Planning and Markets Paper -- Edward H. Clarke

The paper draws on examples of potential applications of the demand revealing process. I began this project, aimed at applying the idea in public decisionmaking, about 20 years ago when the idea (demand revealing) initially addressed to the "free rider" problem of public goods provisioning (Clarke, 1971) was billed as "a new and superior process for making collective choices" (Tideman and Tullock, 1976). One would have thought that Tideman and Tullock had found a philosopher's stone in that the limitations of demand revealing were, in their words, that it will not "cure cancer, stop the tides, or solve many other problems." The procedure, of course, subsequently elicited a host of criticisms, particularly concerning its practicality.

In responding to criticisms of the idea, particularly those concerned with practicality, I have, in subsequent years, worked on methods of applying it in current institutions -- for example, internal budgeting for information technology within the Federal government or even the "governance" of the Nation's airports and air traffic control system. In several essays that form the basis of this paper, I extend the idea to intergovernmental arrangements, both within a Nation-state and among Nation-states, so as to achieve "subsidiarity" through "incentive-compatible" means. Based on recent work by Bailey (1997), I also introduce some new ways of combining this mechanism, often called the "pivotal mechanism," with other tools for encouraging "strong democracy" along the lines of my original attempts at application (Clarke, 1977, 1980).

The 1977 paper acknowledged the need to, in Buchanan's words, "place the method in an appropriate constitution that will limit and define the range of applicability" (Clarke, 1977, p. 39), although there was a tendency to defend rather wide-ranging applicability on the pure utilitarian grounds of "cost-avoidance" relative to current institutions.

A current debate centers on whether the method is appropriate for the "constitution of a future country" (Bailey, 1997) or whether it could fit comfortably within the institutions of a present country, a debate that is implicit at least in this paper. In any case, the debate promises to be a lively one -- centering on the place of mechanism design in the design of political institutions generally.

The issue of practicality reaches to the conflict between the modern public choice variant of classical political economy and those who approach this topic and public policy generally from more traditional perspectives. The conflict, though clearly favoring the more traditional perspectives, is clearly presented in Anderson (1990). Even if one adopts, as I do, much of the pragmatic liberal perspective concerning matters of institutional design, there are others who would cast a particularly critical eye on the entire enterprise as being fundamentally at odds with legal institutions and the entire political science driving these institutions.

To give an example, I introduce Edward Rubin's recent assessment (Rubin 1993) of the practical impact of public choice on modern legal theory and practice. The review casts a particularly critical eye on the behavioral assumptions underlying the public choice vision, which rejects "the romantic notion often proposed by civic republicans that both voters and legislators are, or can be motivated, by public spirit rather than self interest, and that they can effectuate their desires through rational discourse rather than strategic, self-maximizing behavior."

Professor Rubin then notes both an optimistic and pessimistic strand in public choice, including a principal theme (in the optimistic strand) that is the "development of mechanisms for resolving collective choice problems," (referring among other examples to my original 1971 article on demand revealing, "Multipart Pricing of Public Goods" (Clarke, 1971).

Later, in assessing the strengths and weaknesses of public choice, he notes (Farber and Frickley's assessment, in Law and Public Choice, of) the strengths "which lie in the implications for pragmatic, incremental solutions to contemporary problems of governance; its weaknesses in its empirical inaccuracies and in the impracticality of its other implications for these same contemporary problems."

Specifically, at footnote 44: "The impracticality of public choice recommendations should not be underestimated. Consider, for example, Edward Clarke's idea that a taxation scheme could be employed to reveal voter demand for public goods," (Clarke, 1977). "To induce honest declaration of expected gains, he suggests that the person who casts the deciding vote in favor of a given policy should pay a tax equal to the net gain of other voters that would have resulted if the deciding voter had not voted." (In the same footnote, Rubin adds an example of "an equally creative approach" discussed in Chapter 19 of the Calculus of Consent, which the authors, Buchanan and Tullock themselves described as a farfetched but novel way of dealing with special interest legislation).

This pessimistic assessment of Rubin on the optimistic strand of solutions for contemporary problems is echoed, even very recently and in part, by one of the fathers of public choice, Gordon Tullock (a strong advocate of demand revealing). In the New Palgrave (p. 1044), for instance, Tullock notes that "at the concrete level, those who study Public Choice have been able to provide more in the way of suggestions for reform within the bureaucratic structure than in the higher level parts of democracy where the voters control the legislature, and the legislature and the executive control the bureaucracy. Nevertheless, there are suggestions for improving the whole structure of government and, with time, it is hoped, there will be both more ways of making improvements and better scientific evidence that the 'improvements' are indeed improvements."

The shaping of such improvements among the executive, the legislature and the bureaucracy (including the intergovernmental arena) is the principal subject of the several essays, accompanied by critical thoughts of my own concerning the problems motivating the recent criticisms of public choice (and rational choice, more generally). I found myself trying to assimilate much of this criticism (see, for example, Rubin, 1991) while bringing my own critical theory perspective to the practice of public choice, particularly in the realm of institutional design and the management of public regulation.

I should note that, in private communications, Professor Rubin has modified his observations on the perceived lack of practicality as follows: one might distinguish between an arrangement which is "(1.) capable of being put into practice or (2.) capable of being put into practice by real political actors in the foreseeable future. ... I see demand revelation as impractical in the second sense... Administrative agencies may use them to resolve particular problems, but with respect to the general political science, it seems like a visionary rather than a practical approach."

