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How the Social Discount Rate Makes Regulatory Analysis Unsound

Summary:
For several decades now, cost-benefit analysis (CBA) has been the primary analytical tool used by the federal government to evaluate regulations and their impacts. During that time, states also began to adopt CBA, as did governments around the world. While it is potentially a useful tool to guide decision-making, CBA suffers from shortcomings that in other contexts would be considered failures to apply basic economic principles. By frequently ignoring the actual consequences of government policy, cost-benefit analysis today has little connection to the evidence-based tool that economists and legal scholars sold to the American public in the early 1980s. Fortunately, the Biden administration plans to revisit the guidance it gives to federal agencies on how to produce regulatory analysis,

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For several decades now, cost-benefit analysis (CBA) has been the primary analytical tool used by the federal government to evaluate regulations and their impacts. During that time, states also began to adopt CBA, as did governments around the world. While it is potentially a useful tool to guide decision-making, CBA suffers from shortcomings that in other contexts would be considered failures to apply basic economic principles.

By frequently ignoring the actual consequences of government policy, cost-benefit analysis today has little connection to the evidence-based tool that economists and legal scholars sold to the American public in the early 1980s. Fortunately, the Biden administration plans to revisit the guidance it gives to federal agencies on how to produce regulatory analysis, including CBA. Shoring up CBA’s theoretical underpinnings should be a top priority, since the credibility of policy often rests on the credibility of the analysis supporting it.

Discounting the Future

One of the most important inputs into CBA is the “social discount rate.” The social discount rate is the primary means of aggregating individual preferences in CBA, so that they can be compared on a common social welfare scale. The following must be borne in mind when it comes to choosing the social discount rate:

  1. Selection of this rate involves value judgments—about how much weight future health, wellbeing, and lives saved should receive in analysis.
  2. These value judgments take matters beyond the realm of objective fact that can be discovered through scientific exploration—as such, choosing this rate is likely beyond the competence and expertise of federal regulators.
  3. Policy guided by such value judgments is often no more than an expression of the preferences of analysts dictating a course of action.

A Better Way

Social discounting is not consistent with economic efficiency, which is what many economists believe CBA should measure. Also, social discounting is not consistent with consequentialism. By adjusting costs and benefits arbitrarily, analysis no longer evaluates costs and benefits as they will actually occur. This problem is compounded by the fact that federal regulatory agencies overlook some of the most basic costs and benefits in their analysis, including the foregone returns associated with capital investments.

To correct these deficiencies, CBA should be grounded in economic efficiency and consequentialism, and it should account for the opportunity cost of resources. These principles can help guide federal regulatory reformers, as along each of these dimensions current government practices come up short.

Key Takeaway

At first glance, CBA looks scientific. However, a closer examination reveals that it is often used as a tool to justify certain moral imperatives, especially with regards to the distribution of wealth in society, rather than as a tool to objectively describe the actual tradeoffs society confronts each time a policy intervention is considered. It can be argued that even in its present problematic form, CBA at least forces regulators to have to explain their basic reasoning for programs and regulations that can cost billions of dollars. But given what’s at stake, that’s a low bar. As the Biden administration considers how to improve the regulatory analysis and review process, it should consider reforming CBA’s broken foundations, as this would pave the way for significant improvements in evidence-based policy.

Further Reading

James Broughel, “Cost-Benefit Analysis as a Failure to Learn from the Past,” The Journal of Private Enterprise, 35(1), 2020, 105–113.

James Broughel, “The Unlikely Story of American Regulatory Socialism,” The Quarterly Journal of Austrian Economics, Volume 24 | No. 1 | XX–XX | Spring 2021

James Broughel, “The Social Discount Rate: A Primer for Policymakers,” Mercatus Policy Brief, June 2020.

James Broughel, “What Is vs. What Should Be in Climate Policy: The Hidden Value Judgments Underlying the Social Cost of Carbon,” Mercatus Policy Brief, April 2021.

James Broughel, “The Mighty Waves of Regulatory Reform: Regulatory Budgets and the Future of Cost-Benefit Analysis,” The Business, Entrepreneurship & Tax Law Review, Volume 3, Issue 2 Article 3, 2019.

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