A Free Rider Problem Under the Articles of Confederation “The check is in the mail”

Lots of Debts after the War The United States had about $35 million in debt after the Revolutionary War. $25 million owed to the American people. Soldiers waiting for back pay. Businesses which had supplied troops wanting payment. $10 million owed to foreign governments. This needed to be repaid before commercial relations could be normal.

Collective Interest in Paying Debt The national government – as well as all of the state governments – had an incentive to pay the debt. The country faced internal legitimacy. problems if it could not pay the former troops and suppliers. Disgruntled soldiers could be a threat…. Normalized foreign trade was critical to both the national and state economies.

How to address this collective action problem?

Articles of Confederation Congress was responsible for paying the debt. However, Congress had no taxation powers. Congress gave each of the states an annual amount it must pay for its share of the debt. State legislatures had to determine how to raise the funds for these annual payments.

How to raise the money? In order to raise the money for their annual payment, state legislatures typically had to raise taxes on its citizens. Then as now, politicians despised raising taxes! Plus, local economies were still very fragile after the War.

What are the states’ options?

Option #1: Raise Taxes Pros Cons Will have enough funds to pay share of debt. Cons Will have to take unpopular step of raising taxes. May further damage already weakened state/local economies.

Option #2: Keep Taxes the Same Pros Can keep the tax rate the same. Be more popular with electorate. Cons Can’t pay allocated share of national debt.

Which option is a politician, primarily concerned about his local interests, going to choose?

“Option 2!” says State Legislator Smith Legislator Smith would like to do what he can to avoid raising taxes on the people of his state. Members of his state’s congressional delegation contend that such an attitude would mean that the state would shirk its national responsibility! Legislator Smith asks, “What are the ramifications of not paying Congress?”

Enforcement mechanism? The Articles of Confederation had no enforcement mechanism to compel states to make their payments. Thus, only concern for the collective good of paying down the debt was the motivation for payment. Those collective goods are compelling, but wouldn’t they be achieved anyway as long as all the other states (except us!) paid their share?

The Free Rider Problem Without an enforcement mechanism, states had an incentive not to pay their allocation of the national debt and hope that other states would pay enough of the debt to provide most if not all of the collective benefits. In other words, the “shirking” states had an incentive to “free ride” on the backs of the states that were willing to do what it took to pay their allocation.

The Domino Effect Once some states decided to not pay their allocation, other states had extra incentive not to pay their own allocation. Why should the citizens of only some states bear the national debt burden? This results in a Prisoner's Dilemma situation. With this free rider problem, it became clear that the national debt was not going to be paid, and that the collective benefits of doing so were not going to be realized.

How the free rider problem was addressed

The Constitution Article I, Section 8 gave Congress the power to raise taxes directly. States would no longer have to raise funds for the national government. The national government in return would assume any of the states’ outstanding debt related to the War.

This free rider problem is solved by centralizing the ability to raise funds with the national government rather than relying on states to collect the money