In another communication, Tullock has largely concurred with Rubin: "I think Rubin's remarks about the impossibility of putting it in with present day personnel is correct. However, if you can get people in the habit of using something similar on other programs, it may be possible to gradually expand it over a larger and larger area. Perhaps in 200 years, we will have it as our basic constitutional method."

Following the work of Mueller (1996) and Bailey (1997), my attempts at practical applications have focused increasingly on constitutional design within existing institutional arrangements. Admittedly, there is an optimistic sense underlying this work. As Mueller (1996, page 47) states: "the notion that individuals have the capacity to design a set of political institutions that advances their general welfare, embodying them in a constitution, agree to it and abide by it expresses a good degree of optimism about human intelligence and capacity for self governance." The skeptics also, at many junctures, express strong reservations about voting rules that communicate the intensities of preferences (i. e. point voting, demand revealing), noting that while they may sometimes immune from individual strategizing, they are subject to coalitions (Riker, 1979). The real concerns of the skeptics, however, are, I believe more philosophical (perhaps even political) than technical.

This paper builds on Bailey's recent attempts to mimic the competitive market through appropriately designed voting rules in making decisions about the supply of public goods and the control of externalities. See also Clarke, 1980 for an earlier attempt to achieve this objective. Bailey combines the use of the "pivotal mechanism" with strong incentives for putting positive rather than zero sum games on the agenda. The process is driven by competitive citizen committees which might strike one as some kind of Utopian fiction of sorts, resembling Bentham's own Utopian-fictional "public opinion tribunal" (POT) which formed the heart of his "constitutional codes" (Rosen, 1983). In this work, the agenda setting of the POTs, or citizen advisory committees (weak legislatures), are driven by the pivotal or Vickrey-Clarke-Groves (VCG) mechanisms, and are regulated by a Commission responsible for final allocations of Lindahl tax/transfers.

Both the committees and the Commission are rewarded by the success with which their allocations approximate the rule of unanimity in the public economy. The rewards (to the committees) are based on their contributions to social welfare as measured by departures from the status quo and the next best preferred alternatives (the proposals of a second competitive legislature). The final selection among competitive budgetary and regulatory agendas is made by use of the principles of a Thompson referendum (Bailey 1996, Thompson 1966) which also motivates accuracy in the provision of willingness to pay information by citizens or their direct representatives. The use of the pivotal mechanism with the Thompson referendum, described here by way of utilizing Congressional districts as the unit of account, exploits the advantages of each of these basic truth telling mechanisms while minimizing their comparative disadvantages (Bailey, 1996).

In this paper, drawing on several examples from the essays, I explore the chances for practical application of this conceptual approach to incentive compatible design. The examples illustrate an approach to the design of grants-in-aid that motivates subnational entities (state and local governments) to more efficiently allocate grant-in-aid resources. The proposal effectively separates the allocation from the distribution in that an initial entitlement level of spending may be greater or less than the amount that the jurisdiction will actually spend. The paper also illustrates an incentive-compatible approach towards accounting for interjurisdictional spillovers where actions in one jurisdiction benefit or adversely affect another. Specific applications of the approach are illustrated in the context of grants-in-aid for environmental management (construction grants and Superfund) and transportation.

In this and the related contexts elaborated above, I attempt to show how further experimentation with these "truth telling" concepts in limited administrative (budgetary and regulatory settings) could truly promote democracy on a human scale, promoting more meaningful involvement by citizens in the social art -- the science and practice of government.

II. A GENERAL PROGRESS PROGRAM: ON GOVERNMENTAL COORDINATION

I start with the notion of a "General Progress Program" that I developed with the help of Robert Conlan in 1995. I explain this concept as follows in a treatment of "intergovernmental coordination" in a section extracted from the aforementioned essays.

The Nation needs more effective decision-making mechanisms for intergovernmental coordination of expenditures and regulations. Efficient coordination can be achieved in an incentive-compatible way where the effects of spending by any one subunit on another subunit can be more effectively taken into account as compared with current decision-making procedures.

Effective coordination also relates to an important national economic policy concern which is efficient and equitable spending and deficit reduction. The need for better coordination is evidenced by fractious Congressional debate (i. e. the Congressional debate over welfare reform) over how to implement acceptable reductions in intergovernmental transfers, accompanied by reductions in Federally mandated spending requirements.

Given the existence of decision-making mechanisms (i. e. demand revealing) that would motivate decision-makers to accurately reveal the positive and negative effects of spending and regulatory decisions on one another, why not use these mechanisms to achieve more effective coordination? The Federal Government can establish an initial level of entitlements (called a distributional status quo) and then, with appropriate provisions for agenda-control, let the political subunits decide what levels of actual spending, including Federally mandated spending, is required. In effect, Congress determines the initial distribution but allows more implementation flexibility to the subunits, adjusting the financial flows to reflect external effects.

To illustrate, I will assume we are applying the process to all Federal discretionary programs (about $500 billion annually, and including National defense expenditures), later confining it to about $55 billion in programs (transportation, communications and the environment) financed by Federal excise taxes. Assume first that, we take the President's budget and allow a citizen's advisory committee to propose substitutes or eliminations designed to "maximize the likelihood of minimizing harm" (a criterion elaborated by Bailey, 1997). Subject to oversight by a commission, it will allocate cost shares among political subunits (in this case Congressional districts) so as to equalize per capita (or household) net benefits among the jurisdictions.

