At issue | Herald-Leader news stories about spending at Blue Grass Airport, the Lexington Public Library and the Kentucky League of Cities.
With its articles on the Blue Grass Airport, Lexington Public Library and the Kentucky League of Cities, the Lexington Herald-Leader has been remarkably successful in publicizing what academic researchers call "agency problems."
While the reporters have not used this terminology, agency problems are at the root of all three situations that have been vividly described in the paper. It's helpful to recognize the nature of these problems, so that effective solutions can be crafted.
In an agency relationship, one party, called the "principal," hires another party, labeled the "agent," to perform some task on the principal's behalf. If you have ever hired anyone (such as an accountant, a therapist or a basketball coach) to do anything in your interest, you have been the potential "victim" of this problem.
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Why? Because economic theory suggests that people ("agents") are more inclined to look out for their own interests than someone else's.
The most frequently discussed example of an agency problem involves shareholders hiring managers who assume the task of making the owners of the company as wealthy as possible.
Alas, the managers might instead focus on paying themselves excessive salaries and bonuses, riding in company-owned jets to golfing weekends at Pebble Beach or purchasing $15,000 shower curtains for their personal apartments with company funds.
There are two broad classes of solutions to the agency problem: incentives and/or penalties. For example, shareholders typically hire yet another group of agents (the board of directors) to monitor the behavior of managers and penalize them when they screw up and reward them when they succeed.
To assure that directors themselves do not exploit shareholders, each board member assumes a "fiduciary" relationship with the owners. Failure to perform a fiduciary duty invites another form of penalty called litigation.
But penalties cannot be enforced if no one bothers to monitor what agents are doing. Thus, periodic audits are a common way to control agency problems, since checking up is the essence of auditing.
As the Herald-Leader articles made very clear, agency problems can also surface at public, quasi-public or non-profit organizations. The role of the boards in these settings is the same, but now on behalf of the many constituents of these organizations.
But these boards appear to have failed in these responsibilities, and local taxpayers and other constituents collectively seem to have been significant victims of agency problems.
Indeed, the top-level managers of these organizations could be said in many cases to have granted themselves unapproved tax-free increases in compensation (via uncontrolled travel, entertainment and other spending).
The temptation to consume perks is strong because our tax system encourages it.
Buying a $40,000 SUV requires about $70,000 of before-tax income in Lexington. When the same vehicle is provided to a senior executive by his/her organization as a fringe benefit, the executive pays nothing for the car and taxes are due only on the value of the services when the car is used privately. The same logic applies to trips to Ireland or Alaska and expensive meals in New York City or Washington, D.C. But in these cases, the executives (and their spouses, if included) more than likely paid no taxes on the consumption of these goods and services. In fact, if the provider of the fringe benefits is a tax-paying entity, it will deduct the costs of most, if not all, of the perquisites from its own tax bill.
The process used to monitor and approve these kinds of expenditures in the cases described by the Herald-Leader was weak at best, and in some cases rife with conflicts of interest. The audit processes, when they existed, were ineffective.
The Herald-Leader is to be congratulated for carrying out the missing monitoring activities that will, in the short run, presumably curb the excesses.
Discussions have surfaced about the need for reform. But promises to do better hold little prospect of long-run success unless mechanisms exist to incent the right behavior or penalize bad behavior.
For instance, when board members go unpaid, economic theory predicts a low level of director effort. The funds to pay directors could be found by reducing the senior managers' perks.
To help eliminate conflicts of interest and assure that board members act diligently, they also should be placed in a fiduciary relationship to their relevant constituents. Strong internal controls should be established. Periodic, externally performed audits must be required and auditors should be hired by and report to the board.
If the institutional elements of good governance are ignored in the reform process, we can look forward to more articles detailing public agents acting in their private, rather than the public's, interest.