The contractual nature of budgeting: A transaction cost perspective on the design of budgeting...

Policy Sciences 29: 189-212, 1996. �9 1996 Kluwer Academic Publishers. Printed in the Netherlands.

The contractual nature of budgeting: A transaction cost perspective on the design of budgeting institutions

ERIC M. PATASHNIK Department of Political Science, Yale University, New Haven, CT06520, U S.A.

Abstract. Viewing budgets as contracts, transaction cost theory focuses on the costs of negotiating and enforcing the myriad political agreements by which policymakers allocate the government's resources. This essay provides an overview of transaction cost theory and its implications for the design of budgeting institutions. It contrasts the behavioral premises (bounded rationality and opportunism) of the transaction cost approach with those of more traditional budgetary theories, and examines whether commitment and agency costs have structured budget actors' institutional choices. Investigation of the usage of key budget instruments- entitlements, multi-year appropriations, and tax expenditures - suggests that Congress has been more discriminating in its institutional choices than is commonly supposed. Sensitivity to the importance of transaction costs would increase the effectiveness of budget reforms.

Viewed in another light, a budget may be regarded as a contract. Congress and the president promise to supply funds under specified conditions, and the agencies agree to spend the money in ways that have been agreed upon. (When an agency apportions funds to its subunits, it may be said to be making an internal contract.) Whether or not the contract is enforceable, or whether or not the parties actually agree about what the contract pur- portedly stipulates, is a matter for inquiry. To the extent that a budget is carried out, however, it imposes a set of mutual obligations and controls upon the contracting parties.

Aaron Wildavsky (1964: p. 2)

Virtually any relation, economic or otherwise, that takes the form of or can be described as a contracting problem, can be evaluated to advantage in transaction cost economics terms.

Oliver Williamson (1985: p. 387)

T h e concept of budgeting as contracting is a familiar one. The distinguishing feature of a contract is a commitment between two or more parties, and budgeting entails making commitments about the future activities the government will engage in using taxpayer money. Elected officials and lobbyists frequently in- voke the contractual paradigm when seeking to obtain or protect funding for their favored programs. For example, Bud Shuster (R-PA), the chairman of the House Public Works Committee, has stated that the highway and airport trust funds - which earmark the revenues from transportation user charges for infrastructure spending - constitute 'nothing less than a contract ' between the government and the American traveling public. 1 In the case of some programs,

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such as social security, the contract implicitly underlying the activity may create such precise expectations about governmental performance that beneficiaries regard any attempt to alter its terms as a 'breach of faith' (Kettl, 1992: p. 48).

Yet if the concept of budgeting as contracting is easily grasped, scholars have not fully exploited its power. As Aaron Wildavsky pointed out in 1964, viewing a budget as a contract immediately raises the crucial issue of enforceability. Can clientele groups prevent elected officials from reneging on their budget promises? Can legislators ensure that agencies will faithfully execute their spending instructions? This, in turn, raises still other important questions for budgeting scholars. Are all budget transactions - public works projects, government pensions, routine operating expenses - fundamentally the same or do some transactions create more severe contractual hazards than others? What accounts for the myriad of contractual forms - annual appropriations, entitlements, tax expenditures - that are employed in the budgetary process?

To address such questions, a theory of contractual arrangements is necessary. By far the most powerful theory of contracting is transaction cost economics. Transaction costs are the costs of negotiating, monitoring and enforcing agreements. They include the information and decisionmaking costs that actors incur when searching for feasible options, bargaining over alternatives, and monitoring implementation of collective decisions. Such activities are at the heart of public budgeting. Transaction costs also include the 'maladaption' costs that parties incur when contracts break down as well as the haggling costs associated with conflict resolution (Williamson, 1985). Such costs of contracting can be substantial in a world in which citizens depend heavily upon the government, but elect leaders who disagree over what constitutes an appropriate direction for public policy.

Transaction cost theory traces its origins to a pioneering 1937 article by Nobel laureate Ronald Coase, in which he used a transaction cost approach to explain the existence of firms as organizational forms (Coase, 1937). Oliver Williamson then developed the Coasian argument into a sophisticated theoretical framework for analyzing the structure of economic actMty (Witliamson, 1985; 1991). While the transaction cost model was originally developed to explain the organizational logic of the private sector, a growing number of scholars are using it to make sense of variations in public sector organization. Important contributions have been made by Moe (1984; 1989; 1990), Bryson and Ring (1990), Heckathorn and Maser (1990), Frant (1993), Weingast (1993), Twight (1994), and Horn (1995). Horn's work deserves special mention because it examines the implications of transaction cost theory across an unusually wide range of administrative forms, including budgeting structures. 2

What makes application of transaction cost theory to budgeting especially appropriate is that it grows out of the same intellectual tradition as incrementalism. Both theories borrow Herbert Simon's idea that actors are boundedly rational and thus must devise ways of simplifying their calculations (Simon, 1961). Most rational choice theories assume that actors maximize their utility,

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ignoring the constraints actors encounter in the real world. Very much like incrementalism, however, transaction cost theory rests upon the premise of costly information. Yet the transaction cost model goes beyond incrementalism by adding to bounded rationality the behavioral assumption of opportunism (which, I shall argue, massively influences institutional choices) and by empha- sizing that many transactions cannot be carried out in the absence of contractual safeguards. It thereby accounts for a number of important budgetary phenomena - including entitlements - that pose difficult interpretive challenges for incrementalism. 3

Clearly it would be a mistake to import transaction cost theory into budgeting research without subjecting its premises to critical scrutiny. Transaction cost theory presumes that contractual arrangements in the private sector are efficient (else they would not exist). This may not be a reasonable premise for the public sector, however. Government officials lack strong incentives to pursue efficient courses of actions because they have no property rights in governmental outputs, and because the meaning of efficiency in a governmental context is frequently unclear and politically contested (Wilson, 1989). In view of these differences, the three major claims made here are relatively modest: (1) the costs of negotiating and enforcing budget 'contracts' shape the budgetary process and, through it, budget outcomes; (2) political actors deliberately craft institutional safeguards to add durability to their commitments; and (3) budget reforms are unlikely to succeed if they fail to take into account both the potential for opportunistic political behavior and the inherent need of complex transactions for contractual safeguards.