Suppose that the allocation of beneficiary tax-shares resulted in pressures for spending cuts that were nonuniform. For example, spending may be cut 10%, from $5,000 per household on average to $4500. Lower spending districts with lower cost shares might end up with an average of $4,000 while higher spending districts remained close to the original $5,000 average. Under the system, compensating transfers of $500 per household would be made from the higher to lower spending districts. If the advisory committee recommended prudent changes that also generated large net benefits and the compensating transfers were designed to achieve equal or proportional per capita net benefit increases for each district (that, say also averaged $500 per household), then the proposed package of changes would be accepted unanimously. The result is that, relative to the original status quo, the lower spending districts would be loaning $500 per household to the higher spending districts and sharing in the social surplus created by more productive investments.

Although this attractive, but seemingly impossible, result might characterize the package of changes, particular elements of the package may result in positive net benefits for some jurisdictions and negative benefits for others. In this paper, following Bailey, I present an approach combining demand revealing with Thompson insurance to help resolve this difficulty, and while the sharing of gains works out a little differently, these differences do not appear very important. Under the standard demand revealing approach, take for example, a program element where all but two equally populated districts are indifferent to a particular program change. The net benefits of the change are $60 per household for District B but District A would be harmed by the change in an amount of $50 per household. (This might arise when each is equally sharing $100 per h (household) in project costs and District B, with $110 per household in benefits, reaps all the gross benefits). In this case, the incentive compatible "pivotal mechanism" (i. e. demand revealing) described below would result in the change being made but District B would pay $50 a VCG tax that would be refunded to all the other 434 districts on a equal per capita basis (leaving about 12 cents in remaining surplus). Although I will elaborate on the point later, it is also important that the net surplus be sufficiently positive-sum ($60/$50 = 1.2) for the proposed change even to be successfully carried on the agenda.

Under Thompson insurance, where the best effort to reach a perfect Lindahl solution has left District A with $50 per h in harm, A and B would be asked to express their WTP (willingness to pay) for insurance against material harm (resulting from choice of a less preferred alternative), and a statistical group under the aegis of the Electoral Commission would assess the probabilities that A's preferred option would be selected over B's. If these were equiprobable, and the districts expressed their preferences solely in terms of material harm, A would pay $25 (.5 x $50) per h in Thompson insurance, and receive back $50 if A was selected. A total of $55 per h (including B's purchase of insurance) would be collected, and after payment of compensation of $50 to A a surplus of $5 per h from A would remain that would also be distributed among the other districts in the manner described above (leaving about 1.2 cents in undistributed surplus).

One of many advantages of the combined use of the pivotal and Thompson insurance mechanism is that, relative to the pivotal standing alone, the combination is more individually rational for A and B taken together. As indicated above, B for example obtains $25 (1/2 of his loss in compensation) and both A and B are better off by this amount plus a small refund relative to the refund from the pivotal standalone. The advantages are much stronger with respect to coalition and informational incentives, however. In addition to demonstrating important synergy between the pivotal and Thompson's mechanism, Bailey's recent work shows how we get around certain technical limitations of demand revealing (Groves and Ledyard, 1977). In this paper, I try to show how these principles might work as applied to the budget and regulatory processes of a large country while elaborating on other aspects of the relation between the pivotal mechanism and Thompson insurance, including further aspects of the incentive effects of the simple per capita surplus distribution or refund described above, in more detail. The important effects of combining the pivotal mechanism and Thompson insurance is the way in which it corrects for potential misrepresentations when preferences reflect both material and nonmaterial benefits and/or harms, or when participants believe the government's probability estimates are wrong. In addition, through combining the mechanisms, coalition problems associated with the pivotal mechanism are eliminated while giving significant added incentives for citizens to ensure an accurate representation of their preferences, i. e., overcoming the problem of rational ignorance.

In the following section, I explore these concepts in the context of particular distributive Federal programs affecting transportation and the environment. Based on Bailey's work, I will posit use of the pivotal mechanism for agenda setting and combined use of the pivotal mechanism and Thompson insurance in making final budget and regulatory decisions in a manner that will achieve efficiency while minimizing redistributive harm. The added feature here is the integration of Bailey's approach with the Limited Fund Mechanism (LFM) which, like Thompson insurance, uses information generated by incentive-compatible means to compensate losers and minimize redistributive harm, through a process I will now call "compensated incentive compatibility," or CIC.

The second added feature is the combining of the agenda setting process with incentive compatible Congressional voting, at least initially, at the referendum stage. Rather than voting by individuals through direct democracy (explored in a following paper), I rely on representative voting in Congress or by Congressional committees representing regions or states in the process of agenda setting. I shall describe first an agenda setting stage where the system is operating under the aegis of one (monopoly) advisory committee which establishes one set of options for departures from the status quo. The committee works with executive officers (EOs) who essentially represent the interests of constituent regions, i. e., the executive officers substitute for competitive regional committees. In terms of the composition of the committees, following Bailey, I assume about 300 citizens representing a complete cross section of the population with about 30 citizens each drawn from the ten regions of the country. The competitive alternatives may be drawn from 3600 citizens operating in regional committees (300 in each of the regions) with a similar number operating locally. I then turn to cases where there are competitive alternatives, e. g., a national committee's preferred alternatives competing with those of the executive officers or regional committees, where the decisions are made by Bailey's process in the context of Congressional voting via the VCG-Thompson mechanism. While the idea of such a method used in present legislatures may seem initially farfetched, one is usefully led into investigations of how it could be implemented in a second best setting.

