime for environmental protection.268 If states (and individuals acting on their behalf) are regarded as utilitymaximising, rational entities (‘state rationality’), it is fairly obvious that, in terms of game theory, these entities find themselves in a dilemma situation.269 From the perspective of these actors, it is not rational to reduce the cross-border pollutant load at their own expense (and possibly to the detriment of their own economies or citizens), as doing so would benefit other states.270 The production of environmental externalities is often linked to economic activities (i.e. production and trade). States thus have an interest in increasing the international competitiveness of domestic companies by maintaining low environmental standards (‘eco-dumping’);271 this increases the risk of a ‘race to the bottom’.272 Conversely, a unilateral increase in

265

On this point, see Nanda and Pring (2012). On international climate policy, see Carter et al. (2021). 266 See also Rao (2002), 2.2. (pp. 48 ff.). On fish stocks as a global environmental good, see Sykes (2010). 267 Rao (2002), p. 156; Slaughter et al. (1998), p. 375. 268 On the concept and presentation of regimes at an international level, see Rao (2002), 4.5. 269 On this topic, see Sect. 2.5.2 and in general Sect. 1.2.3.1 above. 270 Rao (2002), p. 155. 271 On ‘eco-dumping’ as an instrument of strategic trade policy, see, e.g., Greaker (2003). 272 See Rao (2002), pp. 280 ff.; Fleck and Hanssen (2017).

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environmental standards may lead emitting industries to move abroad (‘emissions leakage’); as a result, such measures would therefore have neither an economic nor environmental justification.273 If the costs and benefits of emissions reductions are considered only in terms of national interests, the outcome is a Nash equilibrium for cross-border environmental policy measures; this will deviate considerably from a global optimum.274

7.4.2

Unilateral Measures by States

States can, of course, act unilaterally to protect the environment (i.e. through unilateral measures). Because environmental goods are generally of a public and crossborder (if not global) nature, however, states do not make sufficient use of their ability to implement (unilateral) measures. This does not mean that no unilateral measures are taken at all (despite the phenomenon of ‘state rationality’). Unilateral action may be motivated by a state’s goal to take a pioneering role and thus gain international recognition. In terms of economic policy, early development of environmentally friendly technologies can also lead to competitive advantages for the national economy (although there may be severe negative competitive effects in the short term).275 To a certain extent, states can also pressure other states to adopt measures protecting environmental goods. An important example of this practice is border adjustments, especially border-adjustment taxes.276 These measures are intended to compensate for the fact that imported products are not subject to the same (financial) burdens imposed by climate change measures. The aim is to establish a level playing field that can prevent the relocation of emissions-intensive production to other countries (carbon leakage). From a political and economic perspective, it is particularly interesting that the effect of such measures is to encourage third countries to adopt more stringent climate change measures, even though this puts an additional strain on their export industry without generating corresponding revenue for the home country (e.g. from ecotaxes or the auction of emission certificates). However, whether such adjustment measures are permissible under international trade law is an extremely controversial question. In Europe, border adjustment measures are currently being discussed in the context of the emissions trading scheme (‘border carbon adjustments’).277 The inclusion of aviation in the European emissions trading system can be seen as a first step in this direction.278

273

On environmental emissions leakage as a governance problem, see Bastos Lima et al. (2019). See Mayr (2009), pp. 23 ff., 39. 275 See Dechezleprêtre and Sato (2017) for an empirical meta-study. 276 See Pirlot (2017). 277 Mehling et al. (2019) and Will (2019). 278 See Helm et al. (2012), pp. 16 ff. 274

