Governments pay when they choose to renegotiate terms

I wrote yesterday about how the Indonesian government were handling a renegotiation of the terms of toll road concession contracts. 

As an example of how this works in countries with more mature regulatory regimes, this article talks about the Victorian government's decision to make trams free in the Melbourne CBD.

The government reported that they did it to help lower the cost of living, and to make it easier for commuters and tourists to use trams in the city. As the operator of the trams would be losing money as a result of this change, the Victorian government had the compensate them for the loss. The cost of the initiative was estimated at around AUD 100 million for the first year of operations.

Reasonable people can differ over whether making trams free is worth the money, or whether AUD 100 million is reasonable compensation for the loss, but the way the Victorian government handled the renegotiation was professional, transparent, and consistent with investor expectations, and good regulatory practice. 

A government like Victoria's knows that it's cheaper to pay AUD 100 million in cash than it is to run the risk of tarnishing their reputation with investors by trying to force the private operator to take the burden of their policy decision. Either way, they'll pay, at least this way they know exactly what it costs them.

All of this contributes to Victoria's perception as a low-risk investment destination, which flows through into cheaper goods and services for Victorian consumers.

User pays, or why public transport shouldn't be free

One concept you hear a lot about in the discussion of public services is “user pays.” This means that, as far as is productive, we should seek to impose the costs of a service on the users of that service. As always is in economics, there are some counterbalancing effects, but let me explain what “user pays” means and why it is a useful concept, then I’ll get in to the limitations.

Why user pays is good

It is very common for public services to not cover the full cost of their provision. In every country I am aware of, petrol taxes and car registration don’t remotely cover the cost of construction and maintenance of the road network. Even in the USA, a country famous for the high private cost of healthcare, the government pays the majority of costs every year. All over the world, water tariffs rarely cover the full cost of service

When the users don’t pay for the full cost of the service that society feels is necessary, the government must make up the difference from the pool of money it uses to fund other services. So, by putting money towards, say, water, you’ve got less money available to fund childcare, the military, arts grants, roads, libraries, tax breaks, or whatever else you like government to allocate resources to.

This can be a bad thing because it represents a wealth transfer from people that don’t use the service to people that do use the service. This is well-illustrated by public transport. I’ll use Melbourne, my home town, as an example, but this analysis applies to, say, Sydney, Singapore, Tokyo and most other cities I’m aware of with well-established well-maintained, highly-patronised public transport.

In Melbourne, the public transport system is based around trams, trains and buses. Trams and trains are mainly laid out in what is called a hub (the city centre) and spokes (various points around the periphery of the city), while buses operate mainly along radial routes. It’s a pretty comprehensive system, but according to a 2009 survey, “approximately 8.8% of the greater urban area and approximately 448,000 residents were serviced within 30 minutes of anywhere in the greater Melbourne area. This concluded that only 10–15% of the residents in Melbourne are serviced by appropriate and timely public transport.” 

Now, not all of these 10-15% of people ride public transport, and some of the 85-90% do ride public transport, but the 10-15% enjoy a disproportionately high share of the benefits from the subsidy to public transport. In fact, even if they don’t ride the trains at all, the 10-15% still benefit from increased property values associated with good access to public transport.

This might be OK if public transport users were disproportionately poor, but that’s not the case in Melbourne. Melbourne train and tram lines have been there for a long time, and because they’re pretty good, property values in areas with good access are higher than those with poorer access. The hub (the city) of the network is also the CBD, where the highest paying jobs are, further compounding this impact. As a result, people that can afford to live in areas with good access to public transport tend to be richer.

The very richest few percent will drive their own private cars, but even with those people removed, the ridership of Melbourne public transport is disproportionately wealthy compared to the general population*. And this is just talking within Melbourne, in fact, public transport subsidies are paid by the state government, so you're taking money out of the pockets of all Victorians, and handing it out to disproportionately wealthy, urban Melburnians.

How much is this wealth transfer worth? It’s a bit hard to estimate, because it combines operating subsidies, and capital expenditure, which can be lumpy depending on the year. In 2013, BITRE estimated total payments to Metropolitan tram, train and bus providers to be almost AUD 2 billion for the 2013 financial year, with farebox revenues covering approximately 30% of that amount. So, society as a whole bears, on average, 70% of the cost of a user’s trip, which represented around AUD 1.4 billion in 2013.

Most of us can agree that public transport has great benefits in decreasing congestion, and providing access to some proportion of poor people, but it’s hard to argue that cost recovery should be any less than it is currently across the whole population.

The limits of "user pays"

There are many cases where having direct users pay the full cost of service is a bad thing. Sometimes it’s just impractical; for example, how would you allocate the cost of running the military, or the diplomatic corps across society? In many cases there are positive externalities, like better overall health for society by having cheap access to healthcare. Or, we might just not like to be the kind of society that charges for access to public parks and libraries. If you were to charge the full financial cost for these activities, you might get outcomes that you don’t like.

I don’t know enough about the efficient costs of running Melbourne’s public transport network to say whether the current costs are inappropriately low or high, but assuming they’re pretty close to the mark, based on the 2013 numbers, we’d need to more than triple our farebox revenue to cover the full cost. Given higher costs would mean ridership would suffer, fares would need to more than triple.

It’s very possible that you would lose so many passengers that there would be no tariff at which Melbourne’s public transport network would cover its costs. Of course, that doesn’t mean we shouldn’t have a public transport system as there are a number of positive externalities that people can point to that might justify the subsidy.

  • Less congestion: More riders means less congestion, which means all of Melbourne gets around to where they need to get to more quickly. This means people in Melbourne get to spend less time travelling, and more time doing other activities that are relatively more valuable to society. As Melbourne generates most of Victoria’s GDP and taxes, this benefits Victorian society as a whole.
  • Cheaper (to society) than car ridership: We also need to compare transport costs with the next best option, and the cost to society of driving a car is higher than the cost of public transport. As road subsidies aren’t likely to change substantially any time soon, you need to price your public transport in that strategic environment.
  • Enhancing access: While the relatively richer disproportionately ride public transport, there are also a significant number of poor people for whom public transport represents their only access to certain parts of town. A subsidy to provide access to those people would seem appropriate to many.

Where externalities are particularly strong, you sometimes even see government paying people to access services. In April This American Life had a story on their podcast about a government program in Richmond, California that paid criminals in cash to turn their lives around. This is the very opposite of a strict interpretation of user pays. You’re finding people that are creating problems for people, and giving them cash out of everyone’s pockets. Yet, by This America Life’s report, it was extremely successful.

The balance

So, how do you know what you should make people pay for and how much they should pay for it?

I like to think that my definition of user pays already incorporates this idea of balance. Above, I said that as far as is productive, we should seek to impose the costs of a service on the users of that service. It is the job of government (and those of us that help them) to figure out what “as far as is productive” means, and try to use the pricing policy to achieve it.

In my experience, for public transport, and many forms of economic infrastructure, the socially optimal user charge is rarely zero.

Footnote: You can try to have it both ways, and many countries do, with price discrimination. The most extreme version I have seen of this was when I was in Mumbai in 2001. First class tickets on their commuter rail got you access to a (dramatically) less crowded carriage, with nicer cushions on the seats, but the tickets cost about 10 times the price of regular tickets!

Melbourne, and all Australian cities that I am aware of do something similar with concession fares for the young, pensioners, etc.

*I’m sure I have read a study showing this, but I can’t find one at the moment. If you find a link supporting (or challenging) this, please let me know.