Robert Frank 2002

ITHACA, N. Y.
From his approach to pollution abatement as governor of Texas to his approach to corporate malfeasance as president, George W. Bush has made voluntary compliance his motto. Explaining his initial opposition to strict criminal sanctions in the recently passed corporate fraud law, for example, he said that while tougher laws might help, "ultimately the ethics of American business depend on the conscience of America's business leaders."

There are indeed limits to the law's ability to regulate human behavior. And public officials should try to nurture our inclination to do the right thing. But the downside to voluntary compliance is that it overlooks the critical role played by enforcement in society's efforts to curb self-interest for the common good. Granted, even laws and regulations with teeth might not be able to prevent offenses like the ones confessed this week by Michael J. Kopper, a former Enron financial executive. But without such enforcement measures, we are asking those who comply voluntarily to shoulder an unfair burden.

Consider the forces confronting honest executives as they weigh how to report their company's earnings. They know that many entries in the company's financial statements entail subjective judgments. Some, for instance, hinge on estimates and assumptions about the future, others on imperfect models for imputing monetary values to nonmarket assets. A broad range of earnings estimates could be defended as reasonable.

And therein lies the problem, because a company's ability to finance future growth depends strongly on how its reported earnings compare with those of its rivals. Indeed, this is how the capital markets decide which companies are most likely to succeed. Stock prices of corporations that report relatively low current earnings often fall sharply in the short run, increasing the risk of failure in the long run.

So it is difficult to see how even the most scrupulous executives could justify calculating their company's earnings on the basis of strictly neutral, let alone pessimistic, assumptions. On the plausible presumption that most other companies will report earnings near the optimistic end of the reasonable range, failure to do likewise would be to understate the company's relative prospects.

The problem is compounded by the fact that the standards defining acceptable accounting judgments depend on context. When almost all companies issue optimistic earnings reports, such reports come to be viewed as normal. Even the most cautious executives then feel pressure to report their earnings even more optimistically, in turn creating room for their more aggressive counterparts to push the envelope further.

Given this dynamic, and the enormous sums at stake in the battle for corporate survival, careful monitoring and stiff sanctions against violators are essential. It is one thing to ask people to forgo ill-gotten gains but quite another to ask them to commit economic suicide.

If we want people to restrain themselves for the common good, the sacrifices we demand must be made by everyone. This applies to areas outside of business as well. To ask athletes not to use steroids in the absence of effective sanctions is to penalize those who comply while rewarding those who don't. To ask people to be scrupulous in their tax filings in an audit-free environment is to reduce the effective tax rate for dishonest taxpayers while increasing it for honest ones.

Congress was wise to include criminal sanctions in its recent corporate fraud legislation. Major League Baseball would do well to include random testing and stiff penalties in the steroid ban under consideration. And President Bush should rethink the wisdom of the sharp cuts in the I.R.S.'s staff and budget, which have reduced the tax audit rate by more than half since 1996.

As Adam Smith himself was well aware, the invisible hand of the marketplace does not always produce the greatest good for all. When individual and social interests conflict, voluntary compliance must be supplemented by sanctions potent enough to matter. As President Ronald Reagan put it, "Trust, but verify."

Robert H. Frank is a professor of economics at Cornell University's Johnson School of Management.