text:
- About Us
- Issues
- Scorecards
Get Informed
- Join
- Connect
- Take Action
- Store
Get Involved
- Contact
- Foundation
- Privacy Policy
Contact FreedomWorks
400 Capitol Street, NW
Suite 765
Washington, DC 20001
- Toll Free 1.888.564.6273
- Local 202.783.3870
400 Capitol Street, NW
Suite 765
Washington, DC 20001
Government goes to those who show up. FreedomWorks makes it easy to hold your elected officials accountable in our fully interactive Action Center.
Find activists, groups, and events right in your own neighborhood. Join FreedomConnector to get involved and learn more about key issues threatening our economic freedom. Whether you're looking for like-minded people, trying to boost your existing group's impact, or simply trying to stay up on current events, FreedomConnector is the place to start. See what's happening in your state today!
Get Connected400 Capitol Street, NW
Suite 765
Washington, DC 20001
Given the dynamics of the 2000 presidential race, special interest groups, politicians, and the media have focused great attention on environmental quality in the state of Texas. Vice President Al Gore and his allies portray Texas as an environmental wasteland, and lay this alleged catastrophe squarely at the feet of Gov. George W. Bush. However, an objective look at the environment in Texas shows that, while there are unquestionably challenges remaining, the state has made significant progress over the past five years.
Given the dynamics of the 2000 presidential race, special interest groups, politicians, and the media have focused great attention on environmental quality in the state of Texas. Vice President Al Gore and his allies portray Texas as an environmental wasteland, and lay this alleged catastrophe squarely at the feet of Gov. George W. Bush. However, an objective look at the environment in Texas shows that, while there are unquestionably challenges remaining, the state has made significant progress over the past five years. In fact, environmental quality in Texas is as good or better than in many other states in the country.
In 1995, Texas saw ozone readings soar as a heat wave blanketed the state. Levels of other airborne pollutants reached dramatic levels. Hundreds of millions of pounds of toxic releases were reported on the Environmental Protection Agency's (EPA's) Toxic Release Inventory (TRI). In the words of the Sierra Club, former Gov. Ann Richards had left the state a "mess."
That Texas faces environmental challenges should come as no surprise. Houston alone has 25 percent of the nation's refineries and 60 percent of the petrochemical industry, major sources of pollution. Yet even with such a large concentration of industry, environmental conditions have improved significantly since 1995.
Despite measurable progress, Texas' environmental record has come under fire from special interest groups, Vice President Gore, and members of the media. These highly partisan criticisms deserve an objective analysis, since they imply that the hard work and sacrifices made by Texans to clean up their state have been in vain.
Texas has already endured a number of political attacks on its environment this election year, and more are certain to come. The millions of dollars spent on these negative ads and partisan charges will do nothing to help further improve the state or the quality of life for its citizens. Rather then dabbling in political campaigns, those who claim to care about the environment should focus on taking actions that will actually improve the quality of the air, land, and water. Such positive actions would benefit all Texans, and all Americans.
Full Study:
Citizens for a Sound Economy
Issue Analysis 109:
Clearing the Air: The Environmental Record in Texas
(PDF format, 9 p. 136 Kb)
Given the dynamics of the 2000 presidential race, special interest groups, politicians, and the media have focused great attention on environmental quality in the state of Texas. Vice President Al Gore and his allies portray Texas as an environmental wasteland, and lay this alleged catastrophe squarely at the feet of Gov. George W. Bush. However, an objective look at the environment in Texas shows that, while there are unquestionably challenges remaining, the state has made significant progress over the past five years.
Regulators and policymakers alike have expressed a seemingly sudden interest in overhauling the way stocks and stock options are traded. There are several reasons. Investor protection has become a populist issue, because more than 76 million Americans now own stock directly or through mutual funds and retirement accounts. A March 2000 Gallup survey revealed that 61 percent of American adults own shares. At the same time, new technologies make it possible to trade shares more quickly than ever before, often replacing many people with a few computers. Internet-based brokerage firms offer commissions one-tenth as large as those charged by traditional brokers. Established financial markets face competition from brokerage firms that match up their own customers' buy and sell orders, and from innovative trading institutions like Electronic Communications Networks (ECNs), which allow buyers and sellers to trade directly with each other.
Amidst all this change, two related issues have sparked concern in Washington: "market fragmentation," and the prices charged for "market data." Fragmentation occurs whenever a security trades in multiple locations, and traders in one location cannot easily trade with those in the other location. Fragmented markets might deprive some buyers and sellers of the opportunity to trade at the best possible price. Market data consist of securities price and quotation information sold by several consolidation networks on behalf of the stock markets that produce the information. Regulators fear that the networks selling the data are monopolies that charge excessive prices. The Securities and Exchange Commission (SEC) has solicited comments on both sets of issues.
Securities regulation can be quite arcane, but the fundamental issue is simple: will regulation promote centralization and stagnation, or will it promote diversity and innovation? Unfortunately, many regulatory proposals are heavy on centralization and light on innovation. To make matters worse, the perceived problems they seek to solve were often created by existing law and regulation. If regulators genuinely seek to promote investor interests, they will take competition, diversity, and innovation as their watchwords.
In the 1970s, Congress and the SEC sought to create a "National Market System" for stocks by establishing centralized systems for reporting price information and facilitating trade across different equity markets. Unfortunately, the Intermarket Trading System can no longer keep pace with varying speeds of innovation in many different equity markets. Treating the dissemination of price data as a monopoly public utility has led the SEC to the edge of the price regulation swamp, and we can only guess whether the commission will plunge right in or recoil in horror once it considers the experience of other utility regulators.
No one quarrels with the fundamental goal of reducing information and transaction costs. However, the results of federal policy suggest that centralization, standardization, and monopolization impose substantial costs on investors. Additional regulations that seek to address problems created by this approach will only plunge the SEC ever deeper into micromanagement of the financial industry – a result the commission says it historically has tried to avoid.
Innovation and diversity can best be promoted through voluntary, bilateral trading links and competing information dissemination networks. To accomplish these goals, regulators and legislators should forbear from forcing the financial industry to develop a centralized set of trading links to replace the outmoded Intermarket Trading System. In addition, the SEC and Congress should explore strategies to promote competition in market data dissemination. These policies would allow financial firms and stock markets to compete by offering investors a diverse array of information and trading opportunities.
Full Study:
When Alabama CSE was listening to its members talk about civil justice reform during "CSE Day" at the State Capitol, the most profound wisdom came from a college student. He put it simply, "If you know the two things that rule the world, [they are] money and power. Arbitration takes both of those away from the attorneys."
With the public's increasing acceptance of both alternative dispute resolution and technology, the trial lawyers are sometimes (and rightfully so) feeling like useless middlemen that even the average consumer can work around. In a world where individuals are a mouse-click away from virtually limitless information, people are discovering that there are many things they can do for themselves that they would never have dreamed possible just a few short years ago.
Arbitration has effectively cut trial lawyers out of a big piece of the action, leading them to launch an assault upon this form of dispute resolution before it grows even stronger. From California and Alabama to the U.S. Congress, the trial lawyers have enlisted their allies to propose anti-arbitration legislation in the guise of consumer protection. In fact, the drive to eliminate arbitration and other forms of alternative dispute resolution has nothing to do with the consumer and everything to do with self-interested motives of the trial lawyers.
Compared to long and expensive court proceedings, arbitration offers a more timely and cost-effective way of settling disputes. In fact, 71 percent of adults believe lawsuits take too long to resolve disputes over money. Additionally, when individuals are informed that the cost of arbitration is typically 75 percent less than the cost of litigation, 82 percent of adults said that they would instead opt for arbitration.
Some studies show arbitration may not only be more efficient in terms of time and money, but more effective overall as well. An American Bar Association study shows that while consumers prevail 71 percent of the time in court, they win 80 percent of the time when they settle matters through arbitration. In the case of non-union employment suits, there is an even starker contrast. While plaintiffs in such employment cases win between 15 percent and 17 percent of the time in court, they win between 63 percent and 74 percent of their claims under arbitration.
It is not the consumer rights groups and advocates that we see attacking arbitration, but rather trial lawyers and their political allies who use our legal system for personal gain. The empirical evidence is clear – arbitration benefits consumers. It enhances consumers' access to a more efficient and cost-effective means of solving legal problems. That is why consumer rights groups and advocates are not attacking arbitration. Only those with a vested interest in an expensive, time-consuming legal system – the trial lawyers and their political allies – oppose arbitration.
The United States Congress and state legislatures need to continue to support efforts to make arbitration more, not less, available to consumers. Under the maxim put forth by the college student from Alabama, it is clear that by taking away the money and the power of the trial lawyers via arbitration, we can give back our legal system to decent, honest Americans with real grievances.
Full Study:
Summary When Alabama CSE was listening to its members talk about civil justice reform during "CSE Day" at the State Capitol, the most profound wisdom came from a college student. He put it simply, "If you know the two things that rule the world, [they are] money and power. Arbitration takes both of those away from the attorneys."
Executive Summary
Stock markets traditionally have used dealers called "specialists" or "market makers" to match buyers with sellers and post prices that balance supply with demand. Recent changes in NASDAQ market rules introduced competition from "Electronic Communications Networks" (ECNs), which let investors bypass the market makers and make offers directly to other market participants. ECNs reduce the marketplace spread between prices offered to buy and sell stocks, saving investors money. NASDAQ spreads are 10 to 13 percent lower when set by offers on ECNs. In addition, buyers and sellers matched through an ECN avoid paying the spread altogether, Commission rules. This change would make it easier for them to trade stocks listed on the New York Stock Exchange, in competition with NYSE market makers. reducing transaction costs by as much as 95 percent. ECNs also give investors better information about others' offers to buy or sell, which helps individuals make better investment decisions.
Some Electronic Communication Networks have applied for recognition as independent stock exchanges under new Securities and Exchange Commission rules. This change would make it easier for them to trade stocks listed on the New York Stock Exchange, in competition with NYSE market makers.
Established stock markets have proposed big changes to meet this competitive challenge. The two largest – the New York Stock Exchange and NASDAQ – plan to convert from member-owned organizations to shareholder-owned companies. This change would help them raise capital to upgrade their technology and establish new organizational structures that would facilitate innovation and reduce the cost of stock trading.
In this changing environment, how can regulators best protect America's 76 million shareholders from fraud and abuse? Ongoing technological and organizational innovations enhance investor protection by increasing competition, improving the availability of information, and creating superior incentives for effective self-regulation. Therefore, regulators can best protect investors by allowing these innovations to unfold.
Competition at the Stock Market
To see how financial market innovation affects investors, it is useful to understand how competition currently sets stock prices. Each stock market has one or more dealers for each stock. These dealers are called "specialists" on the NYSE and "market makers" on NASDAQ. They do three things: (1) match buyers with sellers, (2) publicly post prices that they hope will balance supply and demand for the stock, and (3) stand ready to buy and sell at the posted prices.
Dealers make their money on the spread between the price at which they offer to buy a stock and the price at which they offer to sell. In this sense, the specialist or market maker is like a used car dealer. A used car dealer makes more money if there is a large spread between the price he pays and the price at which he sells. People choose to buy from used car dealers because they provide a valuable service: it is more convenient to shop at a dealership than to shop through the newspaper classifieds. Similarly, going to a specialist or market maker at the stock exchange is much simpler than phoning a bunch of different brokers to see who has orders to buy or sell at various prices. The spread compensates these dealers for their willingness to serve as a buyer or seller of last resort.
