Using Cost-Benefit Analysis to Evaluate Government Policies

1. Using Cost-Benefit Analysis to Evaluate Government Policies David L. Weimer April 11, 2014

2. Outline • What is cost-benefit analysis (CBA)? • How can CBA contribute to government efficiency? • How has CBA use in the Unites States evolved? • How does CBA differ from fiscal analysis? • What are the essential elements of CBA? • What are “shadow” prices? • How can I get started?

3. What is CBA? • CBA is a protocol for systematically assessing alternative public policies in terms of their efficiency • Assess efficiency in terms of net benefits • Choose policies that would maximize net benefits • CBA is comprehensive • It seeks to include all valued impacts • It gives “standing” to everyone in society • CBA is prospective • What net benefits would result if a policy were adopted (including continuation or replication of existing program)?

4. Conceptual Foundations of CBA • Willingness to pay • Policy impacts are valued in terms of individuals’ willingness to pay to obtain or to avoid them • Benefits are the algebraic sum of these willingness-to-pay amounts • Opportunity cost • What is the value of real resources (labor, etc.) in their next best alternative uses? • Costs are the algebraic sum of the opportunity costs of the resources needed to implement the policy • Net benefits • Difference between benefits and costs

5. How can CBA contribute to government efficiency? • Provides way to operationalize goal of “creating public value” • Markets reveal value of purely private goods • CBA imputes value to goods not traded in efficient markets • Offers value in seeking comprehensiveness • Transcends organizational “stovepipes” • Encourages anticipation of impacts, reducing “unanticipated consequences” • Encourages use of evidence and exposes lack of it • Impacts must be predicted: empirical evidence, theory, assumption • Impacts must be monetized: defense of “shadow prices” • Promotes use of sufficiently long time horizon to value investments

6. How has CBA use in the Unites States evolved? • First application to water resource projects • River and Harbor Act of 1902, 1920; Flood Control Act of 1936 • First standardization: 1952 Bureau of Budget Circular A-47 • Routine application to federal infrastructure projects by 1960s • Extensions by environmental economists beginning in the 1970s • New revealed preference methods (e.g., travel-cost method) • Development of stated preference methods (e.g., contingent valuation surveys) • Exxon Valdez damage assessment resulted in big investment in methods • Mandatory application to major regulations • President Reagan EO 12291 in 1981 (Regulatory Impact Analyses) • More recent application to social policy • Washington State Institute for Public Policy • MacArthur/Pew initiative to help states adopt WSIPP model

7. How does CBA differ from fiscal analysis? • Fiscal analysis includes only changes in government revenues and expenditures • Bottom line like that of private organization • Often not comprehensive across government units • CBA includes all impacts valued by people with standing • Net revenues may be larger, smaller, or the same as social benefits • Opportunity cost and willingness to pay should be guiding principles

8. What are the essential elements of CBA? • Specify alternatives to current policy • Determine standing (Whose costs and benefits count?) • Identify impacts • Monetize all impacts with appropriate prices • Sometimes market prices • More often “shadow prices” that take account of distortions, especially missing markets • Discount for time • Take account of uncertainty • Report net benefits

9. What are shadow prices? • Direct valuation • Social cost of a crime: harm to victim (tangible and intangible) and criminal justice system costs (also fear of crime?) • Productivity gain from high school completion: present value of increased earnings over working life • Vertical linkage • Reductions in child abuse reductions in delinquency reduction in adult crime • Horizontal linkage • Higher productivity reductions in crime & improved fertility choice

10. Example: Value of a Statistical Life (or Willingness to Swap for a Micromort) • Literally hundreds of studies • Most based on revealed preferences: tradeoffs between money and risk • Higher wages for riskier jobs • Willingness of people to pay for devices that reduce risk • Some stated preference studies • Generally similar results • Approximately $5 million in U.S. for a 40-year old with median income • Federal agencies generally use a somewhat higher value • Federal agencies commonly use about $200,000 for a life year

11. Vertical linkage: Washington State Institute for Public Policy Child Abuse CBAs • WSIPP did meta analysis to estimate impact of intervention programs on child abuse • WSIPP did meta analysis of studies linking child abuse to reductions in probability of high school graduation (and other effects) • Product of these impacts gives the predicted effect of the program on high school graduation • The present value of increased earnings from high school degree, $175,000, was used as a shadow price for the predicted number of additional graduations resulting from the program

12. How can I get started? • Begin with a back-of-the-envelope CBA • Identify major impacts • Make best estimate of order of magnitude • Either potentially large positive net benefits for new policy or potentially large negative net benefits for existing policy justify moving to full-blown CBA • Require staff, consultants, and evaluators to consider costs and benefits • Develop some in-house expertise (hire my students!) • Take advantage of WSIPP tool • Sound analytical approach • Record of legislative use of analyses

13. Conclusion • CBA provides protocol for assessing efficiency • Helps avoid confusing fiscal effects with costs and benefits • Not cost-beneficial to apply CBA to all policies • Process of doing CBA identifies uncertainties to be addressed • Actually doing CBA requires not only skill but also some courage!

14. Thank you!