Freeman

ARTICLE

Highways: Public Problems, Private Solutions

MARCH 01, 1985 by JOHN SEMMENS

Mr. Semmens is an economist for the Arizona Department of Transportation. The views expressed here are those of the author and do not necessarily reflect Departmental policy.

Early in 1984 an article in The Wall Street Journal was headlined: “In-terstate-Highway Building Projects Are Threatened by Political Stalemate.” The gist of the story was that House Speaker Tip O’Neill was holding a highway appropriations bill hostage in an attempt to get more money for a project in Boston.

The struggle over appropriations is a political struggle over the division of tax receipts. This type of struggle is both a manifestation of the “infrastructure crisis” and a contributing factor in perpetuating infrastructure problems.

The “infrastructure crisis” can be roughly defined as the observed or anticipated deterioration of public facilities like highways, bridges, dams, and the like. The phenomenon becomes a “crisis” because the cost to repair or forestall the deterioration is projected to exceed the available tax revenues. A middle range estimate of the tax revenue shortfall in the case of highways alone has been pegged at $60 billion per year. The magnitude of the forecast of needs easily dwarfs the recent increase in revenues of about $5 billion per year generated by the 1983 5-cent-per-gallon Federal gas tax hike.

The implication of such a huge gap between revenue and cost is that huge tax increases are necessary, perhaps even inevitable. However, before we get swept away in a stampede to throw money at the problem, it might be worthwhile to examine the situation more closely.

If the infrastructure problem is truly as large as some of the figures indicate, it is clear that mere tax hikes within the existing operational structure would be an inadequate answer. In the instance of highway finance, substantial effort was required to pass a 5-cent-per-gallon gas tax increase. Yet, this tax hike generates only $5 billion per year. Raising $60 billion would necessitate another tax increase of 55 cents (or more, allowing for some decline in fuel consumption under higher taxes). Such a large tax increase must be considered highly unlikely.

Since it is unlikely that such huge estimated highway needs can be met from tax revenues, the task of making do with less is of critical importance. Obviously, we cannot accomplish all that some think we “need” to accomplish. Choices will have to be made. Scarce resources devoted to some projects will unavoidably be denied to other projects. How these choices are made will determine whether the “infrastructure crisis” becomes the “infrastructure disaster.”

Changes Required

One point that should be crystal clear is that “business as usual” cannot be maintained. A premise behind the $60 billion annual gap between highway needs and revenues is that all existing facilities must be preserved. Since there won’t be a $60 billion tax hike, this premise be comes infeasible and no longer valid.

The notion that a highway, once built, must be preserved in perpetuity is both impractical and illogical. There is no way that a society can progress if it is to be constrained to carry on the upkeep of every investment it ever made. Roads, because of their long, useful lives, give the impression of permanence. However, there is a crucial difference between longevity and immortality. Times change, and the economic needs of a society change. The investments that were suited to an earlier era are not necessarily suited to the present or future eras.

No vital industry in a dynamic economy attempts to perpetuate every capital facility it ever built. Factories, offices, stores, machines—all wear out, become obsolete, or are replaced by other uses for resources. In fact, failure to anticipate the obsolescence of old facilities is a major drain on an industry’s ability to cope with changing economic conditions. For example, the U.S. steel industry is plagued by aged facilities that threaten the survival of many firms.

Failure to deal with the fact of obsolescence in highways is a definite threat to the public infrastructure. Funds poured into the maintenance and preservation of obsolete roadways are funds that cannot be used to provide new roads. Highway segments that may have had substantial economic justifications when originally built may evolve into economic dinosaurs that consume disproportionate amounts of scarce resources. This endangers the viability of the entire system. Dealing with this situation poses a serious problem for public highway agencies.

While the phenomenon of obsolescence poses difficulties in both public and private sectors of the economy, institutional factors make it much harder for the public sector to cope with these difficulties. The common perception is that government is better situated to deal with problems like the infrastructure crisis. After all, the federal government has more revenue than any other entity in our economy. It has sovereign power to tax. It can borrow more money more cheaply. The federal government can even print money, if necessary. Despite this seemingly unlimited claim on resources, government is severely handicapped in dealing with economic problems.

Unlike government, private firms are forced to rely upon resources voluntarily obtained. Customers cannot be taxed. They must be persuaded to buy. Investors must be induced to provide capital. Resources are harder to come by and more costly than they are for the government. Yet, it is these constraints faced by the private firm that provide the institutional incentives for better economic performance.

Market Discipline

Restricted to only voluntarily obtained resources, private firms must respond to market demands. Their products must fulfill genuinely felt needs or they won’t make any sales. Their operations must be efficient or their competitors will undersell them. Their investments must produce profits or their capital will be depleted. The market provides strict discipline. Resources are channeled to those firms that make the best use of them.