This paper provides an overview of transaction cost theory and its implications for budgeting. I first discuss the behavioral assumptions of transaction cost theory and compare them to the assumptions of competing budgetary models. To explore whether budgeters minimize transaction costs, I identify the defining attributes of budget transactions and describe the performance features of alternative budgetary governance structures. Finally, I discuss the implications of the transaction cost approach for budgetary reform.

Competing models of budgeting

Assumptions about human nature are fundamental to any theory of organizational behavior. Transaction cost theory is no exception. It rests on the assumption that actors are boundedly rational (meaning 'intendedly rational but only limitedly so') and opportunistic (meaning 'self-seeking with guile') (William- son, 1985: pp. 45-47). Since our interest lies in what transaction cost theory teaches us about budgeting, the most direct way to analyze the implications of its behavioral assumptions is by comparing them to the assumptions of competing budgetary theories. Perhaps the two best known models of budgeting are synoptic rationality and incrementalism. The first of these models assumes that budget makers have limitless cognitive capacity; the second differs from

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transaction cost economics primarily in its assumptions about actors' degree of self-interests.

In a world of synoptic rationality, decisionmakers budget comprehensively. They identify fiscal policy goals for the coming year, conduct an exhaustive review of every conceivable course of action, and then enact the budget pack- age that maximizes social utility. The model rests on the assumption that policymakers are both omniscient and benevolent: they know everything worth knowing, and they use this wealth of knowledge to maximize collective well- being. Political considerations count for relatively little (Smithies, 1955).

The incremental model, by contrast, holds that it is unrealistic to expect budgeters to compare every budget item to every other in terms of their contribution to social welfare, Given the severe constraints on the cognitive capacities of human actors, the calculative burden imposed by such a task is simply overwhelming. Incrementalist theorists further argues that synoptic rationality requires a degree of consensus on social values that is unlikely to be realized in a democracy in which citizens and groups are free to pursue their self-interests (Wildavsky, 1964).

In his classic study The Politics of The Budgetary Process, Wildavsky argued that budget participants reduce search costs and moderate conflict by limiting calculation and negotiation to new issues (Wildavsky, 1964). As Joseph White puts it, under incrementalism, 'old knowledge is considered still good until shown otherwise' (White, 1988: p. 186). Budgeters assume continued funding of the 'base' for most agencies. Conflict is restricted to the distribution of 'fair shares' at the margin. In practice, this means that most agencies get the same annual percentage increase. Always, it means that 'program advocates seek to expand their programs by a amount that other participants will recognize as fair' (Kettl, 1992: p. 71). Budget outcomes emerge from free and open bargaining governed by widely-held norms of moderation and fair play (Rubin, 1990). 4

Transaction cost economics accepts the idea that decisionmakers are boundedly rational. However, it strongly rejects incrementalism's faith in the willingness of actors to moderate their demands or abide by norms of procedural fairness. Rather, it holds that opportunistic actors will deceive other players, renege on their commitments, and manipulate the rules of the game, if they can get away with it (Williamson, 1985).

The conceptual differences between incrementalism and transaction cost theory become apparent when one recognizes that transaction costs include both the ex ante costs of negotiating agreements and the ex post costs of safeguarding agreements through time. Implicit in incremental theory is the idea that actors live by their agreements, and that any problems in budget execution can be easily corrected during the following year's budget cycle. Con- sequently, the major organizational task budgeters face is reducing the initial search costs of rearching their decisions. By contrast, transaction costs theory maintains that actors will defect from the letter and spirit of agreements when it suits their purposes, and that long-term contracts are inevitably incomplete. Thus, the organizational imperative for budgeters becomes not merely econo-

Table1. Behavioral assumptions of competing budgetary theories.

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Dimension Model

Synoptic rationality Incrementalist Transaction cost

Rationality Omniscient Bounded Bounded Self-interest orientation Benevolent Self-interested Opportunistic

mizing on decision costs, but ensuring effective contractual performance (Wil- liamson, 1985).

The behavioral assumptions of the three models are summarized in Table 1. Most scholars would agree that in presuming omniscience and benevolence, synoptic rationality is far too utopian to describe how budgeters actually behave (though some reformers still view the model's prescriptions as normatively desirable). Transaction cost theory is the polar opposite of synoptic rationality, pairing as it does severe limitations on cognitive competence with opportunism, the strongest form of self-interestedness. Given incrementalism's pride of place in the budgeting literature, it is reasonable to ask whether this extreme motivational premise is warranted. The evidence from a recent book by former Congressional Budget Office analyst Roy T. Meyers suggests that it is (Meyers, 1994).

According to Meyers' insider account, budget actors, particularly spending proponents in Congress, seek to advance their policy objectives by exploiting loopholes in budget accounting rules, finagling with the technical assumptions underlying budget baselines, and camouflaging the true costs of federal activity. For example, proponents of the Rural Housing Insurance Fund leveraged an extremely hard-to-detect form of Treasury borrowing to supply the program with billions of federal dollars, even while selling 'the fiction that the program carried out activities that were close to costless to the federal government' (Meyers, 1994: p. 37). In a similar vein, defense advocates in 1985 strategically shifted the mix of programs during budget preparation toward slow-spending accounts, making it more difficult for opponents of a major increase in defense spending to monitor actual levels of resources committed (Meyers, 1994: pp. 90-91).

To be sure, most budget actors most of the time do moderate their demands and play according to accepted rules of the budget game. But this is precisely because it is in their self-interest to do so. Those who violate the rules risk being caught. Agency heads who blatantly lie to congressional appropriators are unlikely to remain agency heads for very long. When the same groups of actors interact repeatedly and reputations matter a lot - as was the case during the highly stable era captured in Wildavsky's seminal work - the expected costs of defection will exceed the benefits. This leads to a consensual bargaining process characterized by significant levels of mutual trust. Such norm-abiding behavior is not inevitable, however. When reputation effects are weak and opportunism

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'pays,' budget actors will be unwilling to exercise self-restraint, and norms of procedural fairness are likely to collapse. In sum, cooperative budgeting outcomes are conditioned on the institutional environment in which budgeting takes place. 5 Transaction cost theory thus renders problematic what traditional budget scholars largely took for granted - the maintenance of a stable budgetary process itself.

