When Innovation Collides with Rules, Which Should Prevail?

Regulating cyber-commerce is controversial. The advent of smart phones and web-based interfaces has facilitated many new consumer services. Customers using these digital platforms often insist that existing regulatory models are outmoded and simply shouldn’t apply to new technologies.

As do the companies. When residents of Austin, Texas recently rejected Proposition 1—an ordinance proposed by Uber and Lyft—it generated national attention around this important question: How should a free society deal with innovative new technologies? Should existing regulations apply, should exceptions be made, or should the collision between existing rules and innovation cause us to re-examine the existing rules altogether?

Let’s review some general philosophical principles before considering the case made on both sides.

The classical liberal conception of a free society depends on several things: recognition and protection of private property, a regime of private ordering in the economy relatively free of government regulation, and the maintenance of the rule of law. The last of these, which Americans tend to take for granted, is critically important. In Russia, free market reforms during the 1990s without a concomitant devotion to the rule of law led to widespread corruption, cronyism, and the rise of powerful oligarchs. Imagine organized crime on a national scale—a kleptocracy.

Under capitalism, competition promotes consumer welfare and innovation leads to progress. Witness the prosperity and technological development the West has experienced since the Industrial Revolution. Corruption and cronyism, if they are to be curbed, can only (in a democracy) be curbed by transparency in government, the establishment of an independent judiciary, and the rule of law.

In Chapter 6 of The Road to Serfdom (1944), F.A. Hayek defined the Rule of Law (a term he reverently capitalized) as formal rules, announced in advance, and consistently applied. Hayek saw “equality before the law” as an indispensable component of a free society: “It is the Rule of Law, in the sense of the rule of formal law, the absence of legal privileges of particular people designated by authority, which safeguards that equality before the law which is the opposite of arbitrary government.”

Hayek was quite emphatic about the need for even-handed application of rules. He abhorred arbitrariness. In a free society, rules can be changed or repealed if they prove to be unwise or become outdated. But so long as rules are “on the books,” Hayek believed they should be “universally enforced.” In his words, “It may even be said that for the Rule of Law to be effective it is more important that there should be a rule applied always and without exceptions than what this rule is.” And this: “The important thing is that the rule enables us to predict other people’s behavior correctly, and this requires that it should apply to all cases—even if in a particular instance we feel it to be unjust.”

In The Constitution of Liberty (1960), Hayek elaborated on his conception of “freedom under the law,” explaining that when we obey laws of general applicability “we are not subject to another man’s will and are therefore free. . . . This, however, is true only if by ‘law’ we mean the general rules that apply equally to everybody.”

To Hayek, who understood that some regulation of economic activity is necessary and appropriate, requiring uniform application of laws provides another important benefit, beyond eliminating arbitrariness: it serves as “the chief safeguard” against the adoption of unwise or unnecessary laws. If laws apply to everyone, and “nobody has the power to grant exceptions…little that anybody may reasonably wish to do is likely to be prohibited.”

In other words, bad laws (or, as Hayek calls them, “inexpedient governmental measures”) are more likely to be repealed if their adverse consequences are widely felt. In a democracy, this is an important but often overlooked protection of liberty.

How do these principles apply to innovation? Let us acknowledge the tremendous benefits of technology. I write this post on a computer, not a typewriter, and I will submit it via email, not by hand delivery or the U.S. Postal Service. Progress creates winners and losers.

The proliferation of e-commerce was very disruptive to conventional “brick and mortar” retailers, as every technological innovation is disruptive to the status quo. We can all agree that Amazon and other online sellers provide wondrous convenience (not to mention selection) to shoppers, and that the creation of the technology enabling this type of commerce was a boon to society. But should online sales be treated more favorably than conventional retail purchases?

There was controversy a few years ago when brick and mortar retailers complained that they were required to collect sales tax when online sellers were not, placing them at a competitive disadvantage. The rules were eventually adjusted to require sellers to collect sales tax from buyers in states where they maintained a physical presence, leveling the playing field. Few people regard this as unfair to online sellers; if the government is going to collect a sales tax, it should be collected across the board. Exceptions to the general rule amount to “legal privileges.”

