Overview and analysis of possible transitional strategies:
Moving from a tightly restricted supply model to an open entry taxi industry
Paper prepared for the Victorian Taxi Industry Inquiry
October 2011
Jaguar Consulting Pty Ltd
ABN: 56089 615636
Summary
Where a move to an open-entry taxi market from a starting point of a high level of supply restriction is contemplated, transition strategies are frequently advanced as constituting more feasible reform paths than an immediate opening of entry. Feasibility in this context has several elements: avoidance or minimisation of the disruptions and costs associated with very large market adjustments, avoidance of economic hardship for existing licence-holders, due to the value of the licence being suddenly eliminated, and avoidance of the political risks associated with these adjustment issues.
Several types of transition strategy can be identified. All can be assessed in terms of two key characteristics: the time that would elapse before an open entry market would be attained and the amount, if any, paid to incumbent licence holders during the transitional period. These two characteristics determine the allocation of the costs and benefits of reform.
Delay in achieving an open entry outcome prolongs the existence of deadweight economic losses due to restricted supply. However, they also continue the transfer from consumers to licence-holders that results from supply restrictions. Hence, longer transition periods involve both higher economic costs and greater transfers from consumers to licence owners. The payment of compensation, or adjustment assistance, to licence-holders similarly involves a transfer of the costs of reform from those who have profited from monopoly rents accruing from supply restrictions to consumers and/or taxpayers. The distribution of the costs of reform is determined by both the amount of such payments and the sources of the funds used.
Consistent with this frame of reference, this paper groups transitional strategies into two types: those that involve immediate moves to open entry, but differ according to the amount of compensation or adjustment assistance paid and those that involve staged releases of licences over a period of time. However, it is important to recognise that these two groups of strategies are not, in practice, distinct. A true open-entry market equilibrium only exists when licences are freely available at a cost no greater than that required to recover administrative and regulatory costs. Thus, models that notionally provide for licences to be freely available but incorporate significant annual licence fees as a means of recouping compensation payments cannot accurately be described as involving immediate open entry. The distinction drawn between the two models centres on the question of whether there is a formal limit on the number of available licences, but the practical implications of two strategies that do and do not involve such limits may differ little in practice.
This paper also briefly discusses strategies that aim to manage the relative scarcity of taxi licences without moving to an open-entry market equilibrium.
The discussion is illustrated, where possible, by practical examples of the use of the reform strategies under discussion. However, most of the reform strategies that have been identified by policy-makers or in the academic literature have never been adopted in practice. Hence, the discussion of these options is necessarily conducted at a theoretical level. An appendix considers the experiences of five OECD countries that have moved from a restricted entry model to an open entry model of taxi industry regulation in the past 20 years approximately.
Contents
1.Introduction
2.Immediate opening of entry
2.1.Open entry with full compensation for incumbents
2.2.Immediate open entry with partial compensation
2.3.Immediate open entry with ex gratia payments only
2.4.Immediate open entry with no payments to incumbents
3.Staged releases of licences
3.1.Issue of additional licences to existing licence-holders
3.2.Open market auction of additional licences
4.Formula-based issue of licences
4.1.Description and rationale
4.2.Population ratio based formulae
4.3.Load factor based formula
4.4.Multi-criteria based formulae
4.5.Subjective criteria
4.6.Discussion
5.Other reform options
6.Easing entry to the hire car industry
7.Conclusion
Appendix 1: Jurisprudence in relation to compensation
Appendix 2: Summary of reform strategies pursued in major jurisdictions
Appendix 3: Bibliography
Other readings
1.Introduction
The paper identifies and assesses the merits of a wide range of options for managing transitions from a taxi industry characterised by strong regulatory controls on entry to the taxi industry - such as that currently found in Melbourne - to a regulatory environment free of quantitative restrictions on licence numbers and characterised only by minimum quality standards. Such transitional mechanisms are necessarily also be applicable in a context in which it was proposed to move to a situation in which quantitative restrictions were retained, but substantially eased.
Each transitional strategy is assessed in terms of the following criteria:
- Cost to government;
- Impact on consumers and licence-owners;
- Time taken for full implementation (estimated);
- Feasibility assessment (based on practical experience and theoretical assessments, as required);
- Assessment of key risks.
Four groups of transitional strategy have been identified. The first involves the immediate removal of overt supply restrictions, combined with various mechanisms to address the impact on incumbent taxi licence-owners and, potentially, lessors. The second involves staged increases in the number of taxi licences. This group of strategies is consistent with both an eventual removal of all supply restrictions and an endpoint based on the retention of (less restrictive) supply constrols.