The problem of government commitment

The description of contemporary budgeting contained in Meyers' study challenges the incrementalist premise that budgeting is inherently consensual and noncompetitive, and that once an item becomes part of an agency's base it becomes safe from attack. Indeed, elected officials come across as perpetually worried that funding for their favored activities will be significantly reduced as soon as the coalition of which they are part wanes even slightly in influence. No doubt such anxieties have become more pronounced in the current era of divided government and fiscal stress. However, they stem from a fundamental characteristic of democratic politics: inability to bind one's successors. In the private sector, property rights are generally secure. In the public sector, however, the right to exercise control over government resources is perennially 'up for grabs' because it attaches to public offices, whose occupants are subject to electoral turnover (Moe, 1989; 1990; Moe and Caldwell, 1993). Elected officials are free to enter into the budget contracts of their own choosing, but these contracts are vulnerable to modification or even nullification if future politicians have opposing policy interests. In sum, clientele groups 'run the risk that [current] or subsequent legislative coalitions might undermine the benefits of legislation' (Horn, 1994: pp. 16-17).

Farsighted actors will anticipate this commitment problem. Consequently, they will want the budget promises they care most about to be 'credible;' meaning hard to reverse. A budget commitment can be credible in either of two ways. The first is if maintaining the commitment is compatible with the incentives of current officeholders. Alternatively, a commitment may be credible not because contemporary politicians are themselves motivated to keep it, but because institutional or structural arrangements compel their compliance (Shepsle, 1992). 6

Commitments that are incentive-compatible are self-enforcing. Office hold- ers uphold the original deal because it is in their electoral interest to do so. The extent to which politicians are motivated to keep a given promise is thus influ- enced by all the standard factors that affect constituency strength. The larger and more geographically-dispersed the affected group, the more intense its feelings, and the more resources it commands, the stronger officeholders' incentive to honor existing budget commitments (Wildavsky, 1992: p. 301).

The intended beneficiaries may be too weak or unorganized to influence the political process, however. Under such conditions, commitments are not self- enforcing through time, and farsighted budgeters who wish to ensure that their

Table 2. Credibility of budget 'contracts.'

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Level of institutional protection Officeholders' incentive to maintain promise

Strong Weak

Relatively high Credible (social security)

Relatively low Semi-credible (pork barrel)

Semi-credible (child nutrition programs) Empty promise (migrant health programs)

promises will outlive their tenure in office must rely upon institutional safeguards. It is rarely if ever possible for officeholders to disable the discretion of their successors altogether. As Charles Stewart has noted, 'no structural reform appears to have ever been able to dwarf every social movement that comes along' (Stewart, 1987: p. 604). Yet, if totally eliminating the commitment problem is impossible, officeholders can make promises more durable by devising institutional arrangements so as to 'place substantial transactions costs in the path of change' (Shepsle, 1992: p. 257).

This analysis implies a typology of contractual types in which the incentive of officeholders to maintain commitments varies from weak to strong and the degree of institutional protection varies from low to high (Table 2). The most ironclad budget contracts are those that politicians have a strong incentive to maintain and that are simultaneously enforced through elaborate institutional safeguards. An example is social security. Current and future social security recipients comprise a sufficiently powerful clientele that even fiscally-conserva- tive politicians are leery of tampering with benefit levels, and the social security 'contract' is procedurally insulated (through entitlement status, trust fund financing, fire-wall rules, and so forth). The least credible budget commitments, by contrast, are those which both serve weak clienteles and have few layers of protection. An example might be a health program for low-income migrant workers. Not only is there little electoral incentive for officeholders to keep the promise, but the discretionary nature of the program makes it procedurally easy for officeholders to curtail it. Finally, contracts are semi-credible, meaning reversible at some non-trivial cost, when they (a) provide a stream of electoral benefits to current officials yet are not supported by elaborate safeguards (as in many pork barrel projects); or (b) are structurally advantaged but are backed by relatively weak voting power (as in certain low-income entitlement programs, such as child nutrition programs).

Institutional tiers

In contrast to incrementalism, transaction cost theory maintains that institutional arrangements play a critical role in mitigating against the hazards of

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Table3. Transaction cost analysis of federal budget system.

Transactions (e.g., public works spending, income transfers, interest on the debt, etc.)

are assigned to

Governance structures (e.g., appropriations, entitlements, tax expenditures)

which are embedded in the

Institutional environment (e.g., separation of powers system)

opportunism. 7 The model distinguishes between two institutional tiers: governance structures, and the larger institutional environment (Williamson, 1991) (Table 3).

Governance structures are the institutional arrangements used to carry out par t i cu lar transactions. Examples of budgetary governance structures include annual appropriations, entitlements, permanent authorizations, and the myriad other devises used to administer specific programs and activities. By contrast, the institutional environment is 'the set of fundamental political, social and legal ground rules' that establish the basis for political activity (Davis and North, 1971: pp. 6-7). Seen in this light, the distinguishing feature of the institutional environment of federal budgeting is the separation of powers system. 8 This system is institutionalized through the congressional budget and im- poundment act, the committee system, and the many other rules, structures and arrangements that determine who gets to exercise budgetary power in Washington.

The separation of powers system fragments public authority and makes it relatively hard to alter the status quo. Many argue that such inertia is an advantageous design feature because it tends to constrain the governments' ability to confiscate wealth, which in turn encourages private investment and economic growth (North, 1990; Weingast, 1993). At the same time, however, the system's institutional fragmentation also tends to frustate major policy change. The separation of powers makes it hard to expand the reach of government. But it makes it even more difficult to renege on public commitments once they are made (Shepsle, 1992).