Nobel Prize pundits (Science, October 18, 1996) credit successful applications of William Vickrey's idea to areas such as the spectrum and Treasury debt auctions, as a contributing factor in the award of Vickrey's prize. Why not now, in Vickrey's honor, extend the idea to expenditure allocation affecting distributive Federal programs? Following Vickrey's idea, an incentive-compatible approach to grant-in-aid design for distributive programs was initially set forth in an unpublished paper (Clarke, 1981), entitled "Reforming the Grant-in-Aid Pork Barrel," and was briefly described with respect to "A Limited Fund Mechanism" for allocating Superfund by Tozzi and Clarke (1983). More recently, Brough, Clarke and Tideman (BCT, 1995) described a compensated incentive-compatible approach first elaborated by Tideman (1979) to airport slot management and noise regulation. This method, described in BCT (1995) effectively separates the allocation of a resource (i. e. airport slots) from distributional questions, i. e., whether airlines should be entitled to landing rights as opposed to communities or the public at large. The method is an adaptation of the second price auction (Vickrey, 1961) and Clarke's demand revealing method for public goods allocations (Clarke, 1971).

With respect to distributive grants-in-aid (see Stein and Bickers, 1995), the following section of this paper illustrates the use of the procedure for allocating annual obligations to the state revolving funds (SRFs) under the existing EPA Construction Grant Program. The method could also be adapted to the implementation of the new Safe Drinking Water Act and Hazardous Waste grant management (Superfund). See, for example, Brough (1995).

By comparing a more practical, administrative approach with an admittedly more visionary one, it is possible to better gauge why the latter may appear less acceptable to real political actors and the general political science in the foreseeable future (see Introduction). Winning the hearts and minds of the general political science may simply require proving that the ideas work in simple administrative settings before trying them in somewhat more controversial settings where the new voting rules might supplant existing voting rules. The Nobel Committee noted that the Vickrey auction anticipated (by a decade) the theoretical development of the pivotal mechanism as a means of ensuring truth telling in public project tenders. I am hopeful that, in actual experience and within a decade, the use of the principles of the former (in spectrum and Treasury note auctions) could lead to use of the latter (also in voting on public projects) in appropriately designed institutional settings.

Revisiting the Limited Fund Mechanism: A Practical Approach

There is currently a wellspring of activity in converting from traditional grants-in-aid to revolving funds. Holcombe (1992) examined the general topic of revolving fund finance, focusing on the organization and administration of State Revolving Funds (SRFs) for wastewater treatment. A compensated incentive compatible (CIC) approach towards administration of revolving funds in general can be illustrated as follows.

Take, for example, the existing construction grant program funded in FY 1996 at approximately $2 billion in annual capitalization grants. Under the CIC method, an administrator would establish an initial interest rate, which might be 7% (say 2% below the market rate, so as to reflect the "disutility" associated with administrative strings and Federal requirements). This rate, would be based on evaluations by a national cost-benefit advisory committee and, in future years, also reflect for any given jurisdiction the revealed willingness to pays (WTPs) of other jurisdictions.

Suppose that the average state (J1) had an initial entitlement of S = $100 million. As shown in the following figure, however, J1 would take more and others would take less than their initial shares, and the willingness and ability to flex funds makes the derived supply of funds to each individual jurisdiction rather inelastic. Here, the supply of funds to J1 would be determined by subtracting the amounts that all others would take at 7% from the fixed $2 billion supply of funds. Assume, given a high elasticity, that this would equate with J1's demand for funds at a rate of approximately 7.25%. The amount that J1 would pay is determined in two parts. For an extra $10 million (A - S) over the entitlement level, it pays 7% and other jurisdictions are compensated by a similar amount. For the remaining or next $10 million (B - A), it pays an average of 7 and 7.25%, which is shown by the shaded area in the figure. This is essentially a VCG tax, also here called a general progress payment or GPP, which motivates jurisdictions to provide an accurate expression of preferences, albeit creating a small surplus of about $17,000 in extra annual interest payments for J1 over what is needed to compensate other jurisdictions at the rate of 7%.

Figure 1: Interest Rate Determination for State Revolving Fund (SRF)

The procedure can be viewed as a potentially more effective way of reconciling needs as provided by a formula or determined by a central administrator and the needs as perceived by subnational entities. As Holcombe notes (1992, page 55), the states receive very disparate portions of their EPA determined needs through the formula. "Two states -- Wyoming and North Dakota -- will receive more in SRF capitalization grants from the federal government than their EPA-estimated needs through the year 2008, while the bottom four states -- Arizona, Florida, Massachusetts, and Washington -- will receive only 5% of their estimated needs through 2008 in capitalization grants." For comparison purposes, Holcombe (footnote 11) notes that the median state receives about 14% of estimated needs through the year 2008; the large percentages given to some states is a result of an agreement that each state will receive a minimum percentage of the total of the money regardless of other factors.