The United States has three primary stock exchanges that each trade different stocks: the New York Stock Exchange (NYSE), the American Stock Exchange, and NASDAQ. Other stock exchanges, such as Philadelphia and Chicago, primarily trade stocks that are also listed on one of the big three exchanges. The New York and American Stock Exchanges have a single specialist for each stock that trades on the exchange. But even a sole dealer in a stock on an exchange faces at least three types of competition: dealers on other stock exchanges, floor traders, and limit orders. The NASDAQ market also features multiple market makers on the same exchange and competition from relatively new players called "Electronic Communications Networks."
Competition between exchanges
Many stocks are traded on more than one exchange, so even a single specialist on an exchange must compete with those on other exchanges. To fill an investor's order for Procter & Gamble stock, for example, the broker can go to the NYSE, one of the regional U.S. stock exchanges, or in some cases, an overseas stock exchange.1 To get business, the NYSE specialist has to offer prices at least as good as those offered by specialists on other exchanges that trade the same stocks. This is not just a nice theory; economic studies find that dealers do improve their prices to attract business away from other dealers and exchanges.2
Floor traders
Traders on the floor of the stock exchange can also offer to buy or sell stock. These traders may represent other investment firms or institutional investors, or they may even be professional speculators hoping to make a profit through daily trading activity. Unlike specialists, floor traders do not have an obligation to buy and sell at posted prices.
Limit orders
A third form of competition comes from "limit orders." A buyer who places a limit order specifies the maximum price he or she is willing to pay. Similarly, a seller's limit order specifies the minimum price at which he or she will sell. To get business, a dealer must offer prices that are competitive with those represented by limit orders. (If an order simply states the investor will buy the stock at the prevailing market price, it is called a "market order.")
Due to these forms of competition, dealers do not even make a majority of the stock trades in the market. A 1996 study estimated that NYSE market orders were filled through trades with the specialist only 18 percent of the time. Floor brokers received the trade a little more frequently, 22 percent of the time. A whopping 55 percent of market orders were filled through trades with publicly-displayed limit orders, 4 percent with other market orders on the NYSE's electronic order system, and 1 percent through trades on other exchanges.3 These figures seriously understate the importance of competition from other exchanges, because they include only market orders sent to the NYSE. If orders sent directly to the other exchanges were included in the figures, the specialists' share of trades would be even smaller.
Multiple market makers
NASDAQ market makers also face competition from other market makers on the same stock exchange. Unlike the NYSE, which is a physical place, NASDAQ is an electronic market that links market makers and brokers via computers and telecommunications. Each NASDAQ stock has a potentially unlimited number of market makers. The actual number of market makers varies widely, depending on the type of stock. The largest 1 percent of companies listed on NASDAQ have an average of 47 market makers each. The smallest 10 percent of companies average five market makers apiece. The average number for a NASDAQ stock is 11.4
Electronic Communications Networks
Electronic Communications Networks (ECNs) allow brokers and investors to bypass dealers and transact directly with others in the market who want to buy or sell. If specialists and market makers are like used car dealers, ECNs are like classified ads. Some people choose to buy or sell cars through newspaper or Internet classifieds precisely because they do not have to pay a spread to a dealer. Sellers get a somewhat higher price, and buyers pay a somewhat lower price, than they would if they used a dealer as an intermediary. In the car market, buyers and sellers using the classifieds tolerate some additional inconvenience in exchange for the better prices. In the stock market, ECNs dramatically cut the cost and improve the ease of transacting directly with another buyer or seller.
Securities and Exchange Commission Chairman Arthur Levitt has characterized ECNs as "one of the most important developments in our markets in years – perhaps decades."5 There currently are nine ECNs. Prominent players include Instinet, Island ECN, Archipelago, and Bloomberg Tradebook. In September 1999, such networks traded approximately 22 percent of NASDAQ share volume and 30 percent of NASDAQ trades and dollar volume.6 In July 1999, a quartet of major investment firms announced plans to form yet another network.7
ECNs are not the same thing as online stockbrokers. New, heavily advertised companies like Ameritrade and E-trade pioneered this business, and now even established brokers like Morgan Stanley Dean Witter offer online trading as an option. Online trading simply allows investors to get stock information, review their accounts, and place orders via the Internet instead of walking into a brokerage office or phoning a broker. The broker can use an ECN to execute the order regardless of whether the investor placed the order using the Internet, a telephone, or a visit to a brokerage office.
Millions of Americans affected
The organization of stock markets now affects a large and growing number of Americans. There are 76 million shareholders in the United States – a figure equal to 43 percent of U.S. households. As that figure suggests, stock ownership is not just for the rich. Half of all shareholders have incomes of $50,000 or less. The number of shareholders has more than doubled during the past 15 years.8
Information is Crucial
Stock prices emerge through the competition of a wide variety of traders – specialists or market makers, floor traders, and institutions and individuals placing limit orders. Effective competition in stock trading requires widely available information about competing offers. For this reason, dealers' price offers for each stock are posted in all U.S. exchanges where a stock trades, via a network called the "Consolidated Quotation System." Traders located at one exchange can then offer to buy or sell at another exchange through the Intermarket Trading System. In addition, major stock exchanges publicly post most limit orders. Since 1997, NASDAQ has also publicly posted price offers made by buyers and sellers on ECNs.
The controversy over NASDAQ pricing practices in the 1990s illustrates the importance of information to competition. A scholarly study published in the mid-1990s claimed that spreads on NASDAQ stocks were artificially high because of dealer collusion. By way of comparison, average spreads fell by one-half to two-thirds when stocks traded on NASDAQ moved to the NYSE or the American Stock Exchange.9 Spreads for comparable stocks on the NYSE were about half as large as spreads of their NASDAQ counterparts.10 The high spreads partially reflected market makers' higher costs of holding NASDAQ stocks, but some researchers believe the spreads were excessively high even after taking this factor into account.11
Collusion may or may not have been a big factor, but poor information certainly widened the spreads. NASDAQ, unlike the NYSE, did not publicly post limit orders. Instead, limit orders were treated as private orders sent to market makers. Market makers could also make buy and sell offers on ECNs that were better than their public offers. Since limit orders and offers on ECNs were concealed from public view, market makers did not have to compete with them, and they could maintain higher spreads.12
Since January 1997, Securities and Exchange Commission regulations have required NASDAQ to publicly post the price, and in many cases the size, of limit orders. The requirement includes orders posted on ECNs, and market makers cannot post prices on these networks that are better than the prices they offer on NASDAQ. These changes forced NASDAQ market makers to update their price quotes more than twice as frequently to keep up with the competition – an average of 392,000 updates per day. An additional 195,000 daily updates flow into NASDAQ through ECNs, whose prices previously were not publicized.13
When the 100 largest NASDAQ stocks became subject to the new order-handling rules, spreads fell by 30 percent virtually overnight.14 More broadly, a NASDAQ study concluded that the 1997 changes reduced average spreads on NASDAQ stocks by between 22 and 33 percent, depending on how the spread was measured.15 A National Association of Securities Dealers study that controlled more carefully for other factors found that the order-handling rules reduced spreads on NASDAQ stocks by between 6 and 29 percent, depending on the type of stock, with a reduction at the median of 20 percent.16
These reductions benefit individual investors the most, because individual investors are more likely to pay the spreads. Institutional investors, such as mutual funds and pension funds, typically negotiate stock prices when they trade, and so they are more likely to get better prices than the publicly posted spread. Of course, to the extent that downward pressure on spreads gives institutional investors a better negotiating position, they benefit as well. For this reason, some of the benefits of the lower spreads no doubt show up as lower costs or higher returns in individuals' mutual fund accounts and pensions.
Electronic Communications Networks and Competition
Due to the crucial importance of information, ECNs are a powerful competitive force in stock trading. They currently affect competition at the stock exchanges in three ways:
They offer some investors a lower-cost alternative to trading with market makers.
They lower spreads in the marketplace by bringing more information about prices at which investors are willing to buy or sell.
They induce investors to make more accurate price offers by improving the quality and quantity of investors' information.
Lower transaction costs from matching limit orders
ECNs match up investors who place limit orders. When an ECN matches two investors' orders, they trade without paying a spread. On one leading ECN, for example, clients can trade stocks for one quarter of a cent per share – which means the buyer and seller together pay a half cent per share.17 Spreads on NASDAQ stocks, in contrast, averaged 15 cents per share in June 1999 – a thirty fold difference!18
Who benefits from this type of trading? The only spread-free trades are those in which both parties have placed limit orders. About half of NASDAQ trading volume involves limit orders, split about equally between individual and institutional investors.19 Of course, just because someone places a limit order does not mean it will get executed, or that the other party will also be someone with a limit order. Since ECNs can only match up limit orders, the volume of orders they match is one good measure of the prevalence of spread-free trading. In September 1999, at least 23 percent of NASDAQ trades occurred as a result of order matching on ECNs. These trades account for about 18 percent of the NASDAQ share volume and 24 percent of dollar volume.20
Better marketplace information lowers spreads
ECNs also benefit investors who place market orders by making market participants aware of better price offers. NASDAQ market makers compete against prices available from ECNs. Limit orders posted on ECNs actually determine NASDAQ spreads 6 percent to 15 percent of the time, depending on the type of stock.21 A 1999 study suggests that average spreads are 10 percent to 13 percent lower when set by a quote from an ECN.22 About one-quarter of NASDAQ volume consists of market orders from individual investors, and they are the primary beneficiaries of the lower spreads.23
Improved investor information
In the absence of ECNs, an individual placing a stock order has relatively little current price information. Newspaper stock listings simply report the price of the last trade the previous day, sometimes accompanied by the high and low prices for the day. A broker can tell the investor the price of the latest trade, and either the broker or the Internet can furnish charts of past price movements. But the investor knows next to nothing about the prices at which other traders are currently offering to buy or sell the stock, or how many shares others want to buy or sell at various prices.
ECNs allow individual investors to see others' limit orders. As a result, the investor understands how many shares are currently available at what prices, and how many shares others want to buy at various prices. An investor armed with this information is in a much better position to decide whether and how to place an order.24
Consider, for example, the decision of whether to place a market or a limit order. A market order guarantees that the investor will get the stock, but the investor runs the risk of paying a price much higher than expected if the market price suddenly rises before the order is executed. A limit order controls this risk but introduces new risk. If the market price is well above the investor's limit, there may be no seller. If the market price is well below the investor's limit, the investor might not get the best possible price.
This investor can better understand the tradeoffs involved by consulting an ECN. If there are many sell orders at close to the same price, then the odds are good that the investor can get a pretty predictable price with a market order. If prices vary more widely, then the investor might want to place a limit order to prevent a nasty surprise due to a sudden price run-up. Viewing others' limit orders also helps the investor decide what price to put on his or her own limit order.
The used car market again provides a useful analogy. An investor who places a market order after looking at yesterday's prices in the paper is like a car buyer who agrees to buy at some unknown "market" price after looking up a car's Blue Book value. An investor using an ECN is like a car buyer who consults the classifieds to find out what models and prices are currently available in the market.
A Lower Cost Stock Market?
Although ECNs have delivered significant benefits, their impact has also been limited by the fact that they trade mostly NASDAQ stocks. As a result, trading on the networks does not affect spreads on the large-company stocks listed on the NYSE or the growth company stocks listed on the American Stock Exchange.
That could soon change. Two ECNs – Archipelago and Island ECN – have applied to be recognized as independent stock exchanges, under new rules adopted by the Securities and Exchange Commission in December 1998.
Transforming an ECN into a stock exchange would be the first step in allowing it to compete effectively trading stocks listed on the New York and American Stock Exchanges.25 As an independent stock exchange, an ECN would be eligible to have its prices posted on the Consolidated Quotation System, forcing specialists and floor traders at the exchanges to compete with those available through the ECN.
Since stock exchanges already compete with each other, and some even allow multiple market makers, one might question whether the recognition of ECNs would increase competition in any meaningful way. Adding more of the same type of competitors in a highly competitive market may not benefit customers very much. But ECNs do more than that. They offer a lower-cost way of transacting that also produces more and better information for investors. Therefore, the most important effect of ECNs is not that they represent more competition, but that they provide better competition.