7.4 International Aspects of Environmental Policy

7.4.3

323

International Cooperation

In light of the factors discussed above, states are reliant on cooperation to preserve or recover global environmental goods. The goal of this cooperation is to set a limit on the level of total global pollutants and assign emission contributions to individual states. These efforts are intended to achieve a cooperative ‘prevention level’ that is based on a fair and cost-effective allocation of the required contributions to prevention. The cooperation and coordination involved in such measures is consistent with a number of economic principles.279 For example, the conditions for success in international negotiations can be identified on the basis of game theory, which is used to examine the behaviour of (rational) actors in interdependent decision-making situations.280 Consecutive negotiations have proved to be valuable, especially given the complexity of international environmental problems. This approach allows parties to first agree to general principles (e.g. in a framework agreement), then outline specific legal obligations (e.g. ‘protocols’) to make these principles more concrete. One advantage of time-phased, multistage negotiations is that parties can establish trust and may then respond to breaches of trust by other parties in a later stage. This enables parties to pursue conditionally cooperative strategies.281 The formation of coalitions can also be seen as a kind of step-by-step process, which can facilitate negotiations in cases involving many actors or states as participants. Coalitions have gained great practical significance, especially in the context of climate conferences.282 In terms of the content of international environmental treaties, it is essential to develop a list of criteria for an ‘optimal’ agreement.283 This should be advantageous for all participants and thus highly likely to be implemented; in this respect, it is ‘self-enforcing’.284 This counteracts the rationality of violating the terms of the treaty.285 Elements that introduce flexibility will certainly have a positive influence on compliance. Acceptance of binding commitments is increased if parties to the treaties are allowed to add specific provisions.286 A classic instrument to ensure compliance is the reciprocity of obligations, which is especially important in multistage and repeated negotiations.287 The principle of common but differentiated

279

See Rao (2002), 2.7. Ibid., pp. 78 ff. 281 See, e.g., Andreozzi et al. (2020). 282 See Nordhaus (2015). 283 See, e.g., Rao (2002), 9.6. 284 See Rao (2002), pp. 74 ff. 285 Ibid., pp. 158 f. 286 Ibid., Sect. 4.4 (‘treaty reservations’) and Sect. 7.2.2 (advantages and disadvantages). 287 Ibid., p. 76. 280

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responsibilities is gaining recognition as a significant factor in the flexibility of treaty provisions. In addition to flexibility mechanisms, internal and external stabilisation mechanisms can be incorporated into the treaty to ensure cooperative behavior.288 Internal instruments relate to the agreed-upon environmental policy measures themselves (e.g. emissions reductions). Such instruments can, for example, allow contractual parties to react to a breach of contract by reducing their own efforts at internalisation. These are referred to as reoptimisation strategies because the agreed reduction targets are adapted to the new circumstances.289 Ratification clauses ensure that no one must ‘make an advance payment’ unilaterally; the agreement (and its contractual obligations) takes effect only after it has been ratified by a sufficient number of parties.290 External stabilisation mechanisms (e.g. financial transfers or sanctions) go beyond internationalisation obligations and serve only to ensure that relevant incentives are compatible. In contrast to sanctions, transfers (e.g. transfer payments) provide positive incentives for cooperative behavior by redistributing welfare gains from cooperative environmental policy in an appropriate manner.291 If the benefits of transfers affect other policy areas (e.g. development policy), measures overlap through issue linking. Finally, the deposit of securities (e.g. through payments to an international fund) could serve as an additional instrument for external stabilisation.292 The linkage of rights and obligations from different political spheres (policy or issue linking) may be the most effective aspect of external stabilisation.293 This aspect takes advantage of the fact that states derive different individual benefits from different agreements. It is especially interesting to consider the linkage of environmental treaties with the liberalisation guarantees established under world trade law,294 because this is a source of considerable economic advantages for the individual states.

