Moral hazard in modern democratic politics

Jul 3, 2017

While all Western democracies accept the need for social safety nets, conservative governments point to moral hazard to justify less generous public provisions, while progressive parties prioritize more assistance to the needy over additional minor inconvenience to the better off

Earlier in the year, the Liberal Party suffered a landslide defeat in the state elections of Western Australia. While local issues dominated, PM Malcolm Turnbull’s falling popularity also contributed to the loss. Part of the difficulty afflicting Turnbull and damaging the Liberal brand is the popular perception that he lacks conservative political convictions. Playing to this perception, recently former PM Tony Abbott has sharpened and increased the frequency of his criticisms of Turnbull policies on a wide – and widening – range of issues, always dressing his attacks in the language of conviction-based policy differences.

One potential solution to help Turnbull navigate his way through policy choices is the notion of moral hazard. Originally developed in the 19th-century insurance industry, it referred to the greater risks an insured person will take when the costs of carelessness are transferred to the provider. According to the Financial Times lexicon, “Moral hazard arises when a contract or financial arrangement creates incentives for the parties involved to behave against the interest of others.”

We heard a lot about moral hazard with the taxpayer bailout of big US banks after the 2008 financial crisis. The general problem is that of privatising profits while socialising risks. Why would bank CEOs behave responsibly if the profits when the gamble pays off are kept by shareholders, but any losses are borne by taxpayers? When a fire destroys homes, similarly, some people might be caught out with homes that were uninsured. If the government compensates them for their losses, will this encourage others to drop their insurance policies and look to government bailouts as well?

As rational actors, human beings adjust behaviour to match the perverse incentive structure created when the careless are rewarded at the cost of the prudent. In other words moral hazard is the flip side of self-reliance. However, not everyone elevates rationality above empathy and those in distress always appeal to the better angels of many fellow human beings. In social policy this leads to the creation of publicly funded social safety nets like welfare, minimum wage and penalty rates, unemployment insurance, workers’ compensation and public health.

All modern Western democracies accept the need for some social safety nets. But typically, within a broad national consensus, conservative parties will point to moral hazard to justify less generous public provisions, while progressive parties will prioritize more assistance to the needy over additional minor inconvenience to the better off.

The ALP has been far sharper in prosecuting its philosophy of social burden sharing than the Coalition in explaining the perverse consequences of good intentions on several currently contentious policies.

The main complaint against 18C of the Racial Discrimination Act is the chilling effect on free speech. But offended individuals can also file a complaint, ruin the reputations of others by allegations of racism,  and use investigations by the Australian Human Rights Commission to receive financial reparations. If however their complaint fails, they suffer no financial or reputational cost themselves: the taxpayer covers all financial costs while the defendant suffers reputational and other harm. This creates the perverse incentives structure of moral hazard. As the late cartoonist Bill Leak rightly pointed out, there should be some penalty to deter frivolous and malicious complaints.

In another example of reward for bad behaviour, the perception seems to be growing that the minority group most prone to extremism gets special access to ministers, high profile TV shows and government advisory positions. Other groups notice and resent being ignored or neglected because they are law-abiding citizens who eschew extremism.

All democracies need also to balance adequate social services as part of the welfare state against the need to grow the economy by rewarding enterprise, and the need to reward prudence and thrift to encourage self-reliance. Left-of-centre liberal parties typically argue that the same amount of financial transfer from the rich to the poor greatly enhances the subsistence lifestyle of the latter, for a modest additional inconvenience to the rich. Tax breaks for the rich amounts to stealing from the poor to give to the wealthy.

But the government does not take from the poor to give to the rich. Rather, it aims to give less to the poor but take less from the rich in an effort to change the incentive structure for both. The simple if brutal reality is that the lot of the poor, vulnerable and disabled is infinitely worse in the poorest countries of the world than in the rich countries. Being a wealthy country does not guarantee the poor will be looked after. But being a truly poor country does guarantee that its poorest people cannot be looked after by the state.

Wealth creation and economic growth are necessary for an affordable welfare system. Policies that promote and reward growth are therefore essential for the self-interest of the poor people in the rich countries. Tax policies that only ever move in one direction – always increasing and never cutting taxes for high-income earners – gradually increase the share of net beneficiaries.

Eventually, citizens divide between those who work and others who vote for a living and a perverse incentive structure is created to shift increasing numbers from contributing to the public purse to become state dependants. With fewer and fewer taxpayers, the state heads for bankruptcy as in Greece. And bankruptcy is particularly hard on the poorest people because now the state cannot look after anyone.

A sensible superannuation policy would similarly reward those who save a nest egg to avoid drawing on the public pension. But the temptation for governments is to look at family assets and income only at the point of retirement. This means that if two families have roughly comparable incomes and basic expenditures during their working lives, the wastrels will have little assets on retirement while the savers will have a decent nest egg. If superannuation policy punishes the prudent in order to look after the spendthrifts, more and more people will give up on saving and end up on the increasingly unaffordable public pension.

Yet this is exactly what the Turnbull government proposed just before the last election, adding insult to injury by making the changes retrospective. They then insulted the public’s intelligence by deliberately confusing retroactive with retrospective tax changes. A new analysis shows that a home-owning couple with $400,000 in super, when combined with the aged pension, can earn more than a couple with $1 million in super whose assets disqualify them for receiving the pension. This, it is predicted, will produce a ‘stampede’ by those nearing retirement to spend money on wasteful consumption in order to qualify for the asset-based pension whose financial burden on the state will spiral out of control. Thus the superannuation changes violate core liberal principles in punishing fiscal prudence, thrift and self-reliance. In rewarding and encouraging growing state dependency instead, they create moral hazard and are therefore bound to be ultimately self-defeating.

These are all examples from public policy where true-blood conservative politicians would recognize the moral hazard of punishing good and rewarding bad behaviour so that increasing numbers of people switch from responsible to reckless financial behaviour over a lifetime. Conversely, social democratic parties like Labor would dismiss moral hazard concerns as exaggerated and insist on putting a floor under the misery of the vulnerable groups in need of public assistance.

Professor Ramesh Thakur is a professor at the Crawford School of Public Policy, The Australian National University

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