A study of efforts to reduce spending for old-age pensions in several indus- trialized democracies brings the institutional effects of the American system into sharp relief (Pierson and Weaver, 1993). Imposing losses in pension policy is a difficult task for politicians in any system. The elderly comprise a large and politically-sympathetic group, and the costs of pension cutbacks are generally immediate and visible while the benefits of spending reductions tend to be long- term and diffuse. The separation of powers makes this task even more onerous, however. Because of the diffusion of legislative power, policymakers in the United States have generally been able to reduce pension spending 'only when the alternative appears to be unthinkable,' as when social security threatened to become insolvent in 1983. By contrast, 'the absence of veto points' that charac-

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terize the British parliamentary system have provided wider and more routine opportunities for loss-imposition (Pierson and Weaver, 1993: p. 143). 9

A review of transportation policy commitments in the United States and Great Britain reinforces this conclusion. At various points in the twentieth century, elected officials in both nations entered into similar bargains with transportation clienteles, agreeing to dedicate the revenue from gasoline taxes for road building. Within several years after these bargains were struck, politicians who were not parties to the original deals began attempting to 'raid' the highway funds. In Britain, chancellor of the exchequer Winston Churchill spear- headed an effort to divert gas taxes into the general fund. Churchill's actions were vehemently opposed by both Parliament and motorists groups, which argued that the government was morally bound to uphold its end of the bargain. But the Treasury's monopoly on fiscal policy matters prevented the diver- sions from being stopped, and the road fund was eventually dismantled (Dunn, 1981). By contrast, the sharpest attack on the integrity of the U.S. highway - the attempt by President Richard Nixon to cancel highway spending through impoundments - was much less successful. Congress passed legislation severely circumscribing the ability of presidents to use impoundments to rewrite congressional spending priorities, and it sued Nixon successfully in court. Largely as a result of the institutional endowment of the separation of powers system, the highway trust fund remains basically intact four decades after its establish- ment despite continued attempts of presidents of both parties to weaken it.l~

Dimensionalizing budget transactions

The existence of a separate highway trust fund - which was created in 1956 to 'lock-in' a massive increase in highway expenditure and to assure highway clienteles that their special taxes would actually be spent for their benefit - is important] 1 It suggests that the formidable protections against policy reversal inherent in the checks-and-balances system may be inadequate to close a deal, and that budget actors may deliberately craft institutional safeguards to en- hance the durability of their commitments.

Perhaps no American politician has ever been a more skillful institutional architect than was Franklin Roosevelt when designing the social security program. Roosevelt's advisers pressed him to finance social security at least parti- ally from general revenues. But Roosevelt possessed a keen appreciation for the problem of government commitment, and he insisted on the exclusive use of payroll taxes in order to give contributors a political and legal right to collect their pensions and thereby put future politicians under an implicit contractual obligation. Said Roosevelt in an oft-quoted remark: 'With those taxes in there, no damn politician can ever scrap my sociaI security program' (Derthick, 1979: p. 230). 12

The social security case raises important questions for scholars. Do certain kinds of budget transactions pose more severe transaction problems than others?

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How can such problems be reduced? Transaction cost theory holds that transactions have varying attributes that bear on the level of information and en- forcement costs that parties incur (Williamson, 1985). Two attributes which have especially important implications for budget contracts are uncertainty and asset specificity.

Uncertainty comes in various forms. The form that most plagues budgeting is political uncertainty: program advocates simply do not know what level of political support their favored policies will command in the future. Political uncertainty may be especially high when budget commitments are of a long- term nature, as is the case for social security. Given a long enough time horizon, even programs that were initially very popular are likely to witness an erosion of support due to changing political conditions. Another important type of uncertainty is 'asymmetric information,' meaning uncertainty of the kind where one party to a deal has information that the other party lacks (Kreps 1990, p. 749). An example in a budgeting context is a user free progam in which the users contribute at time t but do not collect benefits until time t + 1. In the absence of an institutional monitoring system, beneficiaries may be unable to tell whether they are receiving their money's worth, particularly if the benefits are not provided on a cash basis.

The second attribute that bears on transaction costs is 'asset specificity.' Asset specificity refers to the degree to which assets involved in a transaction are nonredeployable. Examples of specialized assets in the private sector are specialized equipment, skills, and productive capacities which would expose the investor to significant losses from unanticipated changes in supply or demand (Williamson, 1985). In the public sector, high asset specifijzity Characterizes transactions in which citizens make major life decisions - such as how much to save and when to retire - in the expectation of promised benefits. Government pensions are the paradigmatic example. While workers have many retirement options before pensions are established, once the promise of future benefits is made, they become 'locked in.' 13

Dimensionalizing budgetary governance

Just as transaction cost theory holds that transactions vary in their attributes, so it posits that generic forms of governance have distinctive strengths and weaknesses. For example, markets elicit stronger incentives than firms, but firms possess tighter administrative controls (Williamson, 1985). Key performance features for budgetary governance are decisionmaking efficiency, flexibility, and credibility. 14

Consider three forms of budgetary governance: zero-base budgeting, annual appropriations budgeting, and entitlement budgeting. How do each of these regimes stack up? Table 4 shows the distinguishing attributes of each.

Table4. Attributes of different budgeting regimes.

Attribute Budgeting regime

Zero-base Appropriations Entitlement

Efficiency 0 + ++ Flexibility ++ + 0 Credibility 0 + ++

++ = strong; + = semi-strong; 0 = weak.

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Zero-base budgeting

In its ideal form, zero-base budgeting means that every year Congress would review and prioritize the entire budget. This regime (which is closely related to the idea of synoptic rationality) permits a high degree of flexibility. Governance is responsive to new information and past decisions do not limit future choices. However, the regime imposes tremendous search and information costs because every decision must be reviewed from scratch.

Because every budget contract is rewritten annually, zero-base budgeting destroys the credibility of long-term commitments. These negative effects may explain why 'nowhere does a true zero-base budget exist' (Wildavsky, 1992: p. 439).

Annual appropriations budgeting

Budgeting via annual appropriations - the kind of budgeting described both in The Politics of the Budgetary Process and in Richard Fenno's classic The Power of the Purse (1966) - is much easier to manage. Budgeters need only focus or incremental changes. Flexibility is preserved because increments add up over time. Yet because annual changes are confined to the margin, dramatic shifts in policy become highly unlikely. This gives promises a reasonable degree of durability (Twight, 1994). The fact that appropriations budgeting does not score badly on any criterion probably explains why it continues to be used in most nations (Wildavsky, 1992: p. 426).

