Chapter I. The Role of Economic Analysis in Regulatory Reform
Report
to Congress on the Costs and Benefits
of Federal Regulations
Chapter
I. The Role of Economic Analysis
in Regulatory Reform
- Federal Regulatory Programs
- Development of the U.S. Regulatory Analysis Program
- Basic Principles for Assessing Benefits and Costs
1. Federal Regulatory Programs
The regulatory programs that exist today are the product of many different forces, often operating independently of one another, but with the support -- over many decades -- of both major political parties in both the Legislative and Executive branches.
The History of Major Regulatory Programs
The oldest Federal regulatory agency still in existence is the Office of the Comptroller of the Currency, established in 1863 to charter and regulate national banks. However, Federal regulation is usually dated from the creation in the late 19th century of the Interstate Commerce Commission (ICC), which was charged with protecting the public against excessive and discriminatory railroad rates. The regulation was economic in nature, setting rates and regulating the provision of railroad services. Having achieved some success, this administrative model of an independent, bipartisan commission, reaching decisions through an adjudicatory approach, was used for the Federal Trade Commission (FTC) (1914), the Water Power Commission (1920) (later the Federal Power Commission), and the Federal Radio Commission (1927) (later the Federal Communications Commission). In addition, during the early 20th century, Congress created several other agencies to regulate commercial and financial systems -- including the Federal Reserve Board (1913), the Tariff Commission (1916), the Packers and Stockyards Administration (1916), and the Commodities Exchange Authority (1922) -- and to ensure the purity of certain foods and drugs, the Food and Drug Administration (1931).
Federal regulation began in earnest in the 1930s with the implementation of wide-ranging New Deal programs. Some of the New Deal economic regulatory programs were implemented by the Federal Home Loan Bank Board (1932), the Federal Deposit Insurance Corporation (FDIC) (1933), the Commodity Credit Corporation (1933), the Farm Credit Administration (1933), the Securities and Exchange Commission (SEC) (1934), and the National Labor Relations Board (1935). In addition, the jurisdiction of both the Federal Communications Commission (FCC) and the Interstate Commerce Commission were expanded to regulate other forms of communications (e.g., telephone and telegraph) and other forms of transport (e.g., trucking). In 1938, the role of the Food and Drug Administration (FDA) was expanded to include prevention of harm to consumers in addition to corrective action. The New Deal also called for the establishment of an agency to enforce the Fair Labor Standards Act of 1938 in the Department of Labor, which is now called the Employment Standards Administration.
A second burst of regulation began in the late 1960s with the enactment of comprehensive, detailed legislation intended to protect the consumer, improve environmental quality, enhance work place safety, and assure adequate energy supplies. In contrast to the pattern of economic regulation adopted before and during the New Deal, the new social regulatory programs tended to cross many sectors of the economy (rather than individual industries) and affect industrial processes, product designs, and by-products (rather than entry, investment, and pricing decisions).
The consumer protection movement of that era led to creation in the then newly formed Department of Transportation (DOT) of several agencies designed to improve transportation safety. They included the Federal Highway Administration (1966), which sets highway and heavy truck safety standards; the Federal Railroad Administration (1966), which sets rail safety standards; and the National Highway Traffic Safety Administration (1970), which sets safety standards for automobiles and light trucks. Regulations were also authorized pursuant to the Truth in Lending Act, the Equal Credit Opportunity Act, the Consumer Leasing Act, and the Fair Debt Collection Practices Act. The National Credit Union Administration (1970) and the Consumer Product Safety Commission (1972) were also created to protect consumer interests.
In 1970, the Environmental Protection Agency (EPA) was created to consolidate and expand environmental programs. Its regulatory authority was expanded through the Clean Air Act (1970), the Clean Water Act (1972), the Safe Drinking Water Act (1974), the Toxic Substances Control Act (1976), and the Resource Conservation and Recovery Act (1976). This effort to improve environmental protection also led to the creation of the Materials Transportation Board (1975) (now part of the Research and Special Programs Administration in the DOT) and the Office of Surface Mining Reclamation and Enforcement (1977) in the Department of the Interior (DOI).
The Occupational Safety and Health Administration (1970) was established in the Department of Labor (DOL) to enhance work place safety. Major mine safety and health legislation had been passed in 1969, following prior statutes reaching back to 1910. Enforcement responsibility now lies with the Mine Safety and Health Administration, also in the DOL. The Pension Benefit Guaranty Corporation and the Pension and Welfare Administration were established in 1974 to administer and regulate pension plan insurance systems.
Also in the 1970s, the Federal Government attempted to address the problems of the dwindling supply and the rising costs of energy. In 1973, the Federal Energy Administration (FEA) was directed to manage short-term fuel shortage. Less than a year later, the Atomic Energy Commission was divided into the Energy Research and Development Administration (ERDA) and an independent Nuclear Regulatory Commission (NRC). In 1977, the FEA, ERDA, the Federal Power Commission, and a number of other energy program responsibilities were merged into the Department of Energy (DOE) and the independent Federal Energy Regulatory Commission (FERC).
Another significant regulatory agency, the Department of Agriculture (USDA) (1862), has grown over time so that it now regulates the price, production, import, and export of agricultural crops; the safety of meat, poultry, and certain other food products; a wide variety of other agricultural and farm-related activities; and broad-reaching welfare programs. Agriculture regulatory authorities have changed over time, but now include the U.S. Forest Service (1905), the Natural Resources Conservation Service (1935), the Farm Service Agency (1961), the Food and Consumer Service (1969), the Agricultural Marketing Service (1972), the Federal Grain Inspection Service (1976), the Animal and Plant Health Inspection Service (1977), the Foreign Agricultural Service (1974), the Food Safety and Inspection Service (1981), and the Rural Development Administration (1990).
In addition to the regulatory agencies listed above, most Departments and agencies also issue regulations that affect the public in a variety of ways such as:
- eligibility
standards and documentation requirements for government benefit
programs, i.e., USDA's Food and Nutrition Service, Health and
Human Services's (HHS) Health Care Financing Administration,
Housing and Urban Development's (HUD) Federal Housing Administration,
DOL's Employment and Training Administration, and DOI's Bureau
of Indian Affairs as well as Veterans Affairs, Education, the
Department of Defense, and the Social Security Administration;
- use
and leasing requirements for Federal lands and resources, i.e.,
USDA's Forest Service and DOI's Bureau of Land Management and
National Park Service; and
- revenue collection requirements, i.e., Treasury's Internal Revenue Service, Customs Service, and Bureau of Alcohol, Tobacco, and Firearms.
The consequence of the long history of regulatory activities is that Federal regulations now affect virtually all individuals, businesses, State, local, and tribal governments, and other organizations in virtually every aspect of their lives or operations. It bears emphasis that regulations themselves are authorized by and derived from law. No regulation is valid unless the Department or agency is authorized by Congress to take the action in question. In virtually all instances, regulations either interpret or implement statutes enacted by Congress. Some regulations are based on old statutes; others on relatively new ones. Some regulations are critically important (such as the safety criteria for airlines or nuclear power plants); some are relatively trivial (such as setting the times that a draw bridge may be raised or lowered). But each has the force and effect of law and each must be taken seriously.
It is conventional wisdom that competition in the marketplace is the most effective regulator of economic activity. Why then is there so much regulation? The answer is that markets are not always perfect and when they are not, society's resources may be imperfectly or inefficiently used. The advantage of regulation is that it can improve resource allocