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4/12/96

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COMMENT: Kenneth Arrow, Stanford Economics Department, (415) 723-9165 on April 12. For the rest of April, Arrow will be at All Souls College, Oxford, England, fax 44-1865-279-299 or via e-mail: arrow@forsythe.stanford.edu. Roger Noll is reachable at the Brookings Institution via e-mail: rnoll@brook.edu. Contact the other co-authors through their institutions.

Economists urge better cost-benefit analysis of government regulations

STANFORD -- A human life is worth $200,000 if it is saved using the 1979 safety requirements on trihalomethanes in drinking water but worth $6.3 trillion if saved using 1990 rules for handling the hazardous waste of wood-preserving chemicals.

Stanford Nobelist Kenneth Arrow and 10 other economists, writing in the April 12 issue of Science magazine, use this comparison as part of their attempt to illustrate how public policy might be made more cost-effecient by consistent use of good economic research practice.

Comparison in dollar terms of the desirable and undesirable impacts of proposed policies "has a potentially important role to play in helping inform regulatory decision-making, although it should not be the sole basis for such decision-making," they write. Other important factors include fairness. Decision makers should consider, for example, the fairness of a policy that conferred its costs on one generation and its benefits on another.

The comparison of the value of lives saved in the two Environmental Protection Agency regulations involves dividing the costs to industries and individuals of implementing the regulations by the number of lives the regulation is expected to save. The economists point out that "a reallocation of priorities among these same regulations could save many more lives at the given cost, or alternatively, save the same number of lives at a much lower cost."

The economists suggest that one federal agency come up with a common set of economic assumptions to be used by all the agencies for calculating direct and indirect economic benefits and costs of regulations. They also offer guidance on what those assumptions should be.

The authors are economists that Arrow described as in the "left-center and right-center" of the political spectrum. "It was quite easy for us to reach agreement," he said in an interview, because "we are reaffirming what is a fairly good consensus view among economists."

"But politically," he said, "there are all kinds of ideas out there, and when you get into [making] public policy, the subject matter itself is usually not economics. It's physics or chemistry or biology, so in the policy discussion, you have some people who bring in naive economic ideas, which need to be corrected."

The article was written, he said, with the idea that "if you have a representative group that would set these principles, it would register as a norm for individual decision-makers in the country. That's our hope. We'll see."

The work was sponsored by the American Enterprise Institute, the Annapolis Center and Resources for the Future. The co authors are: Maureen Cropper of the World Bank; George Eads of Charles Rivers Associates In Washington, D.C.; Robert Hahn of the American Enterprise Institute; Lester Lave of the Graduate School of Industrial Organization at Carnegie Mellon University; Roger Noll of the Stanford Economics Department and Public Policy Program; Paul Portney of Resources for the Future; Milton Russell of the Economics Department at the University of Tennessee, Richard Schmalensee of the Sloan School of Management at Massachusetts Institute of Technology; V. Kerry Smith of Duke University; and Robert Stavins of the John F. Kennedy School of Government at Harvard.

The most logical office to issue guidelines for cost-benefit analysis is the Office of Management and Budget, Arrow said. The agency already has tried to impose a uniform way of calculating the present day value of future costs or benefits. "Unfortunately they chose the wrong rate," he said. "We are urging that the future be discounted less sharply."

But, the economists say that "both economic efficiency and intergenerational equity require that benefits and costs experienced in future years be given less weight in decision-making than those experienced today." However, "the rate at which future benefits and costs should be discounted to present values will generally not equal the rate of return on private investment. The discount rate should instead be based on how individuals trade off current for future consumption."

Besides this social discount rate, other key variables to agree upon include the value of reducing risks of premature death and accidents and the value of other improvements in health, the economists wrote. Standardization of assumptions like these would permit better comparison of analyses, they said.

How to use cost-benefit analysis is a subject of political debate in Washington now, where the Republicans, in their Contract with America, proposed that regulations should only be adopted if the reduction in risks exceeded the costs of the regulations.

But lawmakers have sent "mixed signals" over the years to federal agencies responsible for implementing environmental, health and safety regulations, the economists say. The last four presidents all have introduced formal processes for reviewing the economic implications of proposed regulations, while Congress has passed some statutes that "effectively preclude" the use of cost-benefit analysis in decision making.

Examples of statutes cited in the article that have been interpreted to restrict the ability of regulators to consider benefits and costs include the Food, Drug and Cosmetic Act, the Occupational Safety and Health Act, the Clean Air Act, the Clean Water Act, and the Resource Conservation and Recovery Act.

Statutes that explicitly allow such comparisons include the Consumer Product Safety Act, the Toxic Substances Control Act, and the Insecticide, Fungicide and Rodenticide Act. Cost-benefit analysis was particularly important, the authors say, to those who decided on phasing out lead in gasoline and the banning of asbestos products.

The authors list these eight principles for using cost-benefit analysis:

  • Comparisons in economic terms can help decision-makers identify the favorable and unfavorable consequences of proposed actions, even when the cost estimates themselves are highly uncertain.
  • Benefits and costs should be quantified whenever possible, but the uncertainties in the estimates should be described, and any "margin of safety' that an agency introduces into a policy, based on the uncertainty, should be explicitly stated.
  • No agency should be prohibited from comparing the costs and benefits of government action. Congress could promote more effective use of resources by explicitly asking agencies to consider them.
  • Congress should not require agencies to be bound by the results of cost-benefit analysis. These are aggregate costs and benefits for all of society, and equity issues may also be important considerations.
  • Cost-benefit analysis should be required for all major regulatory decisions - decisions where there are large stakes involved or a great potential that the information will influence the policy.
  • External peer review is likely to lead to better cost-benefit analysis and retrospective assessments of selected regulatory impact should be carried out periodically.
  • A core set of economic assumptions and default values for typical benefits and costs should be established by one agency, along with a standard format for presentation.
  • Analysis should focus on the benefits and costs to society as a whole, but it can also identify important distributional consequences. In general, however, environmental, health and safety regulations are "neither effective nor efficient tools for achieving redistributional goals."

-kpo-

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