The importance of this market discipline can hardly be overemphasized. The absence of this discipline in the public sector makes it impossible for even the most well-intentioned public official to efficiently employ resources. The products and services government provides are not really marketed to willing customers, so public officials have no feedback on real demand. True competition doesn’t exist, so there is little pressure to improve efficiency or demonstration of how to do it. There is no requirement to operate-profit-ably, so capital is depleted on investments with negative rates of return.

The private sector transaction between seller and buyer is clear-cut. The customer is not expected to pay for products or services he doesn’t receive. Likewise, businesses are not expected to provide products or services to those who don’t pay for them. The public sector transaction is not so clear-cut. Customers or even non-customers are taxed to pay for services they may or may not receive. Even in the case of public roads in which the user tax approach is employed, these types of inequities exist.

To begin with, nonusers have been paying a growing share of the total revenues devoted to highway purposes. A 1983 U.S. DOT study indicated that by 1980, nonusers were providing nearly 40 per cent of the funds spent on highways at all levels of government. The nonuser percentage has nearly doubled since 1960. The trend is clearly away from the strict user charge principle.

Inequitable User Charges

Even among highway users, the charges vary widely from the estimated cost of service for each type of vehicle. Imbalances between the cost to provide service and the revenues earned imbed inequities and inefficiencies into the user tax structure. For example, the current Federal tax structure charges heavy trucks less than the cost of service. A report by the Federal Highway Administration estimated that this year the heaviest trucks will pay 71 cents in taxes for each dollar’s worth of service. At the same time, smaller trucks would be paying up to $1.31 for each dollar’s worth of service. While this discrepancy may give the appearance of balancing out, the reality is that such a tax structure encourages an expansion of consumption by the heaviest vehicles. Since heavier vehicles are paying less than a compensatory use charge, the highway trust fund takes a loss on the transaction. These losses will tend to grow over time as more users are encouraged to consume these under-priced highway services.

Despite the fact that the charges for the heaviest vehicles do not recover the cost of highway services, intense lobbying to reduce these charges has occurred. This lobbying was successful in altering the tax structure to shift more of the tax toward smaller trucks. Thus, even though highway officials might like to charge compensatory rates, they will not be allowed to do so. In effect, Congress is mandating that the heaviest vehicles be served at a loss.

Congressional intervention in the pricing of publicly provided services presents some economic problems. The rates selected by Congress may make political sense, but be economically destructive. A private firm faced with such intervention by government would sustain serious losses. Government regulation of railroad rates helped make it a sick industry. Political control of highway user charges is having these same effects on the health of the highway system.

This is not to say that the highway agency will go bankrupt. These losses have been, and probably will continue to be, made up from nonuser subsidies and deferred maintenance. While the agency will not go bankrupt, the evidence does indicate that existing investments in highways are not yielding a positive return. The importance of obtaining a positive return is that capital is regenerated and increased. If the economy is to grow, regeneration of capital is necessary. Failure to regenerate capital leads inevitably to decline. The decline in one area could be forestalled by subsidies from other sources. This will, though, involve an opportunity cost in some other economic activity. Some other area would have to forego growth or suffer decline in order for highways to receive a subsidy.

Some will argue that highways provide much more in benefits than they consume in resources. Unfortunately, this is merely an assertion. The evidence indicates that the cost exceeds the value as represented by user charges paid for the service. Granted, the current user tax schedule may not adequately assess the users for services rendered, but it is the only quantifiable measure that we have. It is only by observing the actual paid-for use that we can begin to get an idea of the value of the service rendered by the highway system.

Improved Accounting

So-called cost/benefit studies that presume to sum up consumer surplus and indirect benefits that then exceed the costs of highway investment are not adequate substitutes for positive financial returns. The reason for this inadequacy is that values are subjective. An analyst’s estimate of what he thinks the investment conveys in terms of benefits is only an opinion. Every form of economic activity produces consumer surpluses and indirect benefits. However, none of these benefits are included in the financial returns reported for various investments. To include them only for highway investments or only public sector investments is a distortion that systematically biases the results. Namely, it makes the public sector use of funds appear more productive than it actually is.

To help put the concept of cost/benefit in perspective, if such an approach were used for all prospective uses of capital, the policy implication would be that every undertaking deserved to be subsidized by every other undertaking. Obviously, this is not possible. Consequently, attempting to economically rationalize investments with cost/benefit calculations cannot provide valid guidance for the allocation of scarce resources. Cost/benefit analysis can reveal how alternatives among a strictly limited list compare to each other. Such analysis cannot determine whether an investment is a productive use of resources.

The only valid means of determining whether an investment is a productive use of resources is to observe whether the revenues obtained from sales cover the cost of providing the services. Private sector enterprises get this sort of feedback on a regular basis. Unsurprisingly, the private sector has evidenced an accumulation of capital and growth of resources over time. In contrast, the public sector exhibits a propensity to consume capital. Public sector highways, rather than accumulating capital to meet future growth, seem to require constant infusions of resources from nonusers.