In addition to lower cost, ECNs can also execute trades faster than more conventional stock exchanges. An order delivered to the NYSE through its electronic SuperDot system takes 22 seconds to execute, while an ECN can execute the order in 2 to 3 seconds.26 In today's fast-paced financial markets, a ten-fold difference in execution time lets investors capture fleeting market opportunities that would otherwise vanish.
ECNs will not necessarily make specialists and market makers extinct, any more than newspaper and Internet classifieds have eliminated car dealers. However, they do pose a significant competitive challenge. To retain customers, dealers will either have to reduce spreads by cutting costs or find new ways of creating value for investors and brokers.
Dealers Respond to Competition
And that is precisely what dealers are trying to do. NASDAQ wants to create a single, centralized, public "book" of all limit orders that would effectively make NASDAQ more like a giant ECN.27 Both NASDAQ and the NYSE have announced later trading sessions. More importantly, both have floated plans to radically alter their organizational structures so they can compete more promptly and effectively.
The NYSE is currently owned and controlled by member firms who buy seats on the exchange – specialists, investment banks, securities dealers, individual speculators, and other parties. NASDAQ does not have seats, but it too is owned and controlled by the dealers who do the trading. If the NYSE and NASDAQ transfer ownership to shareholders through a public stock offering, their management would then be responsible to a diverse group of shareholders rather than committees of traders. Current traders could own stock, or they could simply use the organized market as a trading venue.
A force for market efficiency
The managers of the NYSE and NASDAQ likely proposed stock offerings because shareholder-owned firms are generally more flexible and responsive to change than user-owned firms.
Such flexibility is especially important in an era of sweeping technological change. Stock markets currently have opportunities to utilize ECNs and other information technologies to cut the cost of trading and give investors better prices. A market owned by traders, however, potentially faces a conflict between traders who benefit from the new technology and traders who profit from the current way of doing things. Converting a stock market to a publicly held, investor-owned enterprise gives its managers a single, clear goal: make their market as efficient as possible to attract the most trading business. The stock offering also generates funds to "buy out" dealers who would otherwise oppose change – much as two business partners might buy out a third who disagreed with their expansion plans.
Investors should welcome shareholder-owned stock markets. Research on other financial organizations reveals that shareholder-owned firms generally have lower costs and lower probability of failure than user-owned firms.28 The principal reason is that ownership by shareholders makes the organization's management more accountable for good performance. Since shareholders receive the profits, shareholders owning a large number of shares have strong incentives to monitor managerial performance. Since shares can be sold, owners have strong incentives to maximize the long-term value of the enterprise, rather than grabbing a quick profit. In addition, shareholder-owned companies can offer their employees stock and stock options as an incentive for good performance. Managers of shareholder-owned firms also face the threat of takeovers if they do not do a good job. For these reasons, investors can expect shareholder-owned stock markets to reduce the cost of trading and promote long-term survival of the market.
New regulatory challenges?
Stock markets currently practice extensive self-regulation under Securities and Exchange Commission supervision. SEC Chairman Arthur Levitt has raised questions about mixing a self-regulatory organization (SRO) with a for-profit ownership structure: "The potential for conflicts of interest that may arise if the SRO is enmeshed within a for-profit corporation must be defused. At the very least, I believe that strict corporate separation of the self-regulatory role from the marketplace it regulates is a minimum for the protection of investors in a for-profit structure."29 At the very most, others have proposed that stock markets' self-regulatory responsibilities be merged into a single "super-regulator" overseeing all markets.30
Stock markets currently enforce an assortment of rules whose intent is to protect investors by constraining certain activities of traders. Some rules are federally mandated, and others are developed by the markets themselves. The SEC chairman and some market observers argue that a market's management might be reluctant to investigate or discipline a trading firm that also had a large ownership stake in the market.31
However, it is not at all clear why this kind of undue influence is any more likely in a shareholder-owned market than in a member-owned market. NASDAQ, for example, was censured by the SEC in 1996 because its dealer-dominated oversight committees declined to investigate allegations of questionable dealer activities, such as collusion, failure to honor quoted prices, sharing customer information without informing the customers, and failure to indicate when trades were reported out-of-sequence.32 NASDAQ responded to the SEC's criticism by making its regulatory operations independent of its market operations and appointing a lot more outside representatives to key committees. These steps might not have been necessary if NASDAQ had been owned by a more diverse group of shareholders.
A shareholder-owned market likely has stronger incentives than a trader-owned market to promote honest dealing and transparency of price information. A trader-owned market faces a potential conflict between the long-run interest of the institution and the short-run interests of some it its members. The market as an institution benefits by developing a reputation for honest dealing and low transaction costs. A subset of members, however, may find it profitable to oppose moves that improve transparency and lower costs. Such moves could involve anything from technological innovations to enforcement of the market's own regulations that are supposed to promote investor confidence. It is easier for shady traders to rig the game if only traders own the market. It is harder if shareholders whose profits depend on attracting trading business from other markets own the market.
Even if some traders owned large blocks of stock in a for-profit stock market, the board and management of the institution would be responsible to all who own shares. Manipulating the market to benefit a subset of owners would invite a lawsuit from the remaining shareholders. For this reason, ownership by shareholders gives a stock market strong incentives to accomplish precisely what regulators want: an honest, low-cost marketplace that retains the confidence of investors.
It is even possible that the most profitable strategy for a particular market that wants to retain investor confidence is to separate its self-regulatory function from the actual operation of the market, as NASDAQ did under SEC prodding. Unfortunately, we have no way of knowing if this is in fact the best solution unless competing markets are free to adopt or reject it. Imposing it as a regulatory requirement prevents markets from trying other, possibly better, solutions.
"This is not a revolution; it's an earthquake." That's how Robert Schwartz, a finance professor at Baruch College, summarized ongoing changes in stock trading technology and market organization.33 Frank Zarb, chairman of the National Association of Securities Dealers, apparently agrees, noting, "You will not recognize these markets in five years."34
While Internet stock brokerage and day trading have garnered most of the headlines, the most important changes in stock trading are happening elsewhere. Aided by information technology, the U.S. stock systems are continuing their gradual evolution toward a single, national system in which everyone from limit order investors to the dealers and speculators must compete to offer the best prices. Even the exchanges themselves will have to compete to offer better prices and services. Electronic Communications Networks have facilitated this trend, and they could deliver even larger benefits to investors if they are recognized as independent stock exchanges. The NYSE and NASDAQ have responded to this competitive challenge by proposing historic changes in their organizational structure via public stock offerings.
Regulators and legislators can best serve investors by allowing these changes to occur. ECNs save investors money by lowering or eliminating spreads, and they have the potential to give investors more and better information about current market activity. For-profit stock markets will likely reduce transaction costs further as they jockey to attract trading business. For-profit ownership also gives the market's managers strong incentives to practice effective self-regulation. For this reason, proposals to replace each market's self-regulation with a "super-regulator" are unwarranted.
1The five regional U.S. stock exchanges are Boston, Chicago, Cincinnati, Philadelphia, and Pacific. Not all regional exchanges trade all NYSE stocks.
2Marshall E. Blume and Michael A. Goldstein, "Quotes, Order Flow, and Price Discovery," Journal of Finance 52:1 (March 1997), pp. 237-39; Mark Klock and D. Timothy McCormick, "The Impact of Market Maker Competition on NASDAQ Spreads," NASD Working Paper No. 98-04, pp. 11-12.
3Katharine D. Ross, James E. Shapiro, and Katherine A. Smith, "Price Improvement of Super Dot Market Orders on the NYSE," NYSE Working Paper 96-02 (March 11, 1996).
4See September 1999 market maker statistics at (http://www.marketdata.NASDAQ.com).
5Arthur Levitt, "Dynamic Markets, Timeless Principles," speech at Columbia Law School, Sept. 23, 1999.
6See September 1999 ATS figures at (http://www.marketdata.NASDAQ.com).
7The four are Fidelity, Charles Schwab, Donaldson, Lufkin, Jenrette, and Spear, Leeds & Kellogg LLP. See Wall Street Journal (July 22, 1999), p. C1.
8Richard Nadler, "The Rise of Worker Capitalism," Cato Institute Policy Analysis No. 359 (November 1, 1999).
9Most of the difference in spreads was accounted for by stocks for which NASDAQ dealers avoided quoting prices in "odd eighths" of a dollar, which was believed to be the rounding method used to widen the spreads. See William G. Christie and Paul H. Schultz," Why Do NASDAQ Market Makers Avoid Odd-Eighth Quotes?," Journal of Finance 49:5 (Dec. 1994), pp. 1813-40; Michael J. Barclay, "Bid-Ask Spreads and the Avoidance of Odd-Eighth Quotes on NASDAQ: An Examination of Exchange Listings," Journal of Financial Economics 45 (1997), pp. 35-60; Paul Clyde, Paul Schultz, and Mir Zaman, "Trading Costs and Exchange Delisting: The Case of Firms that Voluntarily Move from the American Stock Exchange to the NASDAQ," Journal of Finance 52:5 (Dec. 1997), pp. 2103-12.
10Roger D. Huang and Hans R. Stoll, "Dealer Versus Auction Markets: A Paired Comparison of Execution Costs on NASDAQ and the NYSE," Journal of Financial Economics 41 (1996), pp. 313-57.
11Hendrik Bessembinder, "The Degree of Price Resolution and Equity Trading Costs," Journal of Financial Economics 45 (1997), pp. 9-34.
12Harold Demsetz, "Limit Orders and the Alleged NASDAQ Collusion," Journal of Financial Economics 45 (1997), pp. 91-95. Huang and Stoll, "Dealer Versus Auction Markets," observed, "It is not so much that market makers implicitly collude as that the system provides no incentive for competition, at least in quotes."
14Michael J. Barclay, William G. Christie, Jeffrey H. Harris, Eugene Kandel, and Paul H. Schultz, "Effect of Market Reform on the Trading Costs and Depths of NASDAQ Stocks," Journal of Finance 54:1 (Feb. 1999), pp. 1-34.
16Numbers calculated by the author based on results reported in NASD working paper 98-02, which examines the effect of the limit order rules and NASDAQ's 1997 switch from quoting stocks in eighths of a dollar to sixteenths of a dollar. The combined effect was to reduce spreads by 7-34 percent. At the median, the limit order rules accounted for 85 percent of the spread reduction, so they were responsible for a spread reduction of about 6-29 percent. The term "at the median" refers to the spread reduction for a stock that has the median number of trades, price, float, and volatility. In some sense this could be thought of as a "typical" NASDAQ stock, though all four factors vary quite widely. See Jeffrey W. Smith, "The Effects of Order Handling Rules and 16ths on NASDAQ: a Cross-Sectional Analysis," NASD Working Paper 98-02 (Oct. 29, 1998).
17Hal Lux and Jack Willoughby, "May Day," Institutional Investor (Feb. 1999), p. 45.
18See "Market Quality Statistics" at (http://www.nasd.com).
19Conversation with Jeffrey W. Smith, NASD economist, October 1999.
20Figures for ECN market shares are from "Market Quality Statistics," at (http://www.marketdata/NASDAQ.com). Some ECNs report trades they execute with dealers as part of their volume. However, volume figures for the two ECNs that account for 85 percent of this business – Island and Instinet – include only trades that occurred as a result of customer orders matching on their systems. These two ECNs handled 18 percent of NASDAQ share volume, 22.7 percent of trades, and 24.3 percent of dollar volume in September 1999.
21Smith, "The Effects of Order Handling Rules," p. 26.