Entitlement budgetinS 5

Entitlement budgeting entails budgeting by right: expenditures automatically increase to provide mandated benefits to eligible parties. Entitlement budgeting has credibility advantages. Spending cannot be reduced in nominal or (in the case of indexed entitlements) real terms without changing the law. This make budget contracts very secure (Horn, 1995). Because it mandates shares and

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protects the base, entitlement budgeting simplifies 'political and factual calculation' even more than does appropriations budgeting (White, 1994: p. 123). As with any governance structure, however, the advantages of the entitlement mechanism do not come without a cost. Entitlements narrow policymakers' discretion to respond to changing conditions. As a result, it becomes harder for politicians not only to reallocate resources but to use the annual budgetary process to punish agencies which get out of line.

/

Discriminating alignment?

This point of this discussion is simply that transactions differ in their governance needs while governance structures vary in their performance attributes. Transaction cost theory holds that contractual forms reflect transaction cost economizing: transactions are organized so as 'to economize on bounded rationality while simultaneously safeguarding them against the hazards of opportunism' (Williamson, 1985: p. 32). The prediction is that transactions low in both uncertainty and asset specificity will generally be assigned to simple governance structures, and that added safeguards will generally be reserved for transactions that could not easily be carried out without them. This is in fact what we see in the private sector. When assets are highly redeployable, transactions are generally handled through markets. By contrast, when asset specificity and uncertainty increase, so that contracting parties have more at risk, transactions are generally assigned to firms or other more hierarchical forms of organization. Transaction cost economizing explains vertical integration, the use of debt and equity as corporate financing mechanisms, and a host of other contractual phenomena (Williamson, 1985; 1992).

Elected officials clearly do manipulate budget structures in order to strengthen policy commitments. An important question, however, is whether institutional choices in the public sector vary in systematic ways. Do budget actors assign structures to transactions so as to effect a discriminating match between performance features and governance requirements? A comprehensive examination of the use of alternative budgeting governance structures is beyond the scope of this paper. However, a brief look at the usage of three key budget instruments - entitlements, 'long-term' appropriations, and tax expenditures - is illuminating.

Entitlements

Entitlements (legal obligations on the Treasury to provide eligible parties with benefits) follow a rough transaction cost logic. The alignment between the entitlement governance structure and the transactions it governs (mainly income transfer programs for the aged, poor, and sick) is so tight that governance and transaction become almost indistinguishable in the minds of many. Indeed

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the word entitlement 'is commonly used as a synonym for social-assistance programs, and defined as such in recent Webster's and Random House diction- aries' (Makin and Ornstein, 1994: p. 224).

Yet there is no legal or technical reason why programs other than social- welfare programs could not also be made entitlements. There have been some attempts. For example, highway construction advocates in 1991 tried to place revenues from an increase in the gas tax into a mandatory highway construction program (Mills, 1991). With the exception of the now defunct general revenue sharing program, the commodity price support program (which ulti- mately provides payments to individual farm households), and a few isolated others, however, entitlement programs are almost entirely of the benefit program variety: social security, medicare, civil service and military retirement, veterans pensions, unemployment insurance, and so forth. No major new entitlement program has been created in decades. Total spending for entitlements has, of course, increased rapidly in recent years in order to keep past promises. From a transaction cost perspective, however, the critical point is that policymakers have been extremely reluctant to assign additional transactions to the entitlement structure, suggesting that they recognize the structure's negative features.

Budget transactions governed by the entitlement device share an important characteristic: they cause large numbers of people to make critical personal commitments on the basis of government policy (Wildavsky, 1992). Once made, such decisions are hard to reverse, and beneficiaries are at risk if the contract changes. The entitlement structure makes it less likely that people will be left out on a limb. A second advantage of administering social welfare programs via entitlements is that it enables transfer payments to rise automatically during recessions, thereby helping to moderate swings in the economy (Greenstein, 1995). The entitlement mechanism does make it harder for legislators to sanc- tion agencies ex post. However, the fact that entitlements are concentrated in the area of income transfer programs, whose payments schedules can be 'well specified ex ante,' means that agency problems are not especially severe (Horn, 1995: pp. 85-86).

Indeed, entitlements are superior to other governance alternatives for many budget transactions. ~6 A recent General Accounting Office report examined the feasibility of implementing a budgetary cap on spending for 11 entitlement programs (GAO, 1994). The report found that such a sequester could be im- plemented for some of the programs, but that many of the programs share attributes that would make it difficult for officials to 'plan, apportion, and administer program changes necessary to enforce a cap.' These attributes include difficulty of predicting the number of eligible recipients at the start of the fiscal year, provision of noncash benefits, dependence upon state governments for implementation and financing, and complex program interactions (GAO, 1994).

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Long-term appropriations

Congress appropriates money by means of three organizational forms: annual appropriations, permanent appropriations, and what Allen Schick terms 'long- term appropriations.' The latter include no-year funds (which remain available for obligation beyond the year for which they were appropriated); multiyear appropriations (which remain available until some future date); and advance appropriations (which become available in a later year) (Schick, 1986).

Annual appropriations enable Congress to control its bureaucratic agents by making threats or actual appropriations changes (Wildavsky, 1992). But while annual appropriations reduce agency costs and increase legislative power of the purse, like all governance structures, they have their limitations. They do not signal exactly how much funding will be forthcoming in future years. This could be problematic for budget transactions in which even temporary disruptions of funding would create intolerable uncertainty or organizational instability.

Permanent appropriations are not a significant source of funding for federal activities with the exception of entitlement programs (such as social security and medicare) and interest on the public debt (GAO, 1995). 17 There is a strong transaction cost rationale for giving interest payments permanent spending authority. Failure to make timely interest payments on the national debt would undermine the nation's borrowing credibility and could have disastrous effects on the economy. If interest payments were subject to annual appropriations, the risk associated with holding Treasury obligations would increase, leading to higher interest costs for the government (Schick, 1977). Moreover, it would be extremely difficult for Congress to appropriate interest payments, even if it so desired, because payment levels cannot be calculated precisely ex ante (Bach, 1990).

