The Case for Regulating Before Harms Occur

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Scholar argues that regulators should try to impose penalties before rule violations can hurt society.

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When designing regulations, should regulators provide for the imposition of penalties before or after regulated firms have actually caused someone harm by violating the rules?

For example, polluters can either be required to pay a tax or penalty up front, or they can be held liable only after it is clear they have caused tangible environmental or health damages. Although this difference between penalizing “ex ante” or “ex post” might appear to be trivial, the author of a new research paper suggests that this choice can have major implications for regulating everything from banks to junk food sales.

In a recent article, Professor Brian D. Galle of the Georgetown University Law Center argues that “ex post regulation”—which imposes liability only after a harm occurs—has even more significant disadvantages than previously thought. Since managers at regulated firms have a tendency to discount long-term regulatory consequences, Galle favors “ex ante regulation”—or imposing costs before an actor harms another—as the more efficient way of regulating.

Galle explains that corporations can often avoid ex post penalties by lobbying the regulator to reduce or eliminate the penalty. Corporations can also lobby Congress to reduce ex post penalties, both for the sake of the corporation and for the public at large. For example, some experts have argued that United Kingdom-based bank HSBC has been able to avoid criminal prosecutions over alleged money laundering because of its alleged “too big to jail” status, as fully penalizing the bank would have wide economic implications.

Galle also argues that corporations are insensitive to the size of ex post penalties when those penalties are already massive. To a corporation with $10 million in assets, a penalty of $11 million or $100 million has the same effective impact, namely, the likely liquidation of the company, Galle notes. As a result, business managers might run greater regulatory risks than would be ideal, as the magnitude of a large penalty can be rationally ignored.

Corporate structures in limited liability corporations might also encourage managers to discount ex post risks, Galle points out. Despite limited liability corporate managers’ incentives to do what is best for the company, limited liability structures can make managers more willing to take risks—including the risk of ex post penalties—than would otherwise be optimal. After all, the managers can always leave the company before a regulatory penalty is assessed.

Despite the disadvantages of ex post regulation, Galle does describe one flaw in ex ante regulation: it forces regulators to estimate the magnitude of a potential harm to create an appropriate penalty. Too large or too small of a penalty will result in economic inefficiency; a manufacturing plant subject to an inaccurate penalty for its pollution will either pollute too much or pollute too little and endanger the jobs of its employees.

To mitigate this problem, Galle proposes that regulators attempt to divide harms into categories with different regulatory penalties. Regulators do not need to know the exact extent of a potential harm, only the harm’s rough approximation. Galle suggests that if regulators can divide harms accurately into two or three categories of approximate harm, the inherent inefficiencies of ex ante regulation can be reduced by as much as 90 percent.

For example, Galle suggests that the junk food or soda taxes that some cities have considered could be based on a general categorization system. He states that instead of universally taxing junk food, cities could simply tax junk food at different rates depending on how likely the product is to be used in an unhealthy way. According to Galle, a single Twinkie should be taxed at a much lower rate than a box of Twinkies, as a box of Twinkies is more likely to be associated with unhealthy binge eating, which has a different level of potential harm.

Galle also indicates that ex ante regulation might be beneficial when regulators are attempting to encourage positive behavior instead of discouraging negative behavior. For example, patents reward inventors with the potential for profits that can be reaped upon the success of their invention—a seemingly effective use of ex post regulation. On the other hand, Galle suggests that the ex post approach of the patent system might discourage inventors who cannot raise enough capital to fund their efforts, which is why public subsidies are sometimes needed to promote scientific and technological progress.

Finally, Galle points out that fans of regulatory nudging, where the government regulates by suggesting options and preserving individual choice, should also prefer ex ante regulation. In order for nudges to be effective, they must by necessity come before individuals make their decisions. Thus, Galle again concludes that regulators may often know better than those they regulate, perhaps to the benefit of both.