With respect to a detailed elaboration of this approach in a separate paper, it is fairly easy to see how the administered system might be superior to simple trading or flexing of funds by simple agreement between the jurisdictions so as to, for example, achieve more efficiency in equating the marginal product of investment in a particular activity (i. e. toxic waste cleanup). Except for removing incentives to strategic manipulation to alter the equilibrium price of funds or the interest rate in small number interactions, the device may not be all that superior relative to trading, but it does have growing advantages when we adjust the aggregate level of expenditure. See BCT (1995), particularly in comparing CIC with zero revenue auctions which have been advanced in the environmental permit trading area as a means of achieving more allocative efficiency while preserving distributional stability.

The Limited Fund Mechanism (LFM) was originally advanced in the context of programs where the interjurisdictional spillovers (clean water, hazardous waste sites) were arguably small. However, this ignores the problem of substate allocation, where districts will vie for funds while letting the rest of the State pay for them. Also distributional considerations will intervene in that other jurisdictions may prefer, for example, that there be more clean-up of sites where, say, children are residing nearby as opposed to brownfields development where state WTPs might be higher.

Consider some additional examples of potential application to now evolving new revolving fund programs. EPA is now in the process of writing rules for the formula allocation of a new Safe Water Drinking Act program enacted this year. One could envision a set of simple per capita entitlements, followed by needs or cost-benefit assessments in which jurisdictions with higher "needs" would borrow amounts above their per capita entitlements and others would be compensated for receiving less (at assigned rates of compensation). In this and similar programs, the usual discretionary accounts (5 to 10% of the amounts allocated subnationally) would be allocated to states that exceed their entitlement levels by indications of their WTPs -- thus in effect paying variable matching rates depending on their demand for discretionary funds. In this way, a state with high needs makes a move from a simple per capita distribution (S in Figure 1) to point A (determined by the benefits assessment, which can also take account of projects with spillovers) and then to B (reflecting actual WTPs), creating a minimum surplus (as measured by the shaded area in Figure 1). This approach also minimizes distributional struggles in the initial allocation, where small states usually end up with some "minimum" allocation unrelated to "needs" (see Holcombe, 1992), and we avoid asking them to explicitly loan back funds when program managers may come to believe that these are their owned funds (a sort of flypaper effect).

Federalist Resource Allocation: Agenda Setting and the Pivotal Mechanism

I now turn, in more detail, to a second example involving the establishment of State Infrastructure Banks (SIBs) for transportation infrastructure. Currently, States are allowed to use up to 10% of their formula funds to capitalize the SIBs. I will not dwell here on programmatic features of the SIB that could lend itself to more administrative flexibility in allocation via the LFM. Suffice to say, a few large states would have likely used it intensively. About 10 large states with slightly less than one-half of the population had in fact about two-thirds the originally proposed allocations. In these contexts, the policy analyst would also have concern about strategic influences on the interest rate. Also the supply of funds may be relatively inelastic. In this program, for example, it was anticipated that in the startup the large States might be allowed to exceed outlay restrictions (15% in first year, then 52%, up to 100% by fourth year) as long as the total outlays for all states did not exceed an aggregate outlay limit characteristic of Federal highway aid programs.

To move now from the administrative realm to a more "speculative" realm, let us add in a feature of prominent "Truth in Budgeting" legislation (in the transportation area). This is the proposed use of the 4.3 cents (about $5.2 billion in gas tax money) used for deficit reduction. Suppose states could use a prorata share of this amount, while also assuming the debt repayment obligation, as long as they attempt to meet a performance goal of "maximizing the likelihood of minimizing harm" through beneficiary-related taxes and charges and the use of the funds is approved by the Congress. This idea, and Congressional use of a preference-intensity revealing voting rule to make decisions on budget size and restrictions, will be elaborated in Section C.

In terms of the following example, I will deal only briefly with LFM issues. However, suppose in the following table, option A represented the net present value (NPV) of projects financed by $100 million (10% of New York's unified grant) and option B represented the NPV of projects displaced in New York under current programs. Under this scenario, the LFM would allocate an additional $15 million in NPV costs over and above the interest rate applied to interstate allocations for comparable programs (Construction Grants, Drinking Water) described earlier. This might drive the rate to well over 8% as opposed to 7% in the previous illustrative construction grant project discussion (see also shaded area in Figure 1), and the rate may also be higher if the SIB programs are not subject to project restrictions (e. g. grant assurances) characteristic of Federal grant and loan programs.

Note here that the interest rate escalation may be such that we consider allowing states to turn to the $5 billion deficit reduction account, through procedures elaborated in the following section. Here we assume that the supply of funds is sufficient to finance most worthwhile projects with positive NPVs at reasonable social discount rates.