Competitive Pricing

There is the prospect of increasing user taxes to cover full costs of publicly provided services. While this has its positive aspects, it does present some problems. We could probably hike user taxes substantially and thereby generate a positive return on the highway agency financial statements. This would be due, in part, to the fact that the services provided by highways are more valuable than the cost under the higher tax structure. However, the improved financial returns would also be due, in part, to the monopoly position enjoyed by the public agency.

In the private sector, competition limits the ability of individual firms to charge excessive prices. The fact that customers could resort to competing suppliers gives the customers a strong bargaining position. The lack of competing suppliers in the provision of highway facilities elim inates the possibility of effective bargaining power for the driving public. Consumers cannot easily demonstrate their preferences in the public sector monopoly environment. That these preferences are significant can be discerned from the wide variations in earnings generated on different road segments.

Even though the existing tax structure for highway user charges leaves a lot to be desired in terms of pricing strategy, observing how these taxes translate into earnings on a segment-by- segment basis is instructive. For example, some highway segments yield returns far in excess of their cost. Others earn mere pennies on each dollar invested. In Arizona, State Route 181 is projected to lose 95 cents out of every dollar put into it. In contrast, urban portions of U.S. Route 60 are likely to produce substantial surpluses over cost.

The implication of these discrepancies in yields on various segments owes much to erroneous pricing of the services. Urban highway users are stuck with high prices for relatively poor service. At the same time, many rural segment users are paying far less than the cost of the ser vice. The monopoly position of the public highway system promotes this cross subsidy of rural facilities. In a competitive market, urban consumers would be less vulnerable to this type of exploitation. Profit seeking entrepreneurs would be encouraged to offer attractive alternatives in the urban areas.

In addition to inefficient and exploitive pricing structures, the public sector monopoly over highways reduces incentives to control operating costs. In the private sector, competition prompts firms to restrain overhead costs. Lean operations allow for a better service/price offering to the consumer. Firms that allow overhead to get out of control will be unable to offer as good a deal and still maintain profitability. Monopoly removes the pressure to control internal costs. The effect of public sector highway monopoly on overhead cost is as would be predicted. In the early 1960s, the ratio of overhead expense to actual construction was about 7 per cent. By the early 1970s overhead expense was up to 12 per cent of construction outlays. By the 1980s, overhead had reached 17 per cent of construction outlays. With no competitive pressure to encourage restraint, the public sector highway monopoly has allowed greater proportions of resources to be consumed in administering programs. This means less is available to provide usable facilities and services.

The Privatization Option

Examination of the status and performance of the public highway system reveals an operation plagued with problems. Operational inefficiency, an inequitable tax structure, inability to discern and serve consumer demand, and malinvestment of scarce resources are pervasive characteristics of public sector ownership and control. In fact, Federal law goes out of the way to mandate practices that unnecessarily impede efficiency. A classic example is the Davis-Bacon Act. The Congressional Budget Office estimates that the procedures required by the Act add 4 per cent to the cost of highway construction. While 4 per cent may not sound like much, on a multi-billion dollar construction budget it is substantial. The annual cost of road construction in the United States is probably around $1 billion higher than it has to be as a result of Davis-Bacon.

Bad as the record of public sector ownership and control is, the alternative of privatization is usually portrayed as impractical. Critics of privatization plausibly ask: “Who would be willing to buy and operate roads?” Although the “obvious” answer to such a question is supposed to be “no one,” there are other possibilities.

To begin with, if the real answer is that no one would under any circumstances be interested in acquiring and operating any road segment, the facilities must have no economic value. Such a conclusion is patently false. Roads do provide important services having definite economic value. The existence of self-sustaining toll roads and bridges would seem to indicate that at least some properties could be operated profitably. From a historical perspective, it could be pointed out that privately owned and operated toll roads were common in the United States in the early 1800s. So, the notion that privately owned highways are infeasible is unfounded.

There are many existing highways that could be effectively adapted to a toll operation. The key advantage of a toll facility is the strong link between revenue and need. Only those who use the highway are required to pay. Service need not be provided at less than cost. The strong link between revenue and need provides the wherewithal and the incentive for better maintenance of the roadway. As a result, toll roads are almost always better maintained than nontoll roads serving similar traffic. Interestingly, Federal law explicitly prohibits the charging of tolls on highways that have received any Federal aid.