7.4.4

Climate Policy as an Example of International Cooperation

Climate policy provides a particularly interesting example of the challenges associated with international cooperation to protect the environment. This is due, in part, to the sheer scale of the threats posed by climate change caused by the anthropogenic production of greenhouse gases. More importantly, however, it is due

288

See, e.g., Benchekroun and Van Long (2012). See Endres (2011), pp. 235 f. 290 Endres (2011), p. 236. 291 On related problems, see, e.g., Endres (2011), pp. 237 f. 292 See the detailed discussion in McEvoy (2013). 293 See Endres (2011), pp. 238 f., and Sect. 7.4.4.5 below. 294 On the linkage of climate change obligations to world trade law as a form of ‘repeated game’, see Zenker (2020), pp. 25 ff. 289

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to the fact that the climate, in its ‘pure’ form, has the characteristics of a public good. The challenges of protecting the ozone layer provide one illustration: the direct negative effects of emissions in a given area are negligible (if the effects of ‘coupled emissions’ are excluded). In the context of climate change, or climate protection, it is irrelevant where precisely greenhouse gas emissions are produced or eliminated. Theoretically, then, it would seem possible to establish a globally optimal level of greenhouse gases and implement abatement measures where doing so would be most cost-effective. There is a growing consensus that the coordination of increased carbon prices at a global level would be ideal from both an economic and an environmental point of view.295 This insight is relevant to all problems associated with the global commons. The call for parties to phase out fossil fuel subsidies under the Glasgow Climate Pact (a commitment ultimately watered down to a reduction of ‘inefficient’ subsidies) is thus viewed as an accomplishment. A coordinated carbon price could potentially be achieved through a globally harmonised tax on carbon dioxide (CO2).296 An alternative would consist in common emissions trading schemes, e.g. the linkage of existing ones.297 Given the challenges associated with implementing such harmonised or linked schemes, unilateral action like border adjustment schemes could be a realistic option.298

7.4.4.1 Market Failures In practice, this is precisely the difficulty with international climate policy. Although the international climate policy regime has grown increasingly polycentric since the Paris Agreement,299 national states remain the main actors in international climate policy. On the issue of market failures in international climate policy, there has long been a broad consensus among researchers. Climate diplomacy is considered a pure form of strategic decision-making situation. The participating states and their governments find themselves in a prisoner’s dilemma: from an ‘individual’ perspective, a state would prefer to refrain from typically costly emissions reductions, even as other states implement effective climate protection measures that provide benefits to all.300 As in other cases involving common goods, such actions are associated

295

See the meta-study by Nachtigall et al. (2021). For a discussion of the advantages and disadvantages of a global carbon tax, see Thalmann (2012); for a proposition for a multilateral carbon tax treaty, see Falcão (2019). 297 See, e.g., Mehling (2016). 298 See Sect. 7.4.2 above. 299 See Sect. 7.4.4.5 below. 300 It should be noted that states regularly ignore the theoretical possibility that active climate change mitigation and corresponding innovations could yield competitive advantages and, ultimately, welfare gains. See also Sect. 7.1.4 above. 296

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with various forms of undesirable externalities.301 Climate negotiations have thus been analysed as a repeated prisoner’s dilemma.302 Doubts about this simple and clear-cut assessment have grown significantly in recent times. The theory of free riding presupposes that the states pursuing strong climate policies face disadvantages as a result. Based on cases in which states have implemented such policies, however, it also appears possible that active climate change mitigation, and innovations associated with it, could yield competitive advantages and ultimately welfare gains.303 Empirical evidence on the practice of state climate policymaking has increased scepticism that free riding is in fact a dominant strategy.304 Aklin and Mildenberger argue that there is persuasive empirical evidence indicating that states act in a largely unconditional fashion.305 This action largely depends on domestic constituencies and their preferences. Strong climate change policies fundamentally transform society and the economy, leading to winners and losers; the resulting conflicts— and the way they are orchestrated or managed—strongly influence state climate policies. This argument against the role of free riding as a dominant strategy is supported by another empirically backed observation: the growing influence of diverse climate actors.306 A rising number of cities, associations and even companies are taking steps to participate in cooperative and transnational initiatives.307 This growing cooperation indicates that market failure may be less common in this context than was previously suspected. Such evidence suggests that no single type of market failure explains the (too-) slow progress of climate policies at the international level. Of course, both the coordination among private actors and the coordination among states demonstrate severe deficiencies. It is clear that a global organisation of the private sector poses enormous challenges and would require coordination by official institutions, but both of these arenas can exhibit tendencies towards ‘climate anarchy’.308 Both discourses suffer from inequalities. This is clear for the private sector, but it is also true for states: the states affected most by climate change (which, at least theoretically, have the greatest interest in climate policy measures) are developing countries, which have little international influence. In addition, states tend to have relatively short time horizons; the discount rate that they apply is too low to address the long-