The examples presented below describe how we make decisions on improved budgetary flexibility while also describing the pivotal mechanism in a couple of discrete case contexts. Suppose our voters were Metropolitan Planning Organizations (MPO's) or perhaps New York's 31 Congressional districts. The two alternatives below continue to be competitive projects. Option B is the project initially favored by the National committee, which uses pivotal voting among the national sample of citizens in project selection (see Bailey, 1996a). However, a competitive project is advanced by the Executive officers in the form of option B and adjustments are made in the internal cost allocations within the state by the Electoral Commission to ensure that there is no redistributive harm (i .e there are no negative redistributive impacts by jurisdiction when the projects are considered singly). The most impacted jurisdictions are then polled, again using pivotal voting to determine which project to select. If the benefit impacts were fairly diffuse, none of the Congressional districts might have (singly) a pivotal impact. However, suppose that New York (Urban) in the example below changed the outcome with the result that it paid a $5 million "Clarke tax" or GPP penalty (see Table 1). That is when this jurisdiction (New York City or the New York MPO) voting as a whole has its preferences taken into account, its vote is pivotal (i. e. when its preferences are excluded, option B would have been accepted by a vote of $15 million to $10 miliion with a difference of $5 million). Note also that the executive officers representing Other Regional and Other Regions could also be pivotal, except in this particular case when their preferences are excluded, the result would have been a tie, with no GPP penalty.

These other actors, of course, may have preferences for a particular configuration of services. Drawing from an example for agenda setting in a related paper, neighboring Vermont proposes a modification to City Hall's plan (a further development of an intermodal project involving New York's airport system which includes improved surface transportation access). In this context, a private party in neighboring Vermont (see Table 2) proposes a modification (option C) to City Hall's plan (option A) which has net benefits (also including option B).

	Options (Millions $)
	A	B
New York (Urban)	10	0
New York (nonurban)	0	15
Other Regional	5	0
Other Regions	5	0
Total	20	15

	Options (Millions $)
	A	B	C
New York (Urban)	10	0	10.1
Other Regional	9.8	15.0	9.6
Vermont	2	0	1.0
Total	20.0	15.0	20.7

In this case, Vermont is able to organize a complementary set of expenditures (using say a portion of 10% of its unified grant or $6.7 of $67 million), including those of New York's $100 million, to effect a $.7 million addition to total net benefits. With the selection of option C rather than the next highest option A, there is a slight improvement to New York, a $.2 million "leakage" (disbenefit) to other regions, and a $.8 million improvement for Vermont.

To effect this selection, Vermont would make a GPP payment of $.1 million because in the absence of its expression of net benefit, option A would have been chosen by a vote of $19.8 million to $19.7 million, or $.1million.

These pivotal payments are, of course, small change and could be considered as small adjustments in the interest rate on funds charged to the relevant beneficiary jurisdictions and their private partners. For example, if a base interest rate of 7% yielded some $75 million in present value over 20 years, over and above the $107 million in New York and Vermont capital investment in Option C, pivotal payments of a few million would be a small element in their decision calculations.

Also of importance is the incentive structure driving the agenda setters -- the National committee and the potentially cooperative (or competitive) executive officers as well as the Commission. The above example provides a convenient vehicle for introducing a specific incentive structure to properly motivate these actors. Following Bailey's constitution (1996a), a possible set of incentives would include payments that are a positive function of budget size (.1%), social gain over the status quo (3%) and a negative function (0.5%) of harms. For the advisory committee, this would be about $95,000 when we compare Option A over the status quo (B). Now if a private party is able to convince the committee to add in something like Option C, the incentives might be some 10 times larger. In addition to the small positive reward for budget size (0.1%), the incentive would be 30% of the net social gains less 5% of the harms. This would be shared between the private party and the committee.

The private party could also shop in regional and local legislative fora, putting together options that would compete formally with those advanced by the national committee. There would also be strong incentives to use funds earmarked for particular projects in areas where they may not be used most efficiently. For example, we have a lot of smaller states (like Vermont) as well as in the West and Hawaii that get a lot more in transportation funds than they pay in Federal gas taxes. The GPP gives them the choice of (1.) saving the funds if the opportunity costs are high enough (and reducing their own gas or other taxes with the interest proceeds), (2.) spending the funds for improvements that will improve the use of our cultural heritage while advancing conservation goals or (3.) more traditional projects (airport improvements and highways). To the extent that projects are financed through beneficiary taxes (including land rents), then the local taxpayers are able to invest the funds in projects elsewhere at rates approximating the social cost of capital.

National Resource Allocation: Combining the Pivotal Mechanism and Thompson Insurance

We now present a situation where the efficient rent seeking on the part of potential competitors (the national committee, the EOs and private parties) is very aggressive. Large projects with high rates of return are identified, along with reasonable cost sharing and beneficiary-tax plans that can be approved under the aegis of the Electoral Commission (and appropriate state authorities), so that the incentive-based rewards from selection of the more aggressive projects promise to be substantial.

Let me address first the issue of when we go from agenda setting with the pivotal mechanism to combined pivotal/Thompson representative referenda. The national committee, of course, uses the pivotal mechanism in its deliberations and to the extent this leads to the wisest decisions, no referenda will be needed. This will also be true the extent to which the potentially competitive EO's tailor regional/local solutions to achieving the highest net social benefit.

In addition, we have utilized, in the Federalist setting above, representative referenda guided by the agenda setting activities of the committee and the EO's. However, they operated under budgetary constraints and inflexibilties that might not be always appropriate. In effect, we might carry the agenda setting process to the point that most of the parties are in reasonably unanimous agreement about most resource allocational decisions. However, a remnant of controversy remains to be addressed in the national budget game. In addition, this forum is the appropriate place to make determinations on the question of overall budget size, as instanced by decisions to permit subnational governments to dip into the deficit reduction set aside through a particular decisionmaking procedure designed to implement "truth-telling" in budgeting.