22Figure calculated from research results in Barclay et. al., p. 16. Examining the first 100 NASDAQ stocks subject to the SEC's new order-handling rules, this study found that average spreads fell from 23-26 cents/share to 17.9-19 cents/share in cases where ECNs were not involved in setting the spread. When an ECN's quote set the spread, average spreads fell to 16-16.5 cents/share. Therefore, spreads set by an ECN's quote were 1.9-2.5 cents/share lower, or 10.6-13 percent.
23Proportion of market volume accounted for by individual investors placing market orders is from fn. 18.
24One of the largest networks, Island ECN, even posts its limit orders on the Internet and updates them continuously. To see how this works, go to (http://www.island.com).
25To get its quotes posted on the Consolidated Quotation System, an ECN must first be recognized as a stock exchange, then receive unanimous approval from its competitors – the other exchanges.
26Randall Smith, Greg Ip and Charles Gasparino, "Bitter Rivals Jointly Seek Major Changes in the Markets," Wall Street Journal (Oct. 1, 1999), p. C2.
27Susan Barreto, "ECNs Run Risk of Being DOA," Pensions & Investments (Sept. 6, 1999), p. 10.
28Benjamin E. Hermalin and Nancy E. Wallace, "The Determinants of Efficiency and Solvency in Savings and Loans," Rand Journal of Economics 25:3 (Autumn 1994), pp. 361-381; James A. Verbrugge and John S. Jahera, Jr., "Expense-Preference Behavior in the Savings and Loan Industry," Journal of Money, Credit, and Banking 13:4 (Nov 1981), pp. 465-76, and the references cited therein. Some studies show that mutual savings and loans have lower costs than savings and loans owned by shareholders; this is most likely because for very small institutions, the efficiency incentives are outweighed by the costs associated with issuing stock. (See Mike Carhill and Iftekhar Hasan, "Mutual to Stock Conversion, Information Cost, and Thrift Performance," Financial Review 32:3 (Aug. 1997), 545-68.) Since stock exchanges are very large organizations, the efficiency incentives will most likely outweigh the costs of issuing stock.
29Levitt, "Dynamic Markets."
30Jeffrey E. Garten, "How to Keep the NYSE's Stock High," Wall Street Journal (Sept.13, 1999), p. A44; Michael Schroeder, "Levitt Studies Plan for Single Market Regulator," Wall Street Journal (Sept.21, 1999), p. C1.
31"Levitt Has Doubts About NYSE Plan," Washington Post (Aug. 31, 1999).
32Securities and Exchange Commission, Report Pursuant to Section 21(a) of the Securities Exchange Act of 1934 Regarding the NASD and the NASDAQ Market.
33Diana B. Henriques, "Testing an Emerging Market," New York Times (May 12, 1999).
34Lux and Willoughby, "May Day," p. 48.
Executive Summary
Americans are free to make decisions about their health, education, and welfare. We can choose what to eat, how to exercise, whom to marry, where to worship, and which candidate deserves our vote. Students can use federal financial aid to attend the college of their choice – even a seminary! But most Americans have little ability to choose how or where their children will be educated during their most critical formative years.
Government decides where the vast majority of children in this country attend elementary through high school, and the fate of most children is determined by their address. Parents seeking the best school must either pay private tuition on top of the taxes they pay to support the public schools, or pay a premium to move to a neighborhood with good public schools. A lot of children do well under this system, but many do not. The children hurt the most are the most vulnerable – poor children whose families cannot afford an alternative to the public school in their neighborhood. Since public schools receive funding regardless of whether they do a good job, they face little pressure to improve. As usual, quality suffers when a substantial number of customers have no option to go elsewhere.
In an advanced Information Age economy, lifetime earnings prospects depend on the quality of education more than ever before. It should be no surprise that school choice has recently enjoyed growing support among parents and the general public.
What Makes a Good School?
To answer this question, it's important to understand what does not make a good school. Simply spending more money does not improve performance. Since the 1970s, spending per student has steadily risen and teacher-pupil ratios have steadily fallen. Yet over that same period, standardized test scores remained unchanged. International comparisons reveal that, if anything, larger teacher-pupil are associated with better academic performance! A much-discussed Tennessee experiment found that reducing class sizes from 25 to 15 students increased achievement for kindergarten students but had no effect in higher grades.1 The experience of homeschoolers, meanwhile, suggests that teacher credentials make little difference; 25 percent of homeschooling parents are certified teachers, but their children perform no better on standardized tests than homeschooled children whose parents are not certified teachers.2
Of course, one might argue that student performance would have gotten worse if the amount of resources devoted to education had not risen. To assess the effect of inputs, we really need to look at studies that control for the effects of other factors. Eric Hanushek, an education economist at the University of Rochester, examined most of the major studies on school effectiveness and found that common panaceas like more money, smaller classes, and more teacher training rarely make a difference.
Studies Show More Inputs do not Improve Student Performance
Input Measure | Number of Studies | Studies Showing Positive Effect | Studies Showing Negative or no Effect |
Teacher-Pupil Ratio | 277 | 15% | 85% |
Teacher Education | 171 | 9% | 91% |
Teacher Salary | 119 | 20% | 80% |
Expenditure per Pupil | 163 | 27% | 73% |
Source: Eric Hanushek, "Assessing the Effects of School Resources on Student Performance: An Update," Educational Evaluation and Policy Analysis 19(2), Summer 1997, pp. 141-164. |
The most important factor affecting student performance is the school's organization and management. Effective schools generally exhibit commitment to a clearly defined academic mission, motivated leadership, and teacher participation in decisions. Schools most likely to have these characteristics are the schools that are most free from interference by higher levels of the educational bureaucracy.3 Three kinds of schools have this freedom: private schools, charter schools, and regular public schools not part of large systems or districts. If we want all children to have equal educational opportunities, all parents must have the ability to choose these schools.
Forms of School Choice
Public school choice: Open enrollment, magnet schools, and other programs within the regular public system allow parents to send their children to alternative public schools. Eighteen states offer choice among public schools throughout the state, and 11 more permit choice within or among districts. Other states impose harsh penalties on parents attempting to exercise choice; in Illinois, low-income parents who try to get their children into better public schools by "fraudulently" registering them in a school district where they do not live face a fine of $500 and a 30-day jail sentence.4
Child-centered funding: Allows parents to choose their children's school and then funds each public and/or private school based on the number of children enrolled. Arizona adopted the first child-centered funding plan for public schools in 1998.5 One of the most extensive school systems using child-centered funding is the entire nation of New Zealand, which permits full school choice. The New Zealand government abolished all administration above the level of the individual school, and funds both government and private schools based on enrollment.6
Charter schools: A charter school is a public school that operates independently of the education bureaucracy's rules and teachers' union contracts. A charter school can only educate students if parents choose to send their children there, and it receives public funding based on enrollment. The school's charter specifies the results for which it will be held accountable. If the school fails to deliver on these results, it receives no more public money. Approximately 1,200 charter schools serve more than 300,000 students in 27 states and the District of Columbia. Currently, 38 states have laws permitting charter schools.7
Home schooling: Between 700,000 and 1.5 million American children are home-schooled by their parents or tutors.8 That's three times as many homeschoolers as in 1990, and nine times the number in 1978.9 Some of the most prominent figures in American history received most of their elementary education at home, including Thomas Edison, Andrew Carnegie, Thomas Jefferson, Woodrow Wilson, and both Theodore and Franklin D. Roosevelt.10
Vouchers: Vouchers are scholarships that let students attend a school of their parents' choice. The principal difference between vouchers and child-centered funding is the administrative mechanism. In a voucher system, schools redeem vouchers given to them by students; under student-centered funding, schools simply tell the government how many students they have and receive funding accordingly. Publicly funded vouchers have been used for decades in two states, New Hampshire and Maine, and two cities, Cleveland, Ohio (since 1996), and Milwaukee, Wisconsin (since 1990).
Tuition tax credits/deductions: A direct reduction in taxes that fully or partially offsets expenditures by parents or others on tuition and educational materials, such as books and computers. Minnesota, Iowa, and Arizona currently offer tuition tax credits or deductions.
Tax-favored savings: Various proposals allow parents to defer or eliminate taxes on investments set aside to pay education expenses. The most common proposal would work much like the "Education IRA" that is now available to pay for postsecondary education.
Private scholarships: Since 1991, the Children's Educational Opportunity Foundation has provided scholarships that allow children from low-income families to attend private schools. This fall 36,875 children will receive more than $140 million worth of scholarships in 37 city-based and three statewide programs. One of the most ambitious programs is in San Antonio, Texas, where business leaders have pledged $50 million over ten years to allow every low-income student in the Edgewood Independent School District to attend the school of his or her choice.11
Results of School Choice
Many forms of school choice have been subjected to rigorous academic study, and the results are simple. School choice works:
Students' test scores are higher, and school spending and taxes are lower, in metropolitan areas where the existence of a large number of independent school districts makes it easier for parents to choose among public schools by moving to another neighborhood.12
Massachusetts has permitted parents to choose among public schools since 1991, and the district losing a student must pay up to $5,000 to the district accepting the student. School districts with the largest losses responded by changing their policies and programs in ways that brought back many students in the ensuing years.13
A nationwide survey of charter school students and parents revealed that 80 percent of students who were failing at their previous schools performed average or better in charter schools. More than half of them are now doing "good" or "excellent" work. Results improved for children in all ethnic groups and income levels.14
After four years in a state-funded voucher program in Milwaukee, low-income students performed 11 percentile points better in math and 6 points better in reading than similar students who did not receive vouchers. If the program produced such gains for all students over 12 years of schooling, it would eliminate more than half of the gap in reading performance and all of the gap in math performance between white and minority students.15
After one year, Cleveland students receiving state-funded vouchers scored higher in language, math, reading, and social studies than similar public school students. At two new schools created to serve voucher students, students scored 5.7 percentile points higher in reading and 8.6 percentile points higher in math after one year.16 In contrast, percentile scores of inner-city public school students often fall by a point or two a year.17
After one year, low-income New York City students using private scholarships to attend private schools scored 2 percentile points higher in reading and math than similar students in the public schools. Fourth and fifth graders did even better, with average math scores 5.9 percentile points higher and reading scores 4 points higher.18
Every year students remain in San Antonio's regular public schools, their standardized test scores fall by 2 percentile points in math and 1.4 points in reading. But low-income students receiving privately funded scholarships or choosing to enroll in the city's "multilingual" schools keep up with their nationwide peers, retaining the same percentile scores from year to year.19 Similar results occurred in Indianapolis, where the performance of low-income middle school students receiving private scholarships held steady while that of their public school peers deteriorated.20
Home-schooled students score higher on standardized tests than either public or private school students, and their scores increase more rapidly as they progress from one grade to another. One in four homeschoolers is at least one grade ahead of other students of the same age, and only 5 percent are working below the grade level for their age. The longer students are home-schooled, the better their performance, even after accounting for the fact that homeschooling parents are more highly educated than the general population.21
In 1999, home-schooled high school seniors tied Rhode Island's Seniors for the highest average scores on the ACT college admissions test.22
School choice also improves regular public schools by encouraging innovation and competition:
A new program in Florida offers state-funded vouchers to students at schools who received "failing" grades in two out of four years. Two schools lost students due to vouchers in 1999; one responded by adopting a sharper focus on reading, writing, and math. All teachers in the school spend 90 minutes each morning teaching reading. One mother who took advantage of the vouchers noted, "It took competition to make improvements…Everyone's focus now is the kids. It's a totally different scene. Why didn't they do it before?"23
California's first charter school, the San Carlos Charter Learning Center, developed curriculum and instructional approaches that have been widely copied in its district. The Los Angeles School District revised its purchasing system after a "60 Minutes" story revealed that a charter school principal purchased computers for her school at lower cost than the school district and in much less time – six days instead of a year!