Congressional usage of long-term appropriations display systematic variations. Table 5 shows the distribution of long-term appropriations among agencies for fiscal year 1985. Half of the annual appropriation accounts contain no- year, advance, or multiyear funds, and these long-term appropriations are concentrated in agencies that spend sizable funds on construction (the Depart- ment of Transportation), procurement (the Defense Department), or transfer payments to individuals (the Health and Human Service Department). By contrast, agencies whose budgets are dominated by everyday operating expenses (e.g., Justice, State, and Treasury) tend not to have a high proportion of long- term appropriations, but instead have annual appropriations that must be obligated in the year for which they are made (Schick, 1986: pp. 48-49). Thus, Congress is extremely discriminating in its allocation of long-term money. Programs (such as construction and procurement) that require the continuity provided by long-term appropriations to achieve their performance objectives are allowed to bypass the annual appropriations process. But Congress generally sticks to annual appropriations for other programs. Where an agency's budget is dominated by routine operating expenses (as in the Justice Depart- ment), so that there is no administrative rationale for easy money and where

Table 5. No-year, advance, and multi-year appropriations, 1985.

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Agency Number of regular Number with no- appropriation ac- year, advance, or counts multi-year funds

Amount of no- year, advance, or multi-year appropriations (millions of dollars)

Appropriated to president 30 19 1,967 Agriculture 77 20 6,372 Commerce 18 13 1,681 Defense (military) 64 36 134,268 Defense (civil) 9 8 2,783 Education 21 13 14,684 Energy 20 18 15,732 Health and human services 49 16 41,981 Housing and urban development 16 8 4,355 Interior 44 29 2,104 Justice 20 9 326 Labor 16 4 4,426 State 21 6 362 Transportation 48 41 20,705 Treasury 18 7 357 EPA, GSA, NASA, OPM, SBA 28 14 12,118 Veterans 15 10 16,450 Other 75 21 2,545 Totals 604 292 283,216

Source: Schick (1986) based on Office of Management of Budget data.

opportunis t ic bureaucrats have wider scope to divert unspent funds to their preferred uses, Congress generally prefers to keep depar tments on a tight leash.

Tax expenditures

Tax expenditures - revenue losses attributable to special preferences or exclu- sions in the tax code - have a poor reputation. 18 To their detractors, they are merely ' loopholes ' that serve to favor special interests. F rom a t ransact ion cost perspective, however, a tax expenditure is a governance structure that has distinctive strengths and weaknesses no less than any other budget instrument.

Tax expenditures have credibility advantages because modifying them requires changing the Internal Revenue Code, not merely slicing an appropr ia- tion. This facilitates taxpayer planning. But such added credibility comes at a cost. The proliferation of tax preferences requires tax rates to be higher than they otherwise would be, and it makes the overall budget more inflexible. The critical issue is, therefore, whether tax expenditures are assigned to budget t ransact ions in a discriminating way.

The evidence appears mixed. Many transactions assigned to tax expenditures

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are similar to those handled though entitlements in that people have specific assets at stake (White and Wildavsky, 1989; Wildavsky, 1992). A good example is the mortgage interest deduction. Buying a home is the largest investment decision in most people's lives. Once policymakers decide to use their authority to encourage home ownership, there are good transaction cost reasons for making this contract hard to break. Yet tax expenditures have also been used for transactions in which asset specificity and uncertainty are less pronounced, and where the major intention is simply to circumvent the regular appropriations process in order to aid narrow clienteles (such as ethanol producers, kiwi growers, and horse breeders) or in some cases even specific individuals (Muc- ciaroni, 1995).

Given that all feasible governance structures are flawed, distinguishing 'good' tax preferences from 'bad' tax preferences is difficult. One possible criterion, suggested by Oliver Williamson, is the 'test of time.' In the absence of egregious breakdowns of the political process, modes of governance that endure are pre- sumed to be efficient (Williamson, 1993a). However, there is a major problem with adopting this as a benchmark for policy analysis; namely, it sets forth no standards for evaluating the quality of the political process. 19 Still, it is interesting to note that many tax expenditures clearly do pass the test of time. Deduc- tions for home mortgage interest, property taxes, and state and local taxes were contained in the original tax code, adopted in 1913. Many other major tax expenditures (including deductions for extraordinary medical benefits) were enacted during the 1930s and 1940s (Howard, 1992). Not all tax preferences pass this test, however. As part of the sweeping tax reform bill of 1986, Con- gress eliminated or curtailed hundreds of tax expenditures in an effort to broad- en the tax base and lower marginal tax rates (Mucciaroni, 1995).

Assessment

My discussion of the use of these three budget instruments is intended to be suggestive, not exhaustive. The discussion does imply, however, that Congress has been more discriminating in its institutional choices - particularly in the case of entitlements and long-term appropriations - than is commonly supposed, and that it is fruitful to look at budgeting as a contracting problem. I have tried to show that a transaction cost perspective encourages deeper insights into the structural means by which budget agreements are negotiated, monitored, and enforced.

Many of the points of this essay are not really new. They merely refine and elaborate upon Allen Schick's excellent 1977 study, 'Congressional Control of the Budget,' in which he argued that Congress has demonstrated a willingness to accept a loss of immediate budgetary control 'in order to pursue other budget values: efficiency, stability, and financial certainty' (Schick, 1977: p. 7). That, in a sense, is the point: transaction cost theory appears to have the capacity to integrate a great deal of empirical knowledge about the design of contemporary

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budgeting institutions and to make contact with the best insights from the traditional budgetary literature. Some post-incrementalist scholars pessimisti- cally conclude that budgeting is now so complex that any effort at theory- building is bound to be unproductive, and that researchers should therefore concentrate on more modest goals such as developing 'rules of thumb or heuristics' (Kiel and Elliott, 1992). To go down this path, however, would merely ensure the demise of budgeting as a field of scholarly inquiry. At a time when budgeting lacks a clear research agenda, transaction cost theory has the potential to offer a useful framework for organizing scholarly work. This is not to say the discriminating alignment hypothesis can explain everything. Budget- ing involves not just making commitments but reconciling competing social visions. Any understanding of budgeting institutions would thus be incomplete if it did not take into account the role of both political culture and historical development. (Transaction cost theory makes a contact with the idea that history matters through the concept of path dependence.) The real question is not whether transaction costs matter for budgeting, but how transaction costs interact with other factors to produce the organizational phenoma that we seek to understand.