301

On the different forms of market failure in climate policy, see Piemonte (2010), pp. 7 ff. See, e.g., Nordhaus (2015), pp. 1341 ff.; Keohane and Victor (2016). For an overview of collective action theory, see Aklin and Mildenberger (2020), pp. 7 ff. 303 See also Sect. 7.1.4 above. 304 For empirical reasoning and references to other studies, see Aklin and Mildenberger (2020). 305 Aklin and Mildenberger (2020). 306 See, e.g., Streck (2020). 307 On the new transnational climate governance, see Hickmann (2016); Bulkeley and Newell (2015), Chap. 3 (pp. 68 ff.). 308 Aklin and Mildenberger (2020). 302

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term problem of climate change and thus fails to exert sufficient pressure for action.309

7.4.4.2 An Economic Perspective on Basic Structures of International Climate Change Law The existing framework for international climate policy has a long history.310 Climate change law is the product of a multi-stage process. First, a Framework Convention on Climate Change with near-universal application was adopted in 1992; the Convention’s rather abstract objectives311 and basic principles were to be defined through more concrete ‘protocols’ (Art. 17). The foundations of international climate law are based on two core assumptions that are certainly accurate: climate negotiations represent a ‘repeated game’, and continuous repetition can increase the willingness to cooperate. This framework (and the iterative nature of its development) allows states with the same interests to form coalitions, further facilitating negotiations.312 7.4.4.3 The Quest for Binding Mitigation Commitments and the Failure of the Kyoto Protocol The Kyoto Protocol, which was adopted in 1997 and took effect in 2005, represented a first (modest) attempt to establish a binding climate agreement. In many respects, it fulfilled basic economic requirements for international agreements. First, the agreement contained a ratification clause, which ensured that the treaty would not enter into force until it was ratified by at least 55 states representing at least 55% of the greenhouse gases emissions of all participating parties. This provision was intended to counter fears of unilaterally ‘making advance payments’. Second, ‘flexible mechanisms’ (Joint Implementation, International Emissions Trading and Clean Development Mechanism) were developed as economic measures to account for the irrelevance of the specific location(s) where emissions were reduced. The value of the Kyoto Protocol seemed limited from the beginning, because it represented only a first attempt to establish a binding international legal regime for climate protection. The aim of the agreement was modest; it sought only to secure commitments from industrialised countries and set minimal emissions reduction targets. This approach did not lead to the establishment of adequate incentives.313

309

On this and other factors that weaken states in the context of international climate policy, see Dyer (2014), who views this as part of an emerging ‘climate anarchy’. 310 On the history of climate change governance, see, e.g., Bulkeley and Newell (2015), Chap. 1 (pp. 23 ff.). 311 Article 2(1) UNFCCC reads: ‘The ultimate objective of this Convention. . .is to achieve, in accordance with the relevant provisions of the Convention, stabilization of greenhouse gas concentrations in the atmosphere at a level that would prevent dangerous anthropogenic interference with the climate system.’ 312 For a bargaining game analysis of international climate negotiations, see Smead et al. (2014). 313 For a critical institutional analysis of the Kyoto Protocol, see, e.g., Rosen (2015).