Tolls and Access Charges

It seems likely that privately operated toll roads could be an appealing option in some instances. In other instances, toll roads might appear unattractive. Opponents of the toll road concept lampoon the idea by conjuring up a vision of congested urban traffic brought to a standstill by toll booths at every intersection. Obviously, such a method of operation would be insane. Fortunately, there are some prospective remedies. First, access to urban road systems could be sold in larger units than one block of travel at a time. For example, the city of Singapore sells access to the central business district road system on a monthly basis. Many private sector businesses operate on this type of a marketing system. Access to health club facilities is a prime example of this method of charging for services rendered. Customers usually pay a monthly, quarterly, or annual access charge, not for each dip in the pool, weight lifted, or yard jogged. Fi nancing some road services via access charges would seem a feasible option.

Second, payment for road use could be automated, with traffic electronically recorded and billed periodically. The technology has already been developed for individualized vehicle identification, travel measurement, and billing. A test of equipment in an urban setting is already underway in Hong Kong. The private sector makes use of a related approach in automated scanning of universal product codes to speed traffic flow at retail cash register lines.

Third, highway facilities could be financed by indirect user charges. A frequent argument against the idea of privately owned roads is the problem of the “free rider.” Some contend that roadways must be public goods because of the difficulty of excluding nonpayers. On the one hand, this difficulty is exaggerated. Public agencies already exclude would-be users who don’t pay assorted charges like vehicle registration and driver’s license fees. On the other hand, even assuming that collecting directly from the user is difficult, there is another way.

In the twentieth century, the broadcasting industry grew from nothing to a pervasive part of modern life. Television and radio are multibillion dollar industries. Yet, their services are consumed for “free.” Viewers and listeners pay no money to broadcasters. Anyone with a receiver can consume the broadcasts without paying a dime. The industry is able to thrive by selling access to the audience of free broadcasts. The millions of viewers and listeners are of interest to advertisers.

Highways have millions of drivers and passengers on them every day. This provides the opportunity to sell space for communications. Billboards are one means of communicating. Though billboards can be seen from roads right now, they have been neglected as a source of revenue for sustaining the highway facility.

Tapping Real Estate Values

Another variation of the indirect means of finance would be similar to the method in which shopping center owners charge for lease space. High volumes of traffic improve retail sales and, consequently, lease rentals. Highway facilities could link up with real estate developers to improve the traffic flow to and from a location and receive compensation from the property owners based on the traffic volume. As it now stands, public sector highway construction creates improved real estate values, but receives no revenues based on these values. Windfall gains are created for the lucky or the well-connected real estate holders, while the highways end up losing money.

The above suggestions are meant to show how privately owned highways could conceivably succeed. After so long a period of public sector monopoly, there is no immediate, universally obvious alternative method of operation. Because we cannot now specify exactly how pri vatization would work for all situations does not mean that privatization is not a viable option. The whole point of privatization is that it will expose the problems of highway transportation to the initiative of entrepreneurs. The creativity of entrepreneurs in a market environment is the key advantage of privatization. That we cannot precisely predict what they will create is but further evidence of the shortcomings of centralized planning.

A transition period of experimentation and gradual change would seem advisable. A potential starting point for a transition to privatization could begin with the public sector’s divestiture of poorly yielding facilities. Why would a private firm want to acquire such facilities? Many business ventures are money losers. Yet, in the private sector, purchasers can usually be found for the disposition of the “assets” of failed ventures. Just because the government loses money in the operation of a facility does not necessarily mean that a subsequent owner won’t be able to earn a profit. New management, combining old assets in new ways, can often turn losses into gains.

Selling the Losers

A program of divestiture would need to take a realistic approach. For one thing, public officials should not expect to recover the sunk costs of money-losing facilities. Assets of this kind can only be disposed of at a discount. In fact, for road segments that don’t even generate enough cash to cover out-of-pocket costs, the public highway agency would actually improve its financial condition by giving such segments to whomever will take them.

In addition to discounted prices for divested facilities, the public sector agency will have to avoid the temptation to heap debilitating restrictions on the operation of the privatized facility. Since the very reason for divestiture is the fact that the public agency cannot operate the facility in a cost effective manner, it would be unreasonable for the agency to impose restrictions on the new owner. Besides, the fewer the restrictions, the more salable the assets. The public sector will get better prices for divested properties if they are less encumbered.

As divestitures proceed, both public and private sector participants and observers can learn from experience. Successful techniques for transferring ownership and for operating the privatized assets can be imitated and improved upon. Unsuccessful examples can be analyzed to provide guidance for reducing negative outcomes in the future.

Over time, the highway transportation system should show marked improvement. The public agency’s financial condition will benefit from unloading deficit-ridden highway segments. Both savings in operating costs and revenue from the sale of assets will serve to relieve some of the financial strain. As facilities pass into different hands the prospects for service innovation and experimentation will increase. Highways could begin to be integrated into the more dynamic private sector economy. The successful highway entrepreneurs will make their investments grow. This will enable them to buy or build more segments. The infrastructure, instead of facing a future of deterioration and decay, would have an opportunity to grow and flourish.

ASSOCIATED ISSUE

March 1985

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