Optimal Delegation of Enforcement: Centralization versus Decentralization

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1 Optimal Delegation of Enforcement: Centralization versus Decentralization CESifo & OECD Conference on Regulation: Political Economy, Measurement and E ects on Performance Jing Xu UAB 30/08/2009 Jing Xu (UAB) Optimal Delegation of Enforcement: Centralization versus Decentralization 30/08/ / 15

2 Motivation Regulations: How to allocate regulatory powers at di erent levels of governments Jing Xu (UAB) Optimal Delegation of Enforcement: Centralization versus Decentralization 30/08/ / 15

3 Motivation Regulations: How to allocate regulatory powers at di erent levels of governments Environmental federalism: Distribution of envionmental management over di erent governmental level Jing Xu (UAB) Optimal Delegation of Enforcement: Centralization versus Decentralization 30/08/ / 15

4 Motivation Regulations: How to allocate regulatory powers at di erent levels of governments Environmental federalism: Distribution of envionmental management over di erent governmental level Only focus on regulatory policy Jing Xu (UAB) Optimal Delegation of Enforcement: Centralization versus Decentralization 30/08/ / 15

5 Motivation Regulations: How to allocate regulatory powers at di erent levels of governments Environmental federalism: Distribution of envionmental management over di erent governmental level Only focus on regulatory policy Compliance: 65% of industrial sources violates the air pollution limits by White House Council Jing Xu (UAB) Optimal Delegation of Enforcement: Centralization versus Decentralization 30/08/ / 15

6 Motivation Regulations: How to allocate regulatory powers at di erent levels of governments Environmental federalism: Distribution of envionmental management over di erent governmental level Only focus on regulatory policy Compliance: 65% of industrial sources violates the air pollution limits by White House Council ) Enforcement needed Jing Xu (UAB) Optimal Delegation of Enforcement: Centralization versus Decentralization 30/08/ / 15

7 Motivation Regulations: How to allocate regulatory powers at di erent levels of governments Environmental federalism: Distribution of envionmental management over di erent governmental level Only focus on regulatory policy Compliance: 65% of industrial sources violates the air pollution limits by White House Council ) Enforcement needed Local governments are more involved in tasks rather than policies Jing Xu (UAB) Optimal Delegation of Enforcement: Centralization versus Decentralization 30/08/ / 15

8 Motivation Regulations: How to allocate regulatory powers at di erent levels of governments Environmental federalism: Distribution of envionmental management over di erent governmental level Only focus on regulatory policy Compliance: 65% of industrial sources violates the air pollution limits by White House Council ) Enforcement needed Local governments are more involved in tasks rather than policies European Union Jing Xu (UAB) Optimal Delegation of Enforcement: Centralization versus Decentralization 30/08/ / 15

9 Motivation Regulations: How to allocate regulatory powers at di erent levels of governments Environmental federalism: Distribution of envionmental management over di erent governmental level Only focus on regulatory policy Compliance: 65% of industrial sources violates the air pollution limits by White House Council ) Enforcement needed Local governments are more involved in tasks rather than policies European Union USA: EPA and authorization Jing Xu (UAB) Optimal Delegation of Enforcement: Centralization versus Decentralization 30/08/ / 15

10 State Authority of National Pollutant Discharge Elimination System (NPDES) Jing Xu (UAB) Optimal Delegation of Enforcement: Centralization versus Decentralization 30/08/ / 15

11 Aim who is to set the policy? who is to implement the policy? Jing Xu (UAB) Optimal Delegation of Enforcement: Centralization versus Decentralization 30/08/ / 15

12 Aim who is to set the policy? who is to implement the policy? ) Which level of government is optimal for environmental enforcement? Jing Xu (UAB) Optimal Delegation of Enforcement: Centralization versus Decentralization 30/08/ / 15

13 Assumptions One country or union, two regions, each region has one representative polluting rm with emission: e i Firm s production function: µ i e 1/2 i (gain from avoiding the cost of reducing emissions) µ: bene t of a rm from polluting Each rm self-report their emission: z i Environmental policy exogenously determined: tax t w.r.t emission penalty rate r w.r.t evasion Inspection probability endogenously determined by either central or local agencies α: α C or (α D 1, αd 2 ) Monitoring not perfect: inspection e ectiveness θ i Pollution is public bad and damage depends on total emission: D(e 1 + e 2 ) = (e 1 + e 2 ) 2 Jing Xu (UAB) Optimal Delegation of Enforcement: Centralization versus Decentralization 30/08/ / 15

14 Sequence 1 Agencies (central or local) decide on inspection probability α Jing Xu (UAB) Optimal Delegation of Enforcement: Centralization versus Decentralization 30/08/ / 15

15 Sequence 1 Agencies (central or local) decide on inspection probability α 2 Firms simultaneously choose actual emission and report (tax charged w.r.t report emission) Jing Xu (UAB) Optimal Delegation of Enforcement: Centralization versus Decentralization 30/08/ / 15