The third group of transitional strategies is a variant of the second, in that it involves moving to a formula-based approach to licence issue and/or total licence numbers. Finally, a fourth group of transitional strategies consists of indirect approaches to taxi reform, notably involving the encouragement of competition in related markets.
Some strategies discussed have been implemented in the course of reforming taxi regulation in one or more jurisdictions, while others have been adopted in transitions to deregulated markets in other industries. A third group has been proposed in the literature dealing with regulatory reform in the taxi industry but has not, for one reason or another, actually been implemented. Where practical experience with a transitional strategy is available, this will be assessed as far as possible. Where a strategy has not been implemented in practice, a theoretical discussion of its merits and likely feasibility and outcomes is undertaken.
2.Immediate opening of entry
Immediate removal of restrictions on the number of taxi licences potentially provides the welfare maximising approach to taxi reform, since the efficiency benefits of an open entry market are obtained without delay. However, different variants of this model have substantially different implications, both in terms of the expected rate of increase in taxi supply and in terms of the incidence of the costs of reform. Thus, several variants of this model are discussed below.
2.1.Open entry with full compensation for incumbents
Description and rationale
Providing full compensation to incumbents is generally taken to mean that the government undertakes to purchase any tradable licences at the ruling market price immediately prior to the announcement of the regulatory reform. Given the lack of transparency found in most taxi markets, there is generally some doubt as to the exact "market price" to be applied. Perhaps in consequence, this option is sometimes formulated in terms of government undertaking to pay an amount equal to the highest price for which a licence has previously traded.
While the translation of a "full compensation" policy into practice is simple in relation to perpetual, freely tradable licences, significant difficulties necessarily arise in the increasingly common circumstances in which various kinds of restricted licences have been issued by government. In particular, where these licences are not tradable, there is no readily established "market price". A plausible approach, in cases in which governments have sold these licences for significant sums is that the licence-holder would be refunded the sum paid[1]. However, where governments have sold licences for sums that, while substantial, fall short of the capitalised value of the monopoly rents available from the exploitation of the licences, licence-holders will clearly be made worse-off by a "refund-based" buyback[2]. To this extent, such an approach cannot be said to offer "full compensation". Sales of licences undertaken in Melbourne since 2002 would all fall within this category.
Box 1: The rationale for compensation payments
Soon (1999) argues that the compensation issue is “both a moral and practical one”. Morally, it is possible to argue that licence holders should be compensated for the loss of their licence values, since the government policy change has disproportionately disadvantaged them as a group. However, a strong counter argument is that purchasers of an intangible asset that derives its value entirely from a particular government policy stance must be presumed to be aware of the risk that changes in the government policy position may reduce, or even eliminate, the value of the asset. Policy changes (or, perhaps more correctly, policy stasis) have substantially increased the value of these assets in the past: in fact, licence holders have generally achieved high rates of return which should, arguably, be seen as reflecting the inherently high level of risk associated with the investment[3]. Symmetry would seem to argue that, just as licence holders have been able to reap windfall gains from past government policy choices without these being confiscated, so they must expect to bear windfall losses due to other policy choices.
A particular Australian perspective on this issue can be derived from the experience of implementing legislative reforms under the National Competition Policy. The approach to the losers from reform advocated by the National Competition Council and generally adopted by State and Federal Governments was that there would not be a presumed right to compensation for economic losses due to pro-competitive reform. However, adjustment assistance was made available where it was concluded that there were net social benefits in so doing. In virtually all cases in which it was paid, this adjustment assistance amounted to only a relatively small proportion of the economic losses from reform. Had taxi reforms been widely implemented under the auspices of the NCP process, there would have been a strong presumption in favour of the adoption of this approach[4]. A broadly similar approach was ultimately taken in Ireland, following the failure of legal action seeking compensation for lost licence values (see below). The Irish Government ultimately provided for payments to be made to incumbent licence-holders who could demonstrate that they were suffering financial hardship as a result of the move to an open-entry taxi market.
A further argument against compensation is that payments based on the full, pre-reform market value of licences would be so large in total that virtually the whole of the available benefits of reform would be transferred to the former incumbent producers. Considered alternatively, the whole of the costs of reform would be borne by the taxpayer. Some individuals who are taxpayers but who make little or no use of taxis would almost certainly be worse off as a result of reforms in which full compensation is paid. Moreover, the political difficulty of arguing for such payments suggests that paying compensation may reduce the feasibility of reform, rather than enhancing it.
