Cost benefit analysis and net community benefit

Cost benefit analysis is the primary means by which economics as a discipline influences public policy. These days, no government initiative of any significance — be it a spending or regulatory measure — will be implemented without first being tested for economic efficiency.

The initiative in question will be deemed efficient if it improves community welfare compared to a base case where life goes on without the mooted project, spending program or regulation. Community welfare in this context is not a collectivist concept; it represents the sum of the individual preferences of each community member. Some individuals may place a high value on the benefit promised by the initiative — say, access to a new community facility such as a cycleway — while others may be indifferent as they don’t care for cycling as a transport or recreational option.

If an individual truly values the benefit on offer from the policy initiative, they are assumed to be willing to pay for it, regardless of whether access will be priced. Much of CBA practice is about estimating and aggregating what individuals are willing to pay for anticipated positive effects of a policy initiative.

Often these benefits have no market price, so economists have to resort to indirect measures of willingness to pay. Even when there is a market price, economists must investigate ‘consumer surplus’, the extra amount, over and above the market price, that some individuals would be willing to pay for the service or product. It is in the imputation of benefit value that much of the controversy in cost benefit analysis resides.

Resource and opportunity cost

As well as potentially delivering benefits valued by the community, implementing a new policy will come at a cost. Resources of land, labour, capital and environmental assets that, in the base case, could have been used to deliver other benefits will have to be diverted to the production of benefits promised by the initiative under consideration. These resources have an opportunity cost.

The resource costs of the policy are typically measured at the market price of the land, labour and capital deployed to policy implementation. Where non-priced environmental resources - like clean air and healthy streams — may be ‘consumed’ as part of the policy, value must again be determined based on willingness to pay in the community.

Cost benefit analysis identifies the additional costs incurred by the community in diverting from the base case towards the policy case and contemplates whether these are outweighed by the benefits gained in making the diversion. Often, the timing of costs and benefits will vary, requiring both streams to be expressed in ‘present value terms’. This brings into play another core concept in economics: the ‘social discount rate’.

Social discount rate

This is premised on the assumption that individuals and communities would need to be compensated if they are to be persuaded to defer enjoyment of the proceeds from using land, labour and capital from today to a future period.

To give up a $1 benefit today for a promised return in 5 years, the amount received in that future period would need to be greater than $1 to compensate for foregone interest, inflation and risk. In other words, a nominal $1 received in a future period has a lesser or ‘discounted’ value compared to a $1 received today. This discount can be expressed as an annual interest rate — that is, the amount by which the $ foregone today would need to accumulate in value to provide an amount at a future time which is on par with the current value in the eyes of the person who is making the investment.

Kaldor Hicks rule

Cost benefit analysis as applied in public policy cannot work without a further, more philosophical, concept known as the Kaldor Hicks rule. This provides licence to aggregate and compare costs and benefits across the community regardless of their incidence on individual members of that community.

With this rule in place, the efficiency test becomes one of whether those who gain in welfare from the policy initiative — estimated by their willingness to pay — could, in theory, compensate those who would suffer a loss of welfare and still be ‘in front’. This is known as ‘net community benefit’.

CBA requires rigour and discipline. As a tool in public policy practice for almost a century, conventions have developed to ensure comparability and accountability in these analyses. Nevertheless, it is clear there is considerable room for professional divergence on preferred methodologies. As with any other social science, the evolution of estimation theories and methodologies is governed by the scholarly peer review process.

Cost benefit analysis and regulatory impact assessment

CBA is routinely used in assessing the welfare impacts of all types of regulation other than planning. Across the nation, any policy change which is anticipated to have a significant impact on business and the community generally will typically be subject to a Regulatory Impact Assessment. Under these assessments, it needs to be demonstrated that the direct and indirect costs of compliance with the proposed regulation or policy will be outweighed by the benefits of regulation.

Federal and state governments have set up entire agencies, along with extensive assessment guidelines, for ensuring the appropriate review of new regulations. Notable examples include:

• The Commonwealth Office of Best Practice Regulation (OBPR) Feds
• Better Regulation Victoria
• NSW Best Practice Regulation Guidelines
• Office of Productivity and Red Tape Reduction in Queensland

Indeed, Australia is considered an international leader in regulatory review and assessment, as assessed by the OECD.