In response to a flurry of charter school activity in Boston, the school district and teachers' union launched a "pilot schools" project that offered waivers of district policies and union contract provisions. Other Massachusetts public schools have been forced by charter school competition to open kindergartens and shorten student vacations.24
When parents began applying for vouchers in Cleveland, the public school system offered applicants a chance to place their children in magnet schools and enrichment programs.25
Arizona has the nation's most progressive charter school law and the largest number of charter schools. A survey of teachers in Arizona's regular public schools revealed that principals are much more likely to inform parents about school programs, encourage experimentation in teaching, and involve teachers in decisionmaking when the school faces strong competition from charter schools.26
In Milwaukee, the public school system seeks to retain students by advertising that they will pay for a reading tutor for any child who does not learn to read in regular classes.
Parents Want School Choice
Poll results, surveys of parents in school choice programs, and waiting lists for choice programs all demonstrate that a substantial number of parents want school choice.
Poll results
Support for school choice is especially strong among people who have the most to gain from increased education opportunities. For example, a survey by the Joint Center for Political and Economic Studies found that 57 percent of African-Americans, 65 percent of Hispanics, and 47 percent of whites favor school choice.27 Similarly, a 1998 survey of African-Americans in Philadelphia found that 64 percent support the use of vouchers for any school, including religious schools, and 68 percent said they would opt out of the public school system if cost were of no concern.28
Parental satisfaction
Surveys consistently show that parents whose children participate in school choice programs are much more satisfied with their chosen schools:
Cleveland parents whose children received vouchers expressed much more satisfaction with their chosen schools' academic quality, safety, discipline, and attention paid to their children than parents whose children were still in the public schools. More than 80 percent of parents planned on sending their children back to their chosen school the following year.29
Half of the parents of randomly chosen low-income students receiving privately funded scholarships in New York City give their schools a grade of "A," compared to only 12.5 percent of parents whose children applied for, but did not receive scholarships. More than 80 percent of scholarship recipients plan to attend the same school the following year, compared to 70 percent of similar public school students.30
Surveys of low-income applicants for privately funded scholarships in Washington, DC, and Dayton, Ohio, show that parents of students in private schools are much more satisfied with their schools' academic quality, safety, discipline, and teaching than parents of students in public schools. Half of private school parents gave their schools an "A," but less than a fifth of public school parents did so.31
In San Antonio, Texas, low-income parents whose children received private scholarships reported much higher satisfaction with their children's learning and school discipline than parents with children in public schools.32
Waiting lists
School choice programs typically have many more families interested in participating than can be accommodated. Such excess demand reveals that many parents are well-informed and concerned about their children's education, and want options for their children other than their assigned public schools.
Charter schools in Michigan, for example, usually have three or four applicants for every available seat.33 A nationwide survey revealed that more than 70 percent of charter schools had waiting lists in the 1996-97 school year.34
Publicly funded school choice programs typically receive more applications from parents than they can serve. Cleveland's state-funded voucher program received 6,244 applications for 2,000 partial scholarships in 1996, the first year they were available. Most parents – 85 percent – said they applied in order to improve the academic quality of their children's education.35
Another demonstration of the pent-up demand for school choice comes from private scholarship programs that help children from low-income families attend non-public schools. These programs typically offer only partial scholarships; parents have to come up with a portion of the tuition. Yet wherever tried, the response is overwhelming. In New York City, 20,000 low-income public school students applied for 1,300 scholarships in the first year of the program.36 In Baltimore, 20,000 children applied for 500 scholarships awarded in 1999 – that's 44 percent of all the children whose families had incomes low enough to qualify! Nationwide, 1.25 million children applied for 40,000 scholarships for the 1999-2000 school year.37 The actions of low-income parents speak louder than any polling results; a substantial number of them want school choice!
Mixing Church and State?
A common fear about school choice is that it leads to unconstitutional taxpayer support for religion, because many private schools are affiliated with churches. This concern is misplaced.
Several recent court decisions have determined that choice plans are constitutional if aid under the plan serves a secular purpose, is given according to criteria that neither favor nor disfavor religion, and flows to religious institutions as a result of parental or student choice. Those were the Wisconsin Supreme Court's reasons in 1998 for upholding the constitutionality of the state-funded voucher program in Milwaukee, which permitted low-income students to choose religious schools.38 By a vote of 8 to 1, the U.S. Supreme Court declined to hear the case, allowing the Wisconsin decision to stand.
Applying the same three-pronged test, the Ohio Supreme Court in May 1999 decided that the basic structure of the Cleveland voucher program was constitutional.39 In January 1999, the Arizona Supreme Court upheld a law granting income tax credits for donations to private scholarship programs. The court reasoned that the principal purpose of the program is not to promote religion, but to aid students and parents by making private schools more accessible.40
These results should come as no surprise, since college students generate no constitutional controversy when they use federal aid to attend religiously-affiliated colleges. Some veterans have even used their G.I. Bill benefits to attend seminaries, with no constitutional problems. School choice merely gives the parents of elementary and high school students the same kinds of options that college students enjoy.
Perhaps more surprising is a federal injunction in August 1999 that halted the Cleveland program. After parental protests, the judge allowed it to continue for students who received vouchers in the previous school year. The judge's final ruling will likely set the stage for a series of appeals that could reach the U.S. Supreme Court.
Does School Choice Threaten School Independence?
Some critics of school choice – usually conservatives – have argued that government assistance to students in charter or private schools will inevitably bring greater regulation of school management, curriculum, teacher credentials, and similar factors. Instead of improving regular public schools, such regulation might simply reduce the flexibility and diversity of charter and private schools. This is a real danger that must be dealt with in the design of choice programs.
Some forms of school choice are more vulnerable to this problem than others. Charter schools are in greatest danger, because they are still public schools, and school boards or legislators can always opt to change the rules of the charter school program. For private schools, vouchers may carry a greater danger of regulation than tuition tax credits. In voucher programs, government money flows to private schools as a result of parental decisions. Tuition tax credits, on the other hand, simply allow parents to keep more of their own money if they spend it on private school tuition. Since the money never passed through the government's hands, it is harder for government to use tuition tax credits as a vehicle to promote greater regulation of private schools.
What About Racial Discrimination?
School choice arouses suspicions in some circles because racist southerners used school choice plans in the 1960s to evade the Supreme Court's dictum that schools must be desegregated.41 Under such plans, a few African-American students typically chose to attend historically white schools, but no white students chose to go to the historically black schools, with the result that the system remained virtually segregated.
But private schools and charter schools are not the same as historically segregated public schools. Both Catholic and non-Catholic private schools are more racially diverse than public schools, and have been since at least the early 1980s. Students of different racial backgrounds are even more likely to sit next to each other in private school lunch rooms – especially in religious schools.42
Similarly, studies by the U.S. Department of Education and the Hudson Institute both found about half of charter school students are members of minority groups, compared to 34 percent in regular public schools.43 The U.S. DOE concluded that about 60 percent of charter schools serve the same racial mix as their surrounding district, and most of the rest have a higher percentage of minority students.44
In addition, private schools have strong incentives to avoid discrimination precisely because discrimination is a highly sensitive issue that could undermine support for a school choice program.
Numbers Aren't the Only Issue
Some critics resist educational choice out of a belief that decisions about the education of other people's children are too important to be left to parents. This is a truly frightening argument if we consider the implications for other, equally important, decisions that people make. Nutrition is critically important to both health and intelligence, but we do not establish "public food stores" as a tax-supported monopoly to control eating habits. People's choice of religion plays a large role for good or ill, but history shows that establishing a tax-supported monopoly on religion is a recipe for social strife that actually reduces genuine religious belief.
The argument for educational choice is not just that choice improves academic achievement, but also that choice accommodates different parents' diversity of views about the types of education that they want for their children. The extensive Catholic school systems in the United States, for example, were established largely because poor Catholic immigrants feared that public schools would indoctrinate their children in Protestantism.45 In present-day America, educational choice would put an end to seemingly endless arguments over sex education, textbook choice, and censorship in school libraries; parents could simply choose schools that reflect their values instead of fighting to impose their values on their neighbors' children. The result would be an immeasurable but long-overdue increase in civility and social harmony.
1Eric A. Hanushek, "The Evidence on Class Size," Occasional Paper Number 98-1, W. Allen Wallis Institute of Political Economy, University of Rochester, February 1998, (http://petty.econ.rochester.edu/eah.htm).
2Lawrence M. Rudner, "Scholastic Achievement and Demographic Characteristics of Home School Students in 1998," Education Policy Analysis Archives 7:8 (March 23, 1999), p. 23, (http://epaa.asu.edu/epaa).
3John Chubb and Terry Moe, Politics, Markets, and America's Schools (Brookings Institution, 1990), pp. 152-56.
4Nina Shokraii Rees and Sarah E. Youssef, School Choice: What's Happening in the States 1999 (Heritage Foundation, 1999), p. 34.
5School Choice: What's Happening, p. 5.
6Maurice P. McTigue, "Charter Schools Kiwi-Style," The Oregon Spectator (Feb./March 1999), p. 5.
7Statistics from the Center for Education Reform, (http://www.edreform.com/pubs/chglance.htm), and (http://www.edreform.com/press/ncsd9899.htm).
8Rudner, "Scholastic Achievement," p. 2. Also Web site of the Home School Legal Defense Association, (http://www.hslda.org/central/faqs/index.stm).
9National Home Education Research Institute, Fact Sheet IIB 1999 (http://www.nheri.org/booklet.html).
10Andrew J. Coulson, Market Education: The Unknown History (Transaction Publishers, 1999), pp. 119-20.
11Children's Educational Opportunity Foundation of America, Children First (Winter 1999).
12Caroline Minter Hoxby, "Does Competition Among Public Schools Benefit Students and Taxpayers?" National Bureau of Economic Research Working Paper No. 4979 (December 1994).
13David J. Armour and Brett M. Peiser, "Interdistrict Choice in Massachusetts," in Paul E. Peterson and Bryan C. Hassel (eds.), Learning from School Choice (Brookings Institution, 1998), pp. 157-86.
14Gregg Vanourek, Bruno V. Manno, Chester E. Finn, Jr., and Louann A. Bierlein, "The Educational Impact of Charter Schools," Charter Schools in Action Project: Final Report, Part V (Hudson Institute), pp. 13-16. (Referred to henceforth as "Hudson Institute study.")
15Jay P. Greene, Paul E. Peterson, and Jiangtao Du, "Effectiveness of School Choice: The Milwaukee Experiment," Harvard University Program in Education Policy and Governance Occasional Paper 97-1 (March 1997), (http://data.fas.harvard.edu/pepg/op/mil.htm).
16Paul E. Peterson, Jay P. Greene, and William Howell, "New Findings from the Cleveland Scholarship Program," manuscript (May 6, 1998), Harvard University Program in Education Policy and Governance, pp. 7, 9-10, available (http://data.fas.harvard.edu/pepg).
17Jay P. Greene, William G. Howell, and Paul E. Peterson, "Lessons from the Cleveland Scholarship Program," manuscript (Oct. 15, 1997), Harvard University Program in Education Policy and Governance, pp. 23-25, available (http://data.fas.harvard.edu/pepg).
18Paul Peterson, David Myers, and William G. Howell, "An Evaluation of the New York City School Choice Scholarships Program: The First Year," Mathematica Policy Research and Harvard University Program on Education Policy and Governance (Oct. 1998), pp. 26-27, (http://data.fas.harvard.edu/pepg).
19R. Kenneth Godwin, Frank R. Kemerer, and Valerie J. Martinez, "Comparing Public Choice and Private Voucher Programs in San Antonio," in Paul E. Peterson and Bryan C. Hassel (eds.), Learning from School Choice (Brookings, 1998), pp. 286-87.