To also address questions when a project requires referendum consideration, we might apply certain tests. In the above examples, we could have required that no project where the ratio of material gains less redistributive harms is less than 1.2 would be considered. This is the point where the incentive payments (i.e. 3% of net gains less 0.5% of harms turns approximately negative, at a more precise ratio of 1.16). This might be combined with a presumption against a pure pivotal payment of any significant size -- if pivotal (GPP) payments are generated, a Congressional referendum might be called instead. In the examples previously presented, we would guess the referendum test would be passed as the payments would be regarded as insignificant. In the examples presented in this section, the GPPs are quite large, even though the preferred alternative satisfactorily, but barely, passes the 1.2 test.

The examples illustrate a participatory approach to budgeting that grows out of a 1979 debate (Ferejohn, Forsythe, and Noll vs. Clarke) about the use of demand revealing in making budget allocations, e.g. for the Public Broadcasting Corporation's Station Program Cooperative (SPC). When I advanced the view that demand revealing was also indeed a potentially superior method of public budgetary decisionmaking (Tideman and Tullock, 1976), critics Ferejohn, et. al. (1979) Riker (1979) and others questioned its superiority by illustrating the susceptibility of the method to defeat by coalitions via zero sum games of traditional politics, including the traditional budgetary process.

Bailey (1996) shows that the pivotal mechanism working together with Thompson insurance is relatively immune from coalitions. In addition, the pivotal mechanism preserves the truth telling integrity of Thompson insurance.

Incentive-based Procedures

This section elaborates on the characteristics of the operation of the incentive-based budget procedure when there are major conflicts or controversies between 2 or more separately constituted bodies (the committee, the EOs, and private parties). The competitive process drives each body towards the most socially efficient solution, so there is likely to arise, at the margin, some small gain along with GPP payments, which is always the case if we were evaluating a continuum of budgetary choices. The conflicts also arise when the 2 or more committees are drawing up plans from two separate population samples (i. e. a regional advisory committee vs. a national one), or particularly when some specially chartered committee (essentially a private government) pursues plans at odds with the general population.

The following examples pertain to a wide variety of transportation issues (controversies over major mass transit or intercity rail investments in the New York region or the Northeast Corridor, building a new Interstate (I-31) or a NAFTA corridor through the heartland linking Canada and Mexico, or building a replacement bridge or tunnel for the Woodrow Wilson bridge in the Washington region). They are also being used, in a slightly different format, to illustrate national budgeting of air traffic control and airport investments.

In the current contexts, let me now introduce some ways of resolving the previously identified problems in relation to the actual budgetary parameters used in the earlier debate. I also posit fundamental differences between two competitive committees (national vs. regional) which allows me to explore further the properties of Bailey's approach to incentive compatible governance. In the following example, we have two alternative budgets (A and B) made up of different program packages -- see also tables 11-13 drawn from FFN and Clarke (1979) and reproduced here as Tables 3 and 4 -- that generate different patterns of net benefits for the users. The combinations based on gross costs and benefits presented in Table 4 boil down two most preferred packages, CDE and CDA respectively. Also, our nine regions have been cumulated into five where we have the result for the Middle Atlantic (Region 4), with 15% of the cost shares, presented in Table 3.

Table 3: Comparative Net Benefits for One Region

	Options (Billions $)
	A (CDE)	B (CDA)
Total budget level	3.000	2.850
Cost to region	0.450	0.413
Gross benefit	0.510	0.232
Less GPP	-0.128
Net	0.382

Note: With respect to illustrative budget allocations, the $3 billion total budget level in the example outlined here conforms closely to the FFN and Clarke model of demand revealing and an adaptation (by FFN) of Groves-type procedures in the allocation of an approximately fixed collective common user budget. We use the same gross payoffs, cost shares and net payoffs (after costs) as FFN and Clarke, the only difference being that all payoffs are multiplied by 10 to the 8th x a $30 budget level = $3 billion.

Table 4: Costs and Values of Programs to Regions

	Billions $
Program element	Cost of element	Region 1	Region 2	Region 3	Region 4	Region 5
A	0.60	0.30	0.18	0.24	0.12	0.48
B	0.90	0.12	0.36	0.60	0.18	0.30
C	1.20	0.48	0.84	0.66	0.24	0.54
D	1.05	0.36	0.60	0.36	0.30	0.72
E	0.75	0.12	0.54	0.36	0.42	0.18
Share of costs (%)
100%		10%	25%	30%	15%	20%

Costs:

The model created here now suggests that in lieu of the GPP payments to achieve the preferred outcomes (those shown in Table 5 being a theoretical upper limit that is reduced towards zero in large number interactions involving as many as 435 representatives), we substitute Thompson insurance. In the aggregate, region 4 buys .5 times (.510 less .232b) = .278b in insurance, receiving back a refund measured by an almost certain positive Thompson insurance surplus less incentive pay (see later discussion).

This net benefits and incentive tax calculations (GPP payments) among the five regions are as follows. The figures in parentheses reflect the net differences between options A and B (see Table 5).

Table 5: Net Reported Benefits and Calculation of Incentive Tax (GPP)

Region Millions $

Option A Option B Delta = A - B GPP

1
660.

885.
(-195.) 0.

2
1,230.

908.
(328.) 162.*

3
480.

405.
(085.) 0.

4
4,510.

232.
(278.) 128.*

5
840.

1170.
(-330.) 0.