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The Kyoto Protocol was driven forward by the decision of the EU Member States to become pioneers in climate change mitigation.314 The US, at the time one of the world’s leading emitters, refused to ratify the agreement on the grounds that it contained no obligations for major developing countries like China and India and would therefore create competitive disadvantages for US industry. The Protocol finally entered into force in 2005 after the accession of Russia, which was aware of its strategic role and reached a deal only after tough bargaining: by setting its high emissions levels from 1990 (in the former USSR) as the baseline for its reduction commitments, it accumulated enormous emissions reserves (so-called ‘hot air’). Although the Kyoto Protocol provided for sanctions (e.g. ‘penalties’ for excessive emissions or exclusion from emissions trading), these proved to be entirely inadequate.315 The failure of such measures was demonstrated most clearly when Canada withdrew from the treaty in late 2011 after falling far short of its reductions targets (termination in accordance with Art. 27). This confirms the often observed phenomenon that international treaties are unstable for multiple reasons.316 To protect state sovereignty, truly binding sanction systems are rarely established. Modest penalties and the low probability that a state will actually face sanctions (at least in the near future) frequently provide strong incentives to break the contract. This is especially true if other contracting partners—as in the case of the Kyoto Protocol—have already taken irreversible advance action. After intensive negotiations, the Kyoto Protocol was extended for a second commitment period (2013–2020). The new average reduction targets of 18% below 1990 levels are relatively unambitious. In addition, fewer countries have accepted commitments, which now only account for 15% of worldwide greenhouse gas emissions. As of this writing, there will be no third commitment period after 2020; this has resulted in a regulatory gap for flexible mechanisms, as negotiations under Article 6 of the Paris Agreement continue to proceed at a slow pace.

7.4.4.4 Further Developments The Kyoto Protocol greatly disappointed those who had hoped that an international legal regime on climate change would produce ambitious binding commitments. Over the following years, however, signatories to the UN Framework Convention on Climate Change (UNFCCC) continued to refine key components of the Convention. These efforts culminated in the Paris Agreement, which was adopted on 12 December 2015. The Paris Agreement sets out concrete actions that support the general objectives of Article 2 UNFCCC. According to Art. 2(1)(a) of the Paris Agreement, the treaty aims to ‘[hold] the increase in the global average temperature to well below 2 °C above pre-industrial levels’ and ‘[pursue] efforts to limit the temperature increase to

314 De Filippis and Scarano (2010) argue that the Kyoto Protocol is clearly both a part and a product of EU energy politics. 315 Rosen (2015). 316 For a discussion of possible remedies, see Wagner (2008).

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1.5 °C above pre-industrial levels’. Achieving these targets ‘would significantly reduce the risks and impacts of climate change’. A central feature of the UNFCCC is its reliance on national contributions (‘policies and measures’), as defined under Art. 4(2)(a). These contributions must be reported on a regular basis (Art. 4(2)(b)) and evaluated by the Conference of the Parties (Art. 4(2)(d)). This regime of ‘nationally determined contributions’ (NDCs) has been translated into more concrete terms, including through the principle of progressive commitments (Art. 4(2)). It was clear from the beginning of international climate negotiations that the implementation of a robust legal enforcement system would be challenging. It was also clear that transparency and an exchange of information would play an important role in building motivation and exerting indirect and informal pressure (‘shaming and blaming’). The UNFCCC established the structure for a system of transparency, which instituted (1) national inventories of anthropogenic greenhouse gas emissions by sources and removals by sinks (Art. 4(1)(a)); (2) a reporting system for measures and policies, as well as the development of greenhouse gas emissions and removals (Art. 4(2)(b)); and (3) the communication of information related to implementation (Art. 12). The Paris Agreement further specified reporting requirements for content (Art. 4(8)) and timing (every 5 years, in accordance with Art. 4(9)) and installed a public registry (Art. 4(7)). Article 13 set up an enhanced transparency framework. Another cornerstone of the international climate change regime is the provision of financial and technological assistance. This is based on the principle of common but differentiated responsibilities, which is established in Art. 3(1) UNFCCC. Financial resources are intended to help developing countries fulfil their commitments (Art. 4 (3) UNFCCC). Article 9 of the Paris Agreement elaborates on the ‘Financial Mechanism’ first outlined under Art. 11 UNFCCC, and Art. 10 lays out a technology framework for the analogous ‘Technology Mechanism’ (Art. 4(1)(c) and 4(5) UNFCCC).