20David J. Weisschrott and Sally B. Kilgore, "Evidence from the Indianapolis Voucher Program," in Paul E. Peterson and Bryan C. Hassel (eds.), Learning from School Choice (Brookings, 1998), pp. 330-32.
21Median scores for homeschoolers are higher than median scores for other students. This result holds for all scores examined – reading, language, math, social studies, and science. See Rudner, "Scholastic Achievement," pp. 14-19.
22Andrea Billups, "Students Schooled at Home Ace ACT," Washington Times (Aug. 18, 1999).
24Hudson Institute study, pp. 17-18.
25Greene, Howell, and Peterson, "Lessons from Cleveland," pp. 13-14.
26Frederick Hess, Robert Maranto, and Scott Milliman, "Coping With Competition: How School Systems Respond to School Choice," manuscript (1999).
27Paul E. Peterson, "A Report Card on School Choice," The State Factor (Summer 1998), p. 2.
28Gary A. Furgeson, "The Commonwealth Foundation 1998 Survey on Education Issues Among African Americans in Philadelphia," American Viewpoint, Inc. (April 1998).
29Greene, Howell, and Peterson, "Lessons from Cleveland," pp. 14-19.
30Peterson, Myers, and Howell, "An Evaluation of the New York City School Choice Scholarships Program," pp. 24-15.
31Paul E. Peterson, Jay P. Greene, William G. Howell, and William McCready, "Initial Findings from an Evaluation of School Choice Programs in Washington, DC and Dayton, Ohio," manuscript (Oct. 24, 1998); "Initial Findings from an Evaluation of School Choice Programs in Washington, DC," manuscript (Sept. 1, 1998), Harvard University Program on Education Policy and Governance, (http://data.fas.harvard.edu/pepg).
32Godwin, Kemerer, and Martinez, "Comparing Public Choice and Private Voucher Programs," pp. 280-82.
33Hudson Institute study, p. 16.
34U.S. Dept. of Education, Office of Educational Research and Improvement, A National Study of Charter Schools, 1998, Executive Summary, p. 12.
35Greene, Howell, and Peterson, "Lessons from Cleveland," pp. 4, 10.
36Petersen, Myers, and Howell, "An Evaluation of the New York City School Choice Scholarships Program," p. 2.
37Baltimore and nationwide statistics are from private communications with Towson State University professor Howard Baetjer, a board member of the Baltimore organization administering the scholarships.
38Jackson v. Benson, 578 N.W.2d 602 (Wisconsin 1998).
39The Court ruled that one minor provision of the plan violated the First Amendment – a section that allowed private schools with waiting lists for entry to give priority to children whose parents belong to organizations that support the school. The Court believed this provision may create incentives for parents receiving vouchers to alter their religious affiliations in order to get their children into particular schools. See Doris Simmons-Harris v. John Goff, Case 97-1117, Ohio High Court (May 27, 1999). The Court struck down the voucher program because its enactment as a rider on an appropriations bill violated the Ohio Constitution's "single-subject" rule, and the legislature then re-enacted the program in a freestanding bill.
40Kotterman v. Killian, Arizona Supreme Court No. CV-97-0412-SA.
41Coulson, Market Education, pp. 136 and 275.
42Coulson, Market Education, pp. 276-77.
43Hudson Institute study, p. 2.
44U.S. DOE Study, Executive Summary, p. 11.
45Jerome Ellig and Jack High, "The Private Supply of Education: Some Historical Evidence," in T. Cowen (Ed.), The Theory of Market Failure: A Critical Appraisal (George Mason University Press, 1988).
Americans are free to make decisions about their health, education, and welfare. We can choose what to eat, how to exercise, whom to marry, where to worship, and which candidate deserves our vote. Students can use federal financial aid to attend the college of their choice – even a seminary! But most Americans have little ability to choose how or where their children will be educated during their most critical formative years.
Brand name pharmaceutical companies and federal and state governments are raiding consumers' pocketbooks by preventing them from buying generic drugs. Such restrictions can be an enormous financial drain, especially for low-income Americans and seniors who live on fixed incomes and pay for prescriptions out-of-pocket.
Generic drugs offer consumers more choices and keep prices down by competing with brand name pharmaceuticals, often at savings of 30 percent to 60 percent. When government restricts access to generics, it forces consumers either to buy brand name drugs, which can cost one and a half to three times more, or to do without treatment altogether. This restriction also means higher costs for employers and unions (who provide health benefits); taxpayers (who fund government health programs); and individual consumers (especially seniors). According to Common Cause, a watchdog group that examines the influence of special interests on politics, government suppression of generics is costing Americans $550 million a year, hidden in higher prices for prescriptions.
In effect, government restrictions on generics are hidden taxes that directly benefit brand name pharmaceutical companies. These companies lobby for restrictions on generics to offset the high costs imposed on brand names by the federal Food and Drug Administration (FDA). These companies also seek monopoly rents through lobbying for patent extension. Patents were intended to reward and encourage innovation. Extending patents that have already been granted do not create any additional incentives to innovate.
Full Study
Brand name pharmaceutical companies and federal and state governments are raiding consumers' pocketbooks by preventing them from buying generic drugs. Such restrictions can be an enormous financial drain, especially for low-income Americans and seniors who live on fixed incomes and pay for prescriptions out-of-pocket.
The EPA's proposed air quality standards for ozone and particulate matter might actually do more harm than good, even just in terms of public health. Recent studies suggest that the costs of the proposed standards could be $90 billion to $150 billion annually, forcing consumers to spend less on health care and safety products. A recent study by the Reason Public Policy Institute found that up to 27,000 fatalities may be attributed to the proposed standards.
The EPA's proposed air quality standards for ozone and particulate matter might actually do more harm than good, even just in terms of public health. Recent studies suggest that the costs of the proposed standards could be $90 billion to $150 billion annually, forcing consumers to spend less on health care and safety products. A recent study by the Reason Public Policy Institute found that up to 27,000 fatalities may be attributed to the proposed standards. The EPA's benefits estimate should have included an assessment of all impacts -- adverse as well as beneficial -- to determine if, on net, the standards improve public health. Otherwise, the unintended consequences of regulation can overwhelm the best of intentions.
The EPA is currently revising the air quality standards for ozone and particulate matter. The agency has proposed tougher ozone standards as well as a new standard for fine particles, called particulate matter (PM2.5), that measure 2.5 microns or less in diameter. The EPA claims the new standards will save upwards of 15,000 lives annually, although the scientific community has raised serious questions about the scientific validity of the agency's claims. Nonetheless, the EPA remains confident in its analysis with little sign that the agency will shrink from the proposed standards.
Although there may be concerns with the underlying science, there is little question that the new rules will impose significant costs on the economy. According to the EPA, more than 300 counties in 34 states will be in non-attainment under the new ozone standards, and over 160 counties in 37 states will be in non-attainment with the PM2.5 standard.1 These areas will have to develop and implement plans to achieve attainment status, which typically means adopting a series of costly control technologies and restrictions on various activities. The EPA's own estimates suggest that the standards will cost $6.6 billion to $8.5 billion a year, and that is for only partial attainment.2 Other estimates suggest much higher figures. For instance, President Clinton's Council on Economic Advisers suggests that compliance costs for the ozone standard alone could be as high as $60 billion a year.3 A recent Reason Foundation study places compliance costs for both ozone and PM2.5 at $90 billion to $150 billion annually; ultimately eliminating roughly 200,000 to 400,00 jobs across the country.4
Given the scientific uncertainty and the substantial economic burden generated by the proposed standards, the rationale for the new standards becomes questionable. This is especially true when recent trends in air quality are examined. According to the EPA's air trends report, the air today is 30 percent cleaner than 25 years ago, despite population and economic growth.5 Forecasts suggest this trend will continue for the near future. The 1990 amendments to the Clean Air Act have yet to be fully implemented; as new controls are put in place, emissions reductions will continue, including emissions associated with fine particulate matter.
In fact, the proposed standards may do more harm than good. There is a growing body of evidence that suggests that excessive regulations can have adverse effects that reduce the well being of people living under the regulations and may actually increase the level of premature mortality. Regulations can have unintended consequences that, in some instances, may swamp the intended benefits of the regulation. This is especially true when the regulation in question provides minimal benefits at a high cost, as is the case with the proposed air quality standards.
Setting Air Quality Standards Under the Clean Air Act
The adverse impacts of the proposed air quality standards are a symptom of a more fundamental error in the Clean Air Act. Specifically, both the legislation and the courts make it clear that economic or technological feasibility cannot be considered when setting air quality standards. By law, the EPA is to set primary standards "the attainment and maintenance of which, in the judgment of the Administrator, based on such criteria and allowing an adequate margin of safety, are requisite to protect public health."6 Critics of cost-benefit analysis have raised concerns that it is unethical to place a dollar value on human life. Consequently, there is no mention of economic costs in the language describing how the agency sets the standard. Air quality standards are health-based standards that provide an adequate margin of safety to protect public health. There is no role for a cost-benefit calculus when establishing standards, which has been made clear by the courts.7
Such language suggests an elementary misunderstanding of economics and the notion of cost. All choices entail costs and it is impossible to separate the act of choosing from the imposition of costs. Once a choice is made, the consequences of that choice must be accepted. The consequences of any choice are typically described as "opportunity costs." Costs are not dollars; costs are foregone opportunities or alternative uses of resources. Any elementary textbook in economics provides a discussion of this basic, but important, concept. And when the EPA establishes a standard, by definition, it is making a decision about resource allocations that entails costs. And individuals will bear those costs. As stated by Nobel laureate James M. Buchanan in his seminal exposition on costs, "Those who 'bear the burden'--even though bearing this burden is a subjective experience--need not be those who undergo the agony of choosing."8 This is most evident when a government agency makes a decision to regulate the public's behavior.
Monetary values are often used as a proxy for costs, but the consequences of choice can be measured in other contexts as well. For example, one consequence of a new air quality standard that diverts resources away from individuals and families may be fewer trips to the doctor or a poorer diet due to a reduction in disposable income. To the extent that consequences impact health, it is logically impossible to separate the choice of a standard from cost, even when the standard is a health-based standard. Cost and choice are two sides of the same coin, and the economic consequences of a new standard can have very real impacts on public health, which is the very thing the EPA is mandated to protect.
Every economist understands the importance of unintended consequences. Public policies that focus narrowly on specific benefits often overlook other consequences of regulation that may actually overwhelm the benefits addressed in the regulation. Even the Clean Air Act attempts to address the potential for unintended consequences when setting standards. For example, the EPA is required to establish a secondary standard for the criteria air pollutants "the attainment and maintenance of which, in the judgment of the Administrator, based on such criteria, is requisite to protect the public welfare from any known or anticipated adverse effects associated with the presence of such pollutant in the ambient air."9 By statute, public welfare is defined as, but not limited to, "effects on soils, water, crops, vegetation, manmade materials, animals, wildlife, weather, visibility and climate, damage to and deterioration of property, and hazards to transportation, as well as effects on economic values and on personal comfort and well-being."10
Unfortunately, the EPA interprets public welfare benefits in a very narrow manner, choosing to exclude important secondary impacts that could have an adverse impact on public welfare. In fact, in the ozone proposal, the EPA only focuses on vegetation and crop damage when establishing the secondary standard. For the PM2.5 rule, the EPA limits its assessment of secondary effects to a discussion of "visibility, materials damage, and soiling."11 In other words, the agency examined the potential for PM2.5 pollution controls to reduce visibility and haze problems, the potential for reducing corrosion, and the potential to keep buildings from getting dirty. The agency completely neglected an assessment of personal comfort and well being.12
A more accurate assessment should have attempted a broader comparison of public health and welfare under the current standard and public health and welfare under the proposed standard. By selectively defining public health and welfare, the EPA ignored important unintended and adverse consequences of the rule.