A transaction cost perspective on budgetary reform

Perhaps the most important contribution of the transactions cost perspective may be the guidelines it offers for budgetary reform. One of the strongst tenets of the normative budgetary literature is that every budgetary claim should be treated equally. As Donald F. Kettl puts it, 'The only way to promote equity in the process and to ensure accountability of results is to put everything on the table for careful scrutiny before making decisions and for careful review after they are made' (Kettl, 1989: p. 238). This seems like reasonable advice, but it has never been followed at the federal level. Permanent appropriations, for example, date to the early nineteenth century.

The problem with this prescription is that it fails to recognize that transaction differ in their attributes and therefore in the type of contractual hazards they create. Building a dam is not the same as guaranteeing a pension. Over time, the mix of transactions in the federal budget has undergone a dramatic transformation, shifting from a budget dominated by goods and services to one dominated by income transfer programs (Schick, 1990). It is no accident that the structure of budgetary institutions has changed along with it. Transaction cost theory thus suggests that reformers should not seek the impossible (equiv- alent treatment of all budget transactions). They should instead pursue the more attainable goal of ensuring that contractual safeguards are used only where and to the degree they are needed.

A transaction cost perspective suggests several guidelines for budgetary reform.

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Increase understanding of transactions and governance structures

The central insight of transaction cost theory is that both transactions and institutional forms matter. To avoid creating administrative mismatches by em- bedding transactions in structures that lack appropriate governance capacities, a fuller understanding of the defining attributes of transactions and of the costs and competencies of alternative budgetary instruments is necessary. On the transaction side, such an understanding requires careful examination not just of the intended objectives of tax and spending proposals. It also requires examination of the implications of particular budget transactions for legislative power of the purse, ex post monitoring of administrative performance, and beneficiary expectations. New budget transactions should be profiled along a series of critical dimensions including uncertainty, asset specificity, and information assymmetry. As Bryson and Ring argue, where transactions are highly complex, it may make sense to try to redesign them to permit more effective policy intervention (Bryson and Ring, 1990). 2o

In a similar vein, the comparative strengths and weaknesses of different forms of budgetary organization should also be assessed. The aim should be to develop an inventory of knowledge about the influence of each institutional form on politics and budget outcomes. Kent Weaver's excellent work on indexation (1988), along with my own work on trust funds (1996), represent steps in this direction. By identifying the performance tradeoffs of these instruments across a range of policy criteria, this knowledge will aid policymakers in their efforts to bring about a more discriminating match between 'government's tactics and responsibilities' (Thompson, 1993: p. 314).

Beware opportunistic politicians

An important lesson of transaction cost theory is not to underestimate the willingness of opportunistic actors to manipulate situations for their own advantage. The potential for opportunistic behavior should be assessed before adopting budgetary reforms so that mechanisms can be developed for checking it. Opportunism in a budgeting context is usually associated with self-dealing by bureaucrats. According to one hypothesis, agencies exploit their informa- tional advantages over Congress to maximize the size of their budgetary allo- cations (Niskanen, 1971; see also Blais and Dion, 1991).

What it is often overlooked is that elected officials are also subject to opportunism. Budget reforms that fail to take into account the incentives of both principals and agents are therefore likely to be ineffective. Consider proposals to permit agencies to carry over part of their surplus funds into the next year. The intent of such proposals is to reduce agencies' incentive to purchase waste- ful items so as to avoid giving budget guardians the impression that they can make do with smaller appropriations. At first blush, carry-over proposals seem like a sound reform idea. As David L. Weimer has pointed out, however, budget

207

guardians would have an incentive simply to reduce next year's budget alloca- tions in order to offset any funds remaining in agency accounts. This would merely reinforce the incentive of bureaucrats to spend all they are given. To avoid this perverse result, Weimer cleverly recommends allowing agencies to shield part of their surplus funds from immediate legislative view. Such a 'Swiss-bank approach' would deter budget guardians from punishing agencies for good behavior (Weimer, 1992). More generally, a transaction cost perspective encourages budgetary reformers to engage in a practice known as 'dirty-minded' thinking: reformers should 'think about what could possibly go wrong and who has an incentive to make it go wrong,' and then devise steps for preventing this mischief from happening (Weimer and Vining, 1989: p. 311). 21

'Internalize' flexibility losses

If neoclassical economics cautions that there is no free lunch, transaction cost theory teaches that all feasible forms of governance are imperfect. As long as actors are forced to bear the full costs of their oganizational decisions, the implications of this lesson are not especially worrisome. In the public sector, however, actors frequently do n o t bear the full costs of their institutional choices. By design, entitlements, permanent appropriations, balanced budget amendments, and other 'commitment' devices reduce budgetary flexibility and policymaking discretion. From the perspective of the legislative coalitions who devise such safeguards, the costs of this 'flexibility foregone' are often largely externalities borne by opposing coalitions and future generations. 22

Perfect competition in the 'market' for budgetary governance is probably unattainable. Still, it may be possible to 'internalize' the cost of flexibility losses to some degree through creative institutional designs. Consider the case of social security. Since 1935, payroll taxes have risen dramatically as a percentage of national income to keep the social security funds in balance. This has forced Congress to repeatedly reduce general fund taxes in order to keep the overall tax burden roughly constant (Wildavsky, 1992). Yet while a tradeoff between trust funds and general funds clearly exists, the social security board of trustees - which reports on the trust fund's projected actuarial condition - seldom highlights the implications of social security trends for the rest of the budget. One way to encourage more explicit consideration of this tradeoff would be to appoint another member to the board who would represent the interests of general taxpayers. This would not force Congress to renege on its commitments, but would simply highlight the opportunity costs of keeping pension promises whole. 23

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Conclusion

In 1940, political scientist V. O. Key called for the development of a theory that would address a fundamental question of budgeting: 'On what basis shall it be decided to allocate x dollars to activity A instead of Activity B?' (Key, 1940). More than half a century later, Key's question has yet to be satisfactorily answered. As Wildavsky observed, the task the question sets out - developing a normative blueprint for everything the government should do - is 'impossible to fulfill' (Wildavsky, 1992: p 428).