16 Sequence 1 Agencies (central or local) decide on inspection probability α 2 Firms simultaneously choose actual emission and report (tax charged w.r.t report emission) 3 The agency applies the enforcement policy (true emission will be identi ed with probability θ if inspected) Jing Xu (UAB) Optimal Delegation of Enforcement: Centralization versus Decentralization 30/08/ / 15

17 Sequence 1 Agencies (central or local) decide on inspection probability α 2 Firms simultaneously choose actual emission and report (tax charged w.r.t report emission) 3 The agency applies the enforcement policy (true emission will be identi ed with probability θ if inspected) 4 If rm being caught as evader, he has to pay the evaded taxes t(e z) plus the penalty r(e z) Jing Xu (UAB) Optimal Delegation of Enforcement: Centralization versus Decentralization 30/08/ / 15

18 Firm s decision and government s enforcement strategy Second stage: rm maxmizes pro t Max π = e,z µe1/2 tz αθ(t + r)(e z) First stage: government s objective function Central:Max W (αc ) = π 1 (α C ) + π 2 (α C ) λ C (e 1 (α C ) + e 2 (α C )) 2 α C Local: Max W i (α D α i ) = π i (α D i ) λ i (e 1 (α D 1 ) + e 2(α D 2 ))2 i λ: concern of environment or population Tradeo s: Centralized enforcement: internalizing the negative externality Decentralized enforcement: account for the heterogeneity across regions Information, e ciency or cost advantages Jing Xu (UAB) Optimal Delegation of Enforcement: Centralization versus Decentralization 30/08/ / 15

19 Results: comparison of optimal enforcement Optimal inspection under centralized enforcement: 0 1 α C = 1 λc µ 2 1 (θ C 1 )2 + µ2 2 µ 2 1 θ C 1 + µ2 2 θ C 2 (θ C 2 )2 2 A 1/3 Optimal inspection under decentralized enforcement: 1/3 α D i = λ 1 θ D i (t+r ) i µ 2 i + µ2 j λ2 i λ 2 j Results (assuming λ C = λ 1 + λ 2 ): α C > α D i ) small heterogeneity across regions: λj < 1.5 or θ i θ j < 2.2 α C < α D i, α C > α D λ j ) regions have big di erences: i λj > 1.5 or θ j θ i > 2.2 α C < α D i ) big di erences in inspection e ectiveness between central and local level: θ C θ D > 3p 2 λ i Jing Xu (UAB) Optimal Delegation of Enforcement: Centralization versus Decentralization 30/08/ / 15

20 Results: comparison of welfare Optimal total welfare under centralized enforcement: 0 1 W (α C ) = 3 µ 2 1 θ C 1 + µ2 2 θ C 2 4 λ C µ (θ C + µ2 2 1 )2 (θ C 2 )2 A 1/3 Optimal total welfare under decentralized enforcement: W 1 (α D 1 ) + W 2(α D 2 ) = 3 µ 2 1 λ + µ2 2 1 λ 2 µ λ 2 + µ2 2 1 λ 2 2 λ 2 µ 2 1 λ 1 µ 2 2 λ 2 1 1/3 λ 2 2 total welfare (assuming λ C = λ 1 + λ 2 ): W (α C ) < W (α D 1, αd 2 ) ) big heterogeneity across regions in θ: θ i θ j > 3.4 local welfare (assuming λ C = λ 1 + λ 2 ): W i (α C ) > W i α D 1, αd 2, W j (α C ) < W j α D 1, αd 2 ) λi λ j < 0.85, µ i µ > 2.04, or θi j θj > 3.1 W i (α C ) > W i α D 1, αd 2 ) λi > 0.85, µ i µ < 2.04 or θi j θj < 3.1 λ j Jing Xu (UAB) Optimal Delegation of Enforcement: Centralization versus Decentralization 30/08/ / 15

21 Extension: Central and local governments have di erent agenda Central government puts more weight on environment: λ C > λ 1 + λ 2 (assume λ 1 = λ 2 = λ 0 ) Jing Xu (UAB) Optimal Delegation of Enforcement: Centralization versus Decentralization 30/08/ / 15

22 Extension: Central and local governments have di erent agenda Central government puts more weight on environment: λ C > λ 1 + λ 2 (assume λ 1 = λ 2 = λ 0 ) Central authority s perspective:w (α C )versusw (α D 1, αd 2 ) W (α D 1, αd 2 ) = 2 Σ i =1 π i (α D i ) λ C (e 1 (α D 1 ) + e 2(α D 2 ))2 Jing Xu (UAB) Optimal Delegation of Enforcement: Centralization versus Decentralization 30/08/ / 15

23 Extension: Central and local governments have di erent agenda Central government puts more weight on environment: λ C > λ 1 + λ 2 (assume λ 1 = λ 2 = λ 0 ) Central authority s perspective:w (α C )versusw (α D 1, αd 2 ) W (α D 1, αd 2 ) = 2 Σ i =1 π i (α D i ) λ C (e 1 (α D 1 ) + e 2(α D 2 ))2 Local authority s perspective: Σ 2 W i (α C )versus Σ 2 W i (α D i =1 i =1 i ) 2 Σ W i (α C ) = Σ 2 π i (α C 2 ) Σ λ i (e 1 (α C ) + e 2 (α C )) 2 i =1 i =1 i =1 Jing Xu (UAB) Optimal Delegation of Enforcement: Centralization versus Decentralization 30/08/ / 15

24 Extension: Central and local governments have di erent agenda Central government puts more weight on environment: λ C > λ 1 + λ 2 (assume λ 1 = λ 2 = λ 0 ) Central authority s perspective:w (α C )versusw (α D 1, αd 2 ) W (α D 1, αd 2 ) = 2 Σ i =1 π i (α D i ) λ C (e 1 (α D 1 ) + e 2(α D 2 ))2 Local authority s perspective: Σ 2 W i (α C )versus Σ 2 W i (α D i =1 i =1 i ) 2 Σ W i (α C ) = Σ 2 π i (α C 2 ) Σ λ i (e 1 (α C ) + e 2 (α C )) 2 i =1 i =1 i =1 W (α C ) < W (α D 1, αd 2 ), λ0 1 λ C 2 λ 0 λ C 1/3! 2/3 > θ 1 θ 2 1+ θ1 θ2 2 heterogeneity in θ is large and local concern λ 0 is high Jing Xu (UAB) Optimal Delegation of Enforcement: Centralization versus Decentralization 30/08/ / 15

25 Extension: Central and local governments have di erent agenda Central government puts more weight on environment: λ C > λ 1 + λ 2 (assume λ 1 = λ 2 = λ 0 ) Central authority s perspective:w (α C )versusw (α D 1, αd 2 ) W (α D 1, αd 2 ) = 2 Σ i =1 π i (α D i ) λ C (e 1 (α D 1 ) + e 2(α D 2 ))2 Local authority s perspective: Σ 2 W i (α C )versus Σ 2 W i (α D i =1 i =1 i ) 2 Σ W i (α C ) = Σ 2 π i (α C 2 ) Σ λ i (e 1 (α C ) + e 2 (α C )) 2 i =1 i =1 i =1 W (α C ) < W (α D 1, αd 2 ), λ0 1 λ C 2 λ 0 λ C 1/3! 2/3 > θ 1 θ 2 1+ θ1 θ2 2 heterogeneity in θ is large and local concern λ 0 is high 2 Σ W i (α C ) < Σ 2 2/3 W i (α D 2 i ), 1/3 i=1 i=1 ( λ 0 C )1/3 λ (2 0 > θ 1 θ2 λ C ) 1+( θ 1 θ2 ) 2 heterogeneity in θ is large, and λ 0 is either very high or low comparing Jing Xu (UAB) to λ Optimal Delegation of Enforcement: Centralization versus Decentralization 30/08/ / 15

26 Central and local agencies preferences of enforcement do not coincide x = 2λ 0 λ C, y = θ i θ j Jing Xu (UAB) Optimal Delegation of Enforcement: Centralization versus Decentralization 30/08/ / 15

27 Extension: the agency objective weights environment and inspection cost Centralized: W (α C ) = λ C (e 1 (α C ) + e 2 (α C )) 2 2φ C α C Decentralized: W i (α D i ) = λ i (e 1 (α D 1 ) + e 2(α D 2 ))2 φ i α D i φ : monitoing cost parameter Results similar with the case where government weights pro t and environment E ciency e ect shown more clearly: decentralized enforcement preferred going from centralized to decentralized enforcement constitutes a Pareto improvement when λ C > λ 1 + λ 2, if local inspection e ectiveness is higher, the central and local agencies will not agree with each on optimal enforcement structure. Jing Xu (UAB) Optimal Delegation of Enforcement: Centralization versus Decentralization 30/08/ / 15

28 Central and local agencies preferences when the agency weights environment and cost x = 2λ 0, y = θd λ C θ C Jing Xu (UAB) Optimal Delegation of Enforcement: Centralization versus Decentralization 30/08/ / 15

29 Main Conclusions Which enforcement structure is preferred depends on the charateristics (assuming λ C = λ 1 + λ 2 ) If heterogeneity across regions or local cost/information advantage is strong enough, decentralized enforcement is favored. Only when local cost/information advantages are high will it leads both regions better o under decentralized enforcement (without transfers). When the central concern on the environment is much higher than local consideration (λ C > λ 1 + λ 2 ) If regions are very di erent, or the local concern is relatively low and the local inspection e ectiveness is higher, then the central government desires the centralized enforcement while the local authority prefers the opposite. Applications: Weakness of international environmental agreement: no incentives for compliance ) policy design may focus more on regional institutions Non-environmental enforcement with inter-jurisdictional externalities: patent and copyright Jing Xu (UAB) Optimal Delegation of Enforcement: Centralization versus Decentralization 30/08/ / 15

30 THANK YOU!! Jing Xu (UAB) Optimal Delegation of Enforcement: Centralization versus Decentralization 30/08/ / 15