What are the Costs of the Proposed Standards?
Despite the ban on the use of cost-benefit analysis when establishing air quality standards, the EPA did conduct a regulatory impact analysis to determine the costs of the proposed new standards. According to the agency, the analysis is not to be used in setting standards but the analysis "should be useful in generally informing the public about the potential costs and benefits associated with the implementation of the proposed revisions."13 The EPA estimates that the costs could be as high as $2.5 billion annually for ozone and $6 billion annually for PM2.5. Unfortunately, these numbers do not go very far in informing the public, because these are estimates of partial compliance. At some point, the EPA simply stopped calculating the costs of further reductions of pollutants.
Other studies have attempted to determine the full impact of the EPA's regulations. The President's Council of Economic Advisers (CEA) raised concerns that the ozone standard could cost as much as $60 billion a year. A study by the Reason Public Policy Institute found the costs of meeting the proposed standards for ozone and PM2.5 to be substantially higher. The Reason study concluded that the costs of full compliance with the ozone and particulate matter standards would be $90 to $150 billion annually.14 In turn, these costs would have an adverse effect on economic growth and employment. In fact, the report suggests that net employment impact eventually levels off at roughly 200,000 to 400,000 lost jobs. Across the board, retail and service industries are hit hardest, and the employment impacts disproportionately hit lower income groups. This map illustrates the job losses from the compliance costs of the proposed standards.
200,000 Jobs Lost Nationwide from the EPA's Proposed Air Quality Standards
Up to 1,000 jobs lost. 1,000 to 5,000 jobs lost. 5,000 to 10,000 jobs lost. More than 10,000 jobs lost.
Note: Assumes annual costs of compliance with the new air quality standards of $90 billion per year. (Source: Anne E. Smith, D. Warner North, et al., "Costs, Economic Impacts, and Benefits of EPA's Ozone and Particulate Standards," Reason Public Policy Institute and Decision Focus, June 1997.)
Despite the significant economic burdens imposed by the standards, EPA Administrator Carol Browner is adamant in rejecting such burdens when considering the form and level of the new standard. If the agency is truly interested in protecting public health and welfare, however, it cannot overlook the unintended consequences of an overly stringent standard. Unemployment and income loss can contribute to a decline in public health. Most studies show a positive association between unemployment and mortality, and, as discussed below, there is a statistically significant relation between income loss and mortality.
In addition, it must be remembered that all choices reflect costs. Resources are scarce and a decision to set a stringent standard may divert resources from more cost-effective uses that would save more lives with the same amount of resources. For example, a recent National Center for Policy Analysis study by Tammy Tengs examined 139 government regulations and found that $4.11 billion was spent per year to save 94,000 years of life. Spending that money on more cost-effective regulations could have more than doubled the years of life saved, for a total of 211,000 years.15
Health-Health Analysis
The impact of a regulatory change, such as the proposed air quality standards, can be far-reaching, affecting many aspects of an individual's life. The reason is simple: Individuals have only a limited amount of income. Costly new regulations can reduce disposable income and therefore the quality of life of many individuals. If income levels decline, individuals can no longer afford the same levels of health care, the same dietary choices, or the same investments in healthy lifestyles. These important trade-offs were first raised by Aaron Wildavsky and summarized in his book, Searching for Safety.16 Wildavsky suggested that the costs of government programs might actually have an adverse effect on health because they make people poorer. This analysis, which incorporates unintended health risks that may arise because of increased spending on risk reduction programs, has been termed "health-health" analysis. Such research has created a new field of study that evaluates the relationship between income and mortality.17
Health-health analysis provides an analytical framework that attempts to capture the opportunity cost of regulation strictly in terms of health. The empirical work underlying this analysis avoids the thorny problem of putting a value on human life, which is perhaps the main objection to the use of cost-benefit analysis. Instead, this analysis acknowledges the importance of costs while allowing a broad comparison of the number of lives at risk under the current standard and the number of lives at risk under the proposed standard. The calculation is not in dollars and cents; it is in lives saved versus lives lost.
Using health-health analysis, for example, it is possible to develop an understanding of the broader health impacts of a new standard. A standard that will save 15,000 lives based on adopting new controls can be evaluated according to how many premature deaths may arise due to the loss of income associated with the new controls. Health-health analysis provides a much broader view of health and social welfare than a simple evaluation of the benefits specific to one rule. It is a way to determine whether a rule does more harm than good. In fact, in 1991 Judge Williams, of the U.S. Court of Appeals for the D.C. Circuit, argued that the Occupational Safety and Health Administration (OSHA) should have used health-health analysis or some other analytical tool to reflect the opportunity cost of compliance with a new safety standard.18 Judge Stephen Williams saw health-health analysis as a useful alternative to cost-benefit analysis that should be applied because it can be argued under case law that, like EPA's air quality standards, OSHA's health standards cannot be set using cost-benefit analysis.
Ralph Keeney is one of the pioneers in health-health analysis. His early work suggested that economic growth was more important than government regulation in improving public health. Government policies that hamper or reduce growth affect individuals by lowering their income: "The basic idea to estimate cost-induced fatalities is rather simple. Economic costs of expensive programs are somehow apportioned as costs to individuals. These costs, which decrease the disposable income of individuals, increase their fatality risks. Higher fatality risks lead to additional expected fatalities."19 This type of analysis provides an assessment of the indirect impacts of new standards or regulations, which allows a more accurate assessment of the overall impact on public health associated with regulation.
Ralph Keeney and Kenneth Green have updated this research in a paper published by the Reason Public Policy Institute.20 The findings raise new concerns about the benefits of the EPA's proposed air quality standards. First, there are a significant number of deaths associated with the costs of the proposed standards. A true evaluation of the benefits of the rule should evaluate net benefits, which means evaluating the specific health benefits of the standards, as well as any indirect premature fatalities associated with the costs of achieving the new benefits.
The Reason study provides an analysis of three different scenarios, based on various cost estimates for the proposed standards. Using the EPA's cost scenario, roughly 1,600 fatalities may be induced by adopting the new standards. However, the EPA's analysis only provides the costs for partial attainment, not the full cost of compliance with the standard. The Reason scenario, based on an estimate of the full cost of attainment, provides a more harrowing figure, with premature fatalities of up to 27,000. This number is, in fact, larger than the 15,000 lives the EPA claims will be saved by adopting the proposed standards. By ignoring the potential costs of the regulation and relying on a very narrow definition of the public welfare, the EPA may actually be putting more people at risk than they claim they will save. Further, a more recent analysis of the EPA's benefits claims by Dr. Kay Jones demonstrates that fewer than 1,000 premature fatalities would be avoided by the EPA's proposed rules.21 In this case, even using the EPA's scenario for the costs of the rule, the new standards would do more harm than good.
Moreover, the induced fatality estimates suggest that the EPA's regulations have the potential to disproportionately affect lower income groups and minority populations. For example, if it is assumed that the economic burden of the proposed standards are so pervasive that all households bear the costs equally, then the number of fatalities is higher for low income groups, and the black population is disproportionately affected. On the other hand, if the economic burden is distributed proportionally to income, with higher incomes bearing more of the costs, the number of fatalities is reduced somewhat and the fatalities are shifted to the middle class. However, as Keeney and Green conclude, "Under all scenarios, the majority of induced fatalities occur among people earning less than $35,000 annually, and fall disproportionately among the black population."22
The EPA claims that the proposed air quality standards will provide benefits that far outweigh the costs of new control technologies. However, the narrow scope of the EPA's analysis ignores potential adverse impacts that could overwhelm the benefits claimed by the agency. By neglecting the costs of the primary standard and arbitrarily constraining the definition of public welfare in the secondary standard, the EPA has turned a blind eye to a number of unintended consequences that may actually induce more fatalities than are avoided by the proposed standards. To fully assess the benefits of the proposed air quality standards, the EPA should revisit its analysis of benefits without imposing artificial constraints on the scope of the study.
In the long run, the false dichotomy between health and costs stipulated by the Clean Air Act must be revisited. All choices, even those relating to health, have economic consequences. Those consequences bear directly on the question of health, especially if the choice of a standard reduces individual incomes and increases unemployment. Economic costs reflect alternative uses of scarce resources, not the profit and loss columns of an accounting ledger. Establishing new standards without examining costs provides no way to determine whether society is better or worse off with the new standard. As stated by Tammy Tengs, "All risk reduction policies have two things in common: they have economic consequences and they save lives. Thus it makes sense to compare lifesaving interventions according to their 'value for the money.'"23
In the short run, the EPA's proposed standards should be delayed until more research can be conducted on their impacts. Many in the scientific community have already raised serious concerns about the weak scientific underpinnings of the EPA's proposed standards. Now, there is mounting evidence that costly regulations actually induce fatalities by reducing incomes. Economic studies estimate the costs of the new standards could be as high as $90 billion to $150 billion a year, with a net loss of roughly 200,000 to 400,000 jobs. In addition to the many adverse effects of unemployment, recent research has identified a positive statistical link between income loss and premature mortality. Data suggest that the costs imposed by the new air standards could more than offset the benefits through increased fatalities. To ignore the public health impacts of these findings by arbitrarily constraining the scope of analysis is not in the public interest.
In the medical profession, a doctor's first principle is "primum non nocere"--first, do no harm. When the public's health is at stake, it is a wise policy. The air quality standards currently under consideration at the EPA can have sweeping impacts on individuals and families across the country. Without a thorough understanding of the direct and indirect effects of the standards, the outcome may be just as deadly as a scalpel in the hands of an untrained surgeon. Before issuing new standards, the EPA should examine the broader implications of the proposed standards to ensure that the standards do, in fact, promote public health.
1 Others view this as a conservative estimate. The American Petroleum Institute, for example, states that the proposed standards would result in 800 counties being in non-attainment.
2 Testimony of Mary D. Nichols, Assistant Administrator for Air and Radiation, U.S. Environmental Protection Agency before the Subcommittees on Health and Environment and Oversight and Investigation, Committee on Commerce, U.S. House of Representatives, April 17, 1997. The ozone rule is projected to cost $600 million to $2.5 billion annually, while the PM2.5 standard is estimated to cost $6 billion annually.
3 Alicia Munnell, "Memorandum from Alicia H. Munnell to Sally Katzen, Office of Management and Budget," Council of Economic Advisers, December 10, 1996.
4 Anne E. Smith, D. Warner North, James P. Bekemeier, Nathan Y. Chan, Rana Glasgal, and Justin Welsh, "Costs, Economic Impacts and Benefits of EPA's Ozone and Particulate Standards," Reason Public Policy Institute and Decision Focus Incorporated, June 1997.
5 Environmental Protection Agency, National Air Quality and Emissions Trends Report, 1995, EPA 454, Office of Air Quality Planning and Standards, Research Triangle Park, North Carolina, October 1996.
6 42 U.S.C. 7409 (b)(1) 1996.
7 Lead Industries Association v. Environmental Protection Agency, United States Court of Appeals, District of Columbia Circuit, 1980, 647 F.2d 1130.
8 J. M. Buchanan, Cost and Choice, p. 48.
9 42 U.S.C. 7409(b)(2) 1996.
10 42 U.S.C. 7602(h) 1996.
11 "National Ambient Air Quality Standards for Particulate Matter: Proposed Decision," Federal Register, vol. 61, no. 241, December 13, 1996, p. 65662.
12 For ozone the EPA proposed two options for the secondary standard. One would be identical to the primary standard, and the second option would be a seasonal standard. For PM2.5 the proposed secondary standard is identical to the primary standard with the addition of a regional haze program.