7.4.4.5 Further Options The Paris Agreement significantly expanded on the basic features of the UNFCCC. At the same time, however, it led to a fundamental paradigm shift—away from a strict top-down approach. In continuity with the former climate policy process, it sharpened and concretised several justice principles already anchored in the UNFCCC, such as common but differentiated responsibilities, sustainability, equity and the transfer of finance and technology.317 The Paris Agreement is a hybrid construction, because it combines this material framework with a (voluntary) bottom-up process enshrined in the procedural form of NDCs. This second component is based on the insight that, in repeated dilemma situations, trust can play a vital role in enabling cooperation, and transparency is the precondition to make this approach work.

317

For an assessment of how these principles are reflected in NDCs, see Rajamani et al. (2021).

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The next years will be decisive for the fight against climate change, and a crucial question is whether this system can produce the necessary dynamics within the group of state actors. There are reasons for optimism: national constituencies and even negotiators do not necessarily function as conditional cooperators seeking to free ride.318 In addition, the Paris Agreement was made possible by cooperation among climate hegemons, especially the US, China and the EU.319 This stabilising structure is reinforced by climate clubs as bottom-up coalitions.320 This bottom-up dynamic is fuelled by countless sub-state and private actors, like municipalities, companies and NGOs, who are also engaging and joining forces in networks and clubs.321 These internal stabilising factors can be reinforced by an external one. In this context, there are high hopes for ‘issue linking’.322 The considerable fragmentation of international law323 has led states to act independently in each forum, resulting in missed opportunities for ‘package deals’. In theory, complex incentive structures can develop under these circumstances. For example, if there is already an agreement that the principles of development policy require resources to be transferred from industrialised to developing countries, why should these financial flows not be linked? Coupling resource transfers with trade liberalisation measures is a particularly intriguing prospect. It is quite possible that doing so would have enormously ‘motivating’ effects on countries otherwise hesitant to take action. In order to fully implement the concept of ‘issue linking’ within international trade law, however, the legal regime would need to be developed further, either within the WTO Agreement or supplementary agreements.

7.5

Summary

Environmental law demonstrates how the identification of multiple cases of market failure (e.g. related to public goods, externalities or information asymmetries) led to the design of complex legal instruments. The Coase Theorem has shown the significance of transaction costs and the difficulty in realising the full potential of negotiated solutions in this context. Increasingly sophisticated instruments for assessing (future) environmental damage have inspired a shift towards more rational environmental policy and environmental law (i.e. cost-benefit analysis). It is an ongoing challenge to evaluate environmental policy, design more effective and more efficient instruments and combine instruments coherently. This process is rooted in a systematic critique of environmental regulatory law with the introduction

318

Aklin and Mildenberger (2020), pp. 14 ff. Milkoreit (2019) shows the central role of the US in this development. 320 See, e.g., Nordhaus (2015). 321 See, e.g., Streck (2020). 322 See Sects. 2.5.3.2 and 7.4.3 above. 323 See Sect. 2.5.3.2 above. 319

References

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of greater flexibility. The potential benefits of environmental liability law as an environmental policy tool have been made clear, but so too have its limits (i.e. the risk of excessive avoidance costs). Environmental taxes and charges have played a pioneering role as instruments to internalise external costs. Financial support schemes have been constrained by the concept of internalising positive external costs and have been systematically refined with the regime to promote renewable energy. Green certificates made a major economic concept a practical reality. Informal environmental policy tools have mainly been used to eliminate information asymmetries. The greatest challenges ahead for the field of environmental economics are those related to global environmental goods, including climate change mitigation. International cooperation cannot currently eliminate market failures, particularly dilemma structures. Mechanisms to provide transparency and incentives (i.e. in the transfer of financial resources and technology) represent promising developments. There are also high hopes that a ‘linking of issues’ will yield greater concessions from states.

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