Monday, April 7, 2014
Suppose that a lawmaker is designing a system of legal rules, such as a tax code or financial regulations. Regulated parties have an incentive to find and exploit loopholes, as long as the expected benefits exceed the expected costs. These search/exploitation investments are purely redistributive and thus wasteful. A loophole depends both on the legal rule and the characteristics of the regulated parties. One can envision a legal code drafted in two steps. In its first iteration, the code will be replete with loopholes that are easy to identify and exploit. Regulated parties that partake of the loopholes will reveal information about their types that the lawmaker will then use to draft a second iteration of the code, with fewer loopholes.
Most likely the lawmaker will need more than two periods to reduce loopholes to the optimal number. However, the point is that instead of drafting a system of rules that tries to minimize loopholes from the start, it is better for the lawmaker to strategically include loopholes that, when exploited, will reveal information. In fact, a lawmaker should use information-revealing-loophole-rules even when they are superfluous, from a purely regulatory standpoint.
Of course, sophisticated regulated parties will know that the lawmaker is trying to trick them into revealing information. If there are unsophisticated parties that are sufficiently similar to the sophisticated ones (in all things but their level of sophistication), the lawmaker can use the information revealed by the unsophisticated parties. If the number of sophisticated parties is large and a failure to exploit the loophole will put a party at a competitive disadvantage, then colluding to confuse the lawmaker becomes difficult due to collective action problems. But suppose that regulated parties can reach a self-enforcing agreement to collude—i.e., they agree not to exploit the loopholes. So be it: that was the goal all along.
In fact, a lawmaker can speed things along by announcing: “I have adopted a legal code with strategically placed loopholes. Please exploit them. Doing so will reveal private information about yourselves that I will use to redraft the code. My goal is to reduce the aggregate costs from loopholes. I just need your help, so I can do it efficiently. I will always include information-revealing-loopholes. So if you ever come across a loophole, ask yourself—‘Do I feel lucky?’”