Transaction cost theory proposes that reform-minded scholars address a far less utopian set of questions: What are the defining attributes of proposed budget transaction x? What are the contractual hazards that x is likely to give rise to? What are the strengths and limitations of assigning the transaction to governance structure A verses governance structure B? Answering these questions would not eliminate conflict over the size and scope of government. But it would make policymakers more sensitive to the transaction cost implications of their budgetary decisions, increasing the likelihood that those decisions - whatever their substantive content - will turn out to be administratively effective ones.

Acknowledgments

For valuable criticisms and suggestions, I am grateful to John Ellwood, Gary J. McKissick, Allen Schick, and Dan Tuden. An earlier version of this paper was presented at the 1995 annual meeting of the Western Political Science Associa- tion, Portland, Oregon, March 15-18, 1995.

Notes

1,

2. On Shuster's conception of the trust funds as contracts, see Victor (1995). Horn provides an excellent analysis of the transaction cost logic of entitlements and permanent appropriations. However, Horn does not distinguish transaction cost economics from arguments of traditional budget theory, and he does not specificially discuss the model's implications for budgetary reform. Many budgeting scholars argue that incrementalism cannot account for entitlements because incremental budgeting requires budgeters to have the discretion to allocate increments, and mandatory spending eliminates such control (see, e.g., Schick, 1983; Rubin, 1989; Kettl, 1992). Indeed, the rise of entitlement spending is a major reason for incrementalism's declining influence among budget scholars. Wildavsky himself stated that entitlements 'radically' alter the character of budgeting (Wildavsky, 1992: p. 273). Joseph White has suggested that if incrementalism is defined more broadly as a way of reducing decision costs, entitlement budgeting may appear 'as "incremental" as any other kind' (White, 1994: p. 124). As shown below, transaction cost theory sidesteps this debate by recognizing that each type of budget transaction has distinct governance needs for which the entitlement structure may or may not be appropriate.

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4. As Roy Meyers observes, 'One paradox of this understanding was that the politics of the budgetary process was not very political in the popular and (disparaging) meaning of that term. The actors were strategic, but they were not devious, and although the game was com- petitive, it was played following strict rules of sportsmanship' (Meyers, 1994: p. 3).

5. For a similar view of the importance of environmental factors in shaping actors' behavior, see Rubin (1990: pp. 98-99).

6. Kenneth Shepsle refers to these two senses of credibility as the motivational and the imperative, respectively (Shepsle, 1992). To be sure, electoral incentives are always determined to some degree by the structural arrangements within which actors are situated. The distinction between incentive- and institution-based credibility is thus somewhat artificial. However, it highlights the fact that some budget commitments are supported by explicit institutional safeguards while others are not.

7. By contrast, incremental theory focuses more on informal norms and understandings. To be sure, incremental budgeting is not really 'structure-free' since it takes place within the Con- stitutional framework. However, the role of institutional arrangements was not emphasized in Wildavsky's original work.

8. Indeed, Congress's 'power of the purse' is so unique when viewed in world perspective that White and Wildavsky refer to the federal budget system as 'Madisonian' (White and Witdavsky, 1989: p. 1).

9. However, Pierson and Weaver emphasize that 'the effects of policy inheritances are often stronger than those of political institutions, and they may overwhelm parliamentary-presidential differences.' (Pierson and Weaver, 1993: p. 145).

10. While the U.S. highway trust fund has been more ironclad than its British counterpart, it has not been inviolable. For example, a portion of the trust fund's revenues have been siphoned off for mass transit programs since 1982.

11. On government trust funds, see Patashnik (1996). 12. In this context it is interesting to compare social security with private insurance. In the case of

the latter, the main contractual hazard beneficiaries face is that their insurance companies will fail. Accordingly, the insurance company 'can make a credible commitment to pay its obligations only by amassing sufficient reserves to cover all contingencies' (Marmor, Mashaw and Harvey, 1990: p. 166). In the case of government pensions, by contrast, there is no danger of true insolvency; the government 'has resources in its power to tax and to create money that lend credibility to its unfunded liabilities in a way that no private insurance company can match' (Marmor, Mashaw, and Harvey, 1990: p. 166). What beneficiaries do have reason to fear, however, is the discretion of future lawmakers who may not be supportive of the program. As Roosevelt recognized, the credibility of government pensions thus hinges on the extent to which such policymaking discretion is controlled.

13. In a related vein, scholars have argued that voters may want government to adopt durable projects (such as public works) over other kinds of initiatives since the former are generally more costly for future politicians to dismantle, other things being equal. See Glazer (1989).

14. This discussion draws heavily on the interpretations contained in Wildavsky (1992). 15. Entitlement budgeting is a governance structure that mandates payments to eligible persons.

In practice, some entitlements require annual appropriations, but such appropriations are generally de facto permanent.

16. According to White and Wildavsky, most entitlement programs' would fit poorly into a system of annual appropriations' (White and Wildavsky, 1989: p. 5).

17. Government documents divide federal budget accounts into 18 principal missions. Less than 35 percent of accounts in missions other than social security, medicare, and net interest have available permanent spending authority (GAO, 1995: p. 37).

18. There is a large literature on tax expenditures. Among the many useful studies are Surrey (1973); Witte (1985), Howard (1993), and Mucciaroni (1995).

19. In a subsequent paper, Williamson does suggest some standards, such as whether programs are 'captured' or whether the political process is 'defective.' However, these standards are still too vague to serve as evaluative policy criteria. See Williamson (1993b).

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20. For an argument that transaction cost theory is less useful as a prescriptive framework than as a 'cautionary device' for recognizing the limitations of reforms precisely because government activity often involves transactions of a highly complex nature, see Weare (1995).

21. The practice of engaging in dirty-minded thinking for the purpose of identifying weaknesses in policy ideas was originally recommended in Levin and Freman (1986).

22. The phrase 'flexibility foregone' is borrowed from Shepsle (1992). 23. I am indebted to Gene Bardach for stimulating me to think about this point. Of course, general

taxpayers are by no means the only other interest that could be internalized into the trust fund structure. For example, there is also the interests of children who would have to support their parents if social security benefits were significantly reduced. At some point, reconciling diver- gent interests is a responsibility that can only be exercised by Congress.

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