Another recent technological innovation is the ability to maintain a searchable database for privately owned short-term rentals, complete with online reservation and payment protocols. Thanks to companies such as HomeAway and Airbnb, travelers and tourists can now book a variety of accommodations from their home computers (and even smart phones) without using a travel agent.

This is an enormous benefit to consumers (and property owners wishing to find renters), and has spawned a large and growing industry. But again, should online rentals be facilitated by technological innovations be treated more favorably than “old-fashioned” accommodations such as commercial bed-and-breakfasts or even hotels? To the extent that “standard” rentals are subject to government licensing, room taxes, zoning rules, and other regulations, why should online rentals be exempted? And, if existing regulatory measures are deemed “inexpedient,” shouldn’t they be eliminated for everyone, not just the digital competitors?

Perhaps the biggest (or at least the most popular) innovation enabled by smart phone technology is so-called “ride-sharing” apps that directly dispatch drivers to pick up customers wishing to be driven short distances. Companies employing this technology, notably Uber and Lyft, now operate in cities throughout the world, providing competition to a regulated taxi cab industry that has existed for decades with very little change (or, critics contend, improvement).

In a few short years, Uber and Lyft have become so widely used in the jurisdictions they service (and among the urban millennial demographic to which they cater) that their absence seems unimaginable. Yet last month in Austin, Texas, the self-proclaimed high-tech center and hipster mecca, Uber and Lyft abruptly abandoned the market in protest over the defeat of Proposition 1.

What happened?

In a nutshell, Austin’s newly configured city council late last year enacted an ordinance allowing ride-sharing companies to operate (effectively competing with taxi cabs), but subjecting them to regulation similar to taxis. Controversially, the ordinance required ride-sharing drivers to undergo the same fingerprint check through the FBI data base that taxi drivers are subject to. Uber and Lyft, who internally conduct a different (and, in their view, superior) type of background check for their drivers, vehemently objected, claiming that the requirement of fingerprints would discourage many casual drivers from participating. According to Uber and Lyft, the availability of a large cadre of part-time drivers is essential to achieve the short wait times and low pricing that made ride-sharing so popular.

In opposition to the city’s ordinance, Uber and Lyft collected over 65,000 signatures in favor of an alternative ordinance, which exempted ride-sharing companies (but not taxi cab companies) from fingerprinting. When the city council declined to adopt the alternative ordinance, it was placed on the ballot as Proposition 1.

Declaring their implacable opposition to fingerprinting, Uber and Lyft threatened to leave Austin if Proposition 1 was defeated in the May 7 election in the city (even though Uber had not boycotted other markets, such as Houston and New York City, that also require fingerprinting). The election was highly contentious. In advance of it, Uber and Lyft spent over $9 million campaigning for Proposition 1 (the previous record in a local election was $1.2 million), outspending their opponents almost 50 to1. Austin voters defeated the measure 56 percent to 44 percent. Thus Uber and Lyft had spent about $235 for every “Yes” vote they got. The two firms shut down their apps immediately following the election.

Many observers criticized the outcome, accusing Austin voters of “forcing” Uber and Lyft to leave Austin. Some commentators even denounced Austin as a “second rate city” for opposing Proposition 1. Ultimately, Uber and Lyft chose to abandon the Austin ride-sharing market (which may be filled by a non-profit startup, RideAustin) because they were unwilling to operate subject to the same rules applicable to taxi cabs (or, for that matter, pedicabs).

In a free society, Uber and Lyft can refrain from doing business wherever they want, and for any reason. Uber is a sophisticated, well-financed global company, whose $68 billion market valuation exceeds that of General Motors. Existing customers of Uber and Lyft in Austin are understandably upset at the outcome, and will unfortunately be inconvenienced until the ride-sharing vacuum is filled.

What would Hayek do? From a rule-of-law standpoint, I’m skeptical that different companies providing the same basic service—driving passengers on city streets for payment—should be subject to different rules. If fingerprint-based background checks (required in Texas for teachers, real estate brokers, health care workers, and dozens of other occupations) for drivers are deemed unnecessary, then go ahead and eliminate them for all, not just a privileged group.

Exempting some competitors from “inexpedient” government regulations dilutes the impetus to repeal them for all. Applying the Hayekian formulation quoted above, I believe that Austin voters got it right.