Total
3,720.

3,570.
(150.)

Note: *The GPP is calculated by the difference is net benefit to all others when the other option (B) is chosen in the absence of the region's expression of net benefit (i. e. region 4's GPP = 3338 - 3210 = 128 million). See also Clarke (1979, Table 13).

To illustrate further, we take Clarke's (1979) analysis of the critical choice between CDA and CDE in the FFN model (see Table 5). With our new numbers, this critical choice implies a difference of $3.0 vs. 2.85 billion in the annual budget, for a difference of $150 million. There is also another proposed reallocation of $600 million from expenditures on A to be spent on E. However, if we apply the incentive tax procedure to the gross aggregations shown above in making the efficient choice of option A over B, given the cost shares, the result is $282 million in penalty taxes or GP payments.

The Electoral Commission, of course, has the incentive to try to get as close as possible to the ideal efficient distribution of cost. With a good knowledge of benefits and costs, the Electoral Commission could allocate $282 million more to parties 2 and 4 (54.2% vs. 45% of the cost of having E vs. A) and 9.4% less to parties 3, 5 and 1. We get $150 million in social gains at no cost. The extent to which this result can be achieved will depend, of course, on available information (including how well the sample of the citizenry predicts benefits for the population as a whole), on the costs of further search (including the tailoring of programs by the executive officers to particular regional/local circumstances), as well as such factors/limitations as available tax and budget flexibility (i .e. reasonable uniformity in tax assessments at the subnational level).

The above example reflects a situation where there would be strong pressures for a Thompson insurance referendum, absent successful negotiations between the opposing parties (2,3, and 4 vs. 1 and 5). Absent such agreement, the parties would now ask the Electoral Commission for odds on either side winning. Let us take these as equiprobable. Also the preferences are expressed solely in terms of material gain with the result that A is selected with total compensation of $525 million paid to regions 1 and 5, while reducing their harm to .5 x $525 million = $263 million. There is also a Thompson insurance surplus of $75 million which would be used to make incentive payments and cover administrative costs with the remainder returned to the participants through the refund procedure described earlier.

Returning now to the incentive payments described briefly above in the context of the New York-Vermont examples, we have the national committee with the winning proposal (A) receiving approximately $29 million in incentive payments. Of this there is $2 million relating to budget size, part of which has been shared with the other committee for common elements (CD) in the proposed budgets. There is another $27 million (or $45 - 18 million measured by 30% of social gain less 5% of uncompensated harm). According to Bailey, there would also be smaller payments to the members of the Electoral Commission unrelated to budget size, thus inducing that body to make appropriate Lindhal tax-transfers, to the extent practicable, to maximize social gain while minimizing redistributive harm.

The idea that Congress or any legislative body would ever use preference intensity voting rules may seem farfetched (see also Mueller, 1996, Ch. 11, also with reference to the use of demand revealing). However, as shown in a related paper on aviation governance, it is easier to see a government-controlled corporation administering airports and air traffic control governed by procedures analogous to those contained herein. The corporation would be subject to strong agenda control and the use of preference intensity voting would carry right up to a representative referendum described in this section where some form of determining budget size and restrictions is obviously called for. At that point, we might have to turn to more conventional tools such as qualified majority rules in the traditional legislature to resolve contentious issues. Nevertheless, the relative properties, and advantages/disadvantages of the preference-intensity revealing rules should be a lively arena for research, also applied to particular institutional settings explored in this and related papers.

In this paper, I have applied the same principles of agenda control to the allocation of distributive programs by the Congress. Professor Rubin and other skeptics may be right about the potential reluctance of "real political actors" and the "general political science" to adopt such procedures in real political settings. However, this should not be viewed as resulting from technical or operational limitations as much as the obvious difficulties inherent in changing our approach to the exercise of power and influence in matters affecting public decisionmaking.

How might all this play back in city or town hall? In concluding, I now link the national game to the results in Sections II. In these contexts, what happens to our projects advanced by the national agenda setter representing the projects designed in City Hall and town hall? The projects, presumably contained as marginal ones in the rejected package (CDA) advanced by the national committee contained about $207 million in project costs. The jurisdictions would have presented WTPs aggregating $35.8 million and paid about $17.9 in Thompson insurance. If they are in the end position of now loaning a unused portion of their entitlement, they would be compensated for savings at the compensation loan rate and receive additional net compensation approximating $17.9 million plus a refund of about $100,000 per Congressional district.

Even if they were proposing, as was the case, projects that exceed their entitlement levels (S in Figure 1), they would also receive up to one-half their revealed net willingness to pay, because, in part, they were included in a national budget package of projects that met a cost-benefit test with positive NPVs. They are compensated in part for this loss. In this sense, the procedure is a further refinement of the compensated incentive compatible procedure we introduced in Section III and elaborated later in the section.

The above has provided first-step suggestions concerning how we can use incentive-compatible procedures in selected areas concerning the allocation of resources to distributive governmental programs. As a first step, it could be applied to about $25-30 billion annually in transportation programs (as well as perhaps another $25-30 billion in environmental and communications infrastructure investments), while tailoring the associated regulatory regime to make these investments more productive. A complementary paper addresses issues of regulatory flexibility and local public goods provisioning, using some of the ideas contained herein to attack the problem of rational ignorance (See also Clarke, 1980 and Bailey, 1997).

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