In the modern era, many facets of a president’s agenda rest on economics. Economic analysis increasingly plays a role justifying public policies of all types, and if it has glaring blind spots, well, then the very credibility of a president’s agenda is at stake. That’s why it is not all that surprising that on Joe Biden’s first day as president, he signed an executive memorandum directing the Office of Management and Budget (OMB) to reconsider guidelines that govern economic analysis for federal regulations.
Most Americans have never heard of OMB Circular A-4, as the guidelines are called, but among regulatory experts it is a well-known and important document. It includes the standards to which regulators are expected to adhere when producing economic analysis, and this analysis can be a deciding factor in the decision of how or whether to regulate, as well as help determine whether regulations, once implemented, survive court challenges.
Perhaps nowhere is Circular A-4 more controversial than in its recommendations of the social discount rate that is used in a cost-benefit analysis. This rate is applied to expected future benefits and costs of a policy to determine their worth to society in the present. OMB currently recommends agencies use two social discount rates: 7% annually as a base case and 3% as an alternative for comparison purposes.
Biden will likely be reconsidering these two rates as part of any potential update of Circular A-4, and this will have important implications for his (and any successor’s) agenda going forward.
The two OMB rates can be thought of as accommodating two groups of economists. First, some economists want the discount rate to reflect society’s time preference. They argue that society prefers to consume benefits sooner rather than later, so the relatively low 3% rate is meant to appease this group, as it is based on an estimate of the rate that consumers discount future consumption due to time preference.
A second group of economists, meanwhile, wants to discount because of opportunity cost, i.e., because a dollar invested today would grow into some greater value in the future. The 7% rate, reflecting the rate of return to capital, is meant to accommodate this group.
Strangely, both groups of economists make some fundamental economic errors, which is why the very credibility of a lot of regulatory policy, including environmental policy, rests on shaky ground.
First, consider the 7% rate. The benefits and costs of government policy are often not financial. Environmental benefits like preserving a coral reef or protecting an endangered species are classic examples. These don’t produce a stream of financial returns that can be invested in the bank, so saying these benefits have to be discounted because capital earns a rate of return is a non sequitur argument. The logic just doesn’t follow.
The 7% rate is best thought of as a kind of crude rule of thumb. Those who recommend lower social discount rates recognize this. They understand that the rate of return to capital only applies to capital assets, not to every conceivable benefit and cost found in an economic analysis.
However, rather than correct the mistakes the 7% advocates make, the low-discount-rate economists instead argue that the opportunity cost of capital—how resources that are invested rather than consumed would grow in value over time—can simply be ignored. They assert that government projects don’t impact investment much, or that projects create as much investment as they displace. These arguments aren’t convincing, but this (ironically, very uneconomical position) is actually the stance taken by many economists.
So when the government discounts benefits and costs using the 3% rate, there is an implicit assumption being made in the background, which is that no investment is impacted by policy (or, similarly, that the rate of return on investment is exactly equal to society’s time preference, which is also a questionable assumption).
This is why the advocates of the 7% approach—despite knowing they are wrong—stick to their guns. To them, ignoring opportunity cost—as the 3 percenters do—is a much worse sin.
The end result of this messy state of affairs is that benefit and cost present values discounted at the 3% rate ignore opportunity cost. Those discounted at the 7% rate are incoherent (so long as they are not financial). Thus, cost-benefit estimates are problematic regardless of the method used.
The situation sounds bad, and it is, but fixing these problems turns out to be easier than one might think.
One solution is that analysts can simply separate benefits and costs into different categories with similar characteristics. Some agencies, like EPA, already try to put items traded in markets on the cost side of the cost-benefit ledger and items that are not traded in markets—like the coral reef or endangered species mentioned earlier—on the benefits side. If this practice were adhered to consistently, then each category could be assigned its own rate of return based on how the value of resources in the category changes over time.
The Biden Administration’s update of regulatory analysis guidelines is an opportunity to make improvements along these lines so that regulatory policy rests on firmer ground. However, not all changes the administration makes will necessarily be for the better.
For example, lowering the 3% rate (as many expect the administration to do in at least some settings), without simultaneously accounting for opportunity cost, will further erode the integrity of regulatory policy by steering analysis in an unapologetically political direction. Like a politician who ignores evidence critical of his position, an economist who ignores opportunity cost is an advocate, not, as he should be, a dispassionate analyst or observer.
It will be impossible to craft credible regulatory policies if OMB and federal agencies continue to neglect opportunity cost. An update of OMB Circular A-4 creates a rare opportunity to address these problems. The question now is whether Biden’s OMB will take advantage of it or double down on practices that turn government analysts into politicians in economists’ clothing.
Biden’s Regulatory Agenda Rests On Shaky Economics, But There’s A Way To Fix It - Forbes
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