At a practical level, Soon argues that:
Reform is less likely to be disruptive if affected interests can be “bought off”. Though New Zealand succeeded in deregulating its taxi industry without any compensation, it did so in an extraordinary period when many other reforms took place.
This argument may, however, be unduly pessimistic. New Zealand is not the only jurisdiction with high pre-reform licence values to have removed supply restrictions immediately without paying compensation: as noted elsewhere, Ireland also followed this path in 2000 despite Dublin licence values being little lower than Melbourne licence values at the time of reform.
Does paying compensation remove political opposition to reform?
While incumbents would clearly prefer to obtain compensation, rather than not, it is less clear that the promise of compensation would substantially eliminate opposition to reform from this quarter. From the viewpoint of licence-holders, the maximum amount of compensation likely to be payable by a reformist government will not exceed the immediately realisable value of the licence. In a context in which licence values have historically risen rapidly, licence-holders can be expected to prefer the prospect of continued gains to a compulsory buy-out at existing prices.
Cost to government
The cost to government of full compensation based schemes is extremely large in jurisdictions, such as Victoria, where persistent regulatory failure has led to very large imbalances between supply of, and demand for, licences and, hence, very high licence values. At an average licence value of $500,000, buyback of even the 3,100 unrestricted licences on issue in Melbourne would cost around $1.55 billion, while additional expenditures would be required to buy back many or most of the remaining licences - almost 2,000 in number.
The prohibitive nature of these costs has frequently led to consideration of options for recovery or part or all of the buyback expenditure. Most commonly, it is proposed that a substantial licence fee be imposed on an annual basis, either for a fixed period or until a certain proportion of the buyout cost has been retrieved. This option was adopted in practice in the Northern Territory in the context of its National Competition Policy-based reforms in 1999. In Darwin, where $95,000 had been paid per licence in compensation, the annual fee imposed was $16,000. The government initially stated that this fee was to be removed following recoupment of the compensation costs, estimated to occur in seven to eight years.
A plausible alternative approach to recouping buyout costs might be to impose a consumer levy, in the form of a fare surcharge. Thus, for example, a 10% fare surcharge could be collected by the ATO in parallel with the GST/BAS system. Two potential benefits of such an option are that it provides greater transparency for consumers regarding the cost and financing of the payment of compensation and that it may have a lesser impact in limiting entry to the industry in the early years after supply restrictions are removed.
Impact on licence-owners
A full compensation largely insulates licence owners from the cost of reform, if considered in the static sense. However, opposition to reform is likely to remain, even under such an option. A key reason for this opposition lies in the opportunity costs involved: licence owners lose the opportunity to continue with an investment that has historically generated high and stable annual returns[5]. In addition, there may be concerns as to whether full compensation will actually be paid in a timely fashion.
The Northern Territory reforms constitute a practical example of a case where reform was strongly opposed by licence-owners despite full compensation being paid at the outset. This opposition was maintained after the opening of the entry and ultimately led to the reforms being reversed.
Impact on consumers
Consumers theoretically obtain maximum benefit from any strategy based on immediate removal of entry restrictions, since both the deadweight losses and the transfers to producers associated with licence-owners exploiting monopoly rents available in a restricted-entry market are immediately eliminated.
However, where governments seek to recover substantial costs incurred in making compensation payments to incumbents via hypothecated charges, much lower consumer benefits will be obtained in the medium term. Most obviously, where a substantial annual taxi licence fee is imposed in order to recoup these compensation payments, the rate of entry can be expected to be lower than otherwise, since the licence fee constitutes a substantial additional operating cost. The major practical example of this dynamic is the case of the Northern Territory in 1999-2000, where entry rates were substantially below those experienced in New Zealand following the opening of the market due to the requirement for all licence-holders to pay a $10,000 annual fee. It was initially anticipated that this fee would remain in place for around eight years, during which time entry rates would necessarily remain substantially lower than would be the case in the absence of the fee.
Time taken for full implementation
Consistent with the above point, implementation of an open entry policy can only be judged to be complete when any "clawback" mechanism - such as an annual licence fee or consumer surcharge - has been removed. That is, it is only at this point that an equilibrium number of taxi licences will be sought and obtained, as a result of the supply-inhibiting impact of the licence fee being eliminated. Basic arithmetic indicates that attempts to recover fully the costs of a full compensation package will necessarily involve the adoption of such charges over many years.