13 Federal Register, December 13, 1996, p. 65667.
14 Anne E. Smith, D. Warner North, et al. "Costs, Economic Impacts, and Benefits of EPA's Ozone and Particulate Standards," Reason Public Policy Institute and Decision Focus, June 1997.
15 Tammy O. Tengs, "Dying Too Soon: How Cost-Effectiveness Analysis Can Save Lives," NCPA Report No. 204, National Center for Policy Analysis, May 1997, p. 1.
16 Aaron Wildavsky, Searching for Safety, 1988.
17 For a survey of health-health analysis, see, Regulatory Program of the United States Government, April 1, 1992 - March 31, 1993, Executive Office of the President, Office of Management and Budget, 1993, pp. 19-28.
18 UAW v. OSHA, U.S. Court of Appeals for the D.C. Circuit, No. 89-1559, 1991.
19 Ralph L. Keeney, "Mortality Risks Induced by Economic Expenditures," Risk Analysis, vol. 10, no. 1, 1990, p. 149.
20 Ralph L. Keeney and Kenneth Green, "Estimating fatalities induced by the Economic Costs of Proposed Air Quality Standards for Ozone and Particulates," Working Paper, Reason Public Policy Institute, May 12, 1997.
21 Kay Jones, Is the EPA Misleading the Public about the Health Risks from PM 2.5? An Analysis of the Science behind EPA's 2.5 Standard, Citizens for a Sound Economy Foundation, May 1997.
22 Keeney and Green, p. 11.
23 Tammy O. Tengs, May 1997, p. 1.
The EPA's proposed air quality standards for ozone and particulate matter might actually do more harm than good, even just in terms of public health. Recent studies suggest that the costs of the proposed standards could be $90 billion to $150 billion annually, forcing consumers to spend less on health care and safety products. A recent study by the Reason Public Policy Institute found that up to 27,000 fatalities may be attributed to the proposed standards.
Dr. Kay Jones' analysis of the Environmental Protection Agency's (EPA) annual mortality estimates from fine particles has resulted in the discovery of several problems. His study demonstrates that the EPA's dependence on a key but highly flawed study, as well as its questionable use of this study's data, has led it to exaggerate the health risk from PM2.5. Dr. Jones concludes that promulgation of the proposed standard is scientifically unwarranted.
A statistical error recently prompted the EPA to lower its estimate of the number of annual deaths from fine particulate matter (PM2.5) in the atmosphere for the third time, from 20,000 to 15,000 (see graph on next page). According to former Carter administration environmental advisor Dr. Kay Jones, who is credited with catching the statistical error, even this "correction" fails to show the true implications of the statistical error.1 In fact, the implications, revealed in a recent Citizens for a Sound Economy (CSE) Foundation report by Jones, suggest that the underlying science does not support the standard proposed by the agency, and that the EPA's annual estimated mortality from PM2.5 should have been lowered to less than 1,000.2
Mean-median error. The EPA used mislabeled air quality data from an American Cancer Society (ACS) study to underpin its new standard.3 Air quality data in the ACS study was used by the EPA to determine a threshold -- the level of PM2.5 exposure where mortality effects appeared noticeable. The agency concluded that these effects began at 15 micrograms per cubic meter (g/m3), where it then set the annual standard. But the data used came from a chart that was labeled as mean PM2.5 exposure levels, when it actually contained median data. Median exposure levels are not appropriate for use in standard setting, since they do not relate to what people breathe. Jones concluded the mean exposure level of PM was at least 25 percent above the EPA's median level. As a result, the level of PM2.5 at which the EPA claimed mortality was noticeable in the key ACS study was not the reported 15 micrograms per cubic meter (g/m3), but 18 g/m3 or greater. This should have led the agency to increase the proposed level of the standard, which would also decrease the number of people exposed to PM levels beyond the EPA's stated margin of safety. However, any PM2.5 standard would still remain unjustified in light of the inadequate mortality data in the ACS study. The agency responded to this error by decreasing the estimated annual mortality by 5,000 people, although it did not increase the level of the standard.
Phantom Benefits. The new mortality estimate, however, fails to consider yet another problem in the EPA's calculation of annual mortality.4 The EPA claims reductions in annual mortality that cannot be attributed to the proposed standard. In the proposed rule, the agency stated the new standard provided an adequate margin of safety, meaning it believed exposure to levels of PM2.5 below the 15 g/m3 standard posed no significant health risk.5 But Jones found that the EPA's mortality estimates wrongly included deaths from PM2.5 exposure below the 15 g/m3 standard. After recalculating annual mortality, without predicted deaths from people exposed to PM2.5 levels below the corrected 18.75 g/m3 standard, Jones estimated the number of lives at risk to be fewer than 1,000.
EPA's Response. The EPA has rejected Dr. Jones' analysis without explanation and has yet to specifically rebut the problems detailed in the CSE Foundation study. The agency has only said that the premises behind his recalculated mortality estimates were invalid stating, "EPA scientists believe that Dr. Jones' critique of this particular study is inaccurate."6 The agency is currently standing by its estimate of 15,000 annual premature deaths from PM2.5.
The EPA's failed and flawed analysis of the ACS study. The agency's mortality estimates must be further discounted due to its reliance on a controversial ACS study.7 The agency used one important statistic from this study, called the "relative risk," in its calculation of the annual mortality from PM2.5. Relative risk is the statistic epidemiological studies produce to quantify the level of risk from a given substance. Jones found several problems with that study, which lead to an overstated relative risk associated with PM2.5 exposure. He found problems with the data in the study severe enough to disqualify it from further use in the standard setting process, but the agency never caught these problems. In discussions with EPA staff, Dr. Jones discovered that the ACS study never received the type of scrutiny it should have received, especially since the agency relied so heavily on its results. Apparently, EPA scientists found the ACS study's appearance in the American Lung Association Journal enough to validate its results.
Jones, along with Michael Gough and Peter VanDornen of the Cato Institute, tried to reproduce the ACS study's findings to assess the accuracy of the risk it reported. In their analysis, they found the study's data was plagued by inaccurate and incomplete air quality and mortality data, which the EPA staff failed to note. Jones et al. attempted to obtain the omitted and inaccurate data to make the appropriate corrections, but they were denied access by the ACS study's authors. Jones et al. proceeded to evaluate additional data using information from readily available EPA and Centers for Disease Control databases. Unfortunately, until the underlying data from the ACS study is publicly released, interested scientists will not be able to tell for sure the extent of the study's inaccuracy. The following problems discovered by Jones et al., however, are an indication that the EPA must reconsider the study:
The ACS study did not include data from several major metropolitan areas. The data in the ACS study was skewed, because it did not truly represent national exposure to PM2.5. In fact, Jones et al. found that available data from major cities, such as New Orleans, Pasadena, New York, Pittsburgh, St. Louis, and San Antonio, were omitted from the study without explanation. Jones et al. attempted to obtain the missing data from the ACS study's authors, but were refused release of the data. Instead, they attempted to reproduce the study using more recent and readily available data for 24 cities, which included data from six cities included in the ACS study. The association between PM2.5 and mortality was not statistically significant.
Faulty data from one city resulted in a further overestimation of the risk from PM2.5. The PM2.5 exposure data from one city, Ashland, Kentucky, was radically different than other cities in the study. EPA staffers should have viewed this city's measured PM levels with skepticism, since this single data point was pivotal to the EPA's interpretation of the data above the proposed standard. Jones et al. found the PM levels in Ashland suspiciously high and attempted to reconcile the exposure levels reported by ACS with another database. They found that the PM2.5 data for Ashland should have been corrected or thrown out.
The ACS study concluded that non-smokers are more at risk from PM2.5 exposure than smokers, which suggests the health risk from PM2.5 was inflated by inaccurate mortality data. This conclusion should have raised red flags with EPA staff, since smokers are much more susceptible to heart and lung disease. It is highly unlikely that more non-smokers died from PM exposure than smokers. This conclusion suggests that the ACS study was counting smokers as non-smokers. The cause of this spurious conclusion is likely self-reporting error. Instead of using data collection specialists, the ACS study estimated mortality using health history data collected from friends and relatives of the deceased who were unlikely to have accurately reported smoking history. Further, the ACS study reported that 22 percent of the people who participated in the study were smokers, which is much lower than the 32 percent of Americans who were active smokers at that time, according to the Center for Health Statistics.
The errors found by Jones et al. raise serious concerns about the problems with the EPA's estimates of annual mortality reductions that would result from its proposed standards. These problems only add to the existing data gaps and uncertainties surrounding the EPA's PM2.5 rule. Once these problems are considered, the validity of the new standard as a whole must be questioned. Some of the more fundamental problems include:
The EPA is relying on a statistical association between PM exposure and mortality that is so weak that many consider it insignificant;
The EPA has not identified a biological mechanism to show why PM2.5 is harmful;
Sufficient PM2.5 exposure data has yet to be collected. Without a nationwide monitoring network, there is not enough air quality data to answer the numerous questions about the health effects of PM2.5 exposure.
Conclusion. The questions raised by Jones et al. about the ACS study and the EPA's analysis will not be fully answered without a substantial re-analysis of the underlying data, which the ACS study's authors refuse to release. Now that only a few weeks remain before the standard is finalized, the EPA must halt the rulemaking process to allow questions about the underlying science to be answered. The unwillingness of the study's authors to allow access to basic data is troubling; such secrecy is incompatible with the modern scientific process. Worse yet, this may be evidence that the political process of administrative rulemaking has made real science within the EPA difficult, if not impossible.
Ultimately, if the EPA is to prove the scientific validity of the PM2.5 standard, it must see that the data behind the ACS study is publicly released for further re-analysis. Only through an open, scientific debate between critics and supporters of the new standard will the public, which will pay billions of dollars for the new standard, be convinced that a genuine health risk from PM2.5 exists.
1 Dr. Jones is the head of Zephyr Consulting, a Seattle-based environmental consulting firm. Dr. Jones served as senior advisor on air quality at the President's Council on Environmental Quality (1975-79) and also as a senior technical advisor and research manager for the Environmental Protection Agency. He has written the air quality status and trend chapters for eight of the last fourteen Presidential CEQ Environmental Annual Reports to Congress. Dr. Jones is an adjunct scholar at Citizens for a Sound Economy Foundation.
2 Kay Jones, Michael Gough, and Peter Van Doren, "Is EPA Misleading the Public About the Health Risks From PM 2.5, An Analysis of the Science Behind EPA's PM 2.5 Standard, Addendum," Citizens for a Sound Economy Foundation, May 12, 1997.
3 C. A. Pope, III, M. J. Thun, M. M. Namboodin, D. W. Dockery, and J. S. Evans, "Particulate Air Pollution as a Predictor of Mortality in a Prospective Study of U.S. Adults," American Journal of Respiratory Critical Care Medicine, Vol. 151, 1995.
4 The EPA issued a press release on April 2, 1997, acknowledging the error and provided a revised estimate of benefits that reduced the number of lives saved annually from 20,000 down to 15,000.
5 EPA, Federal Register, Vol. 61, No. 241, December 13, 1996, p. 65660.
6 Katherine Rizzo, "Scientist raises new questions about deaths from dirty air," Associated Press, May 12, 1997.
7 C. A. Pope, III, M. J. Thun, M. M. Namboodin, D. W. Dockery, and J. S. Evans, "Particulate Air Pollution as a Predictor of Mortality in a Prospective Study of U.S. Adults," American Journal of Respiratory Critical Care Medicine, Vol. 151, 1995.
Dr. Kay Jones' analysis of the Environmental Protection Agency's (EPA) annual mortality estimates from fine particles has resulted in the discovery of several problems. His study demonstrates that the EPA's dependence on a key but highly flawed study, as well as its questionable use of this study's data, has led it to exaggerate the health risk from PM2.5. Dr. Jones concludes that promulgation of the proposed standard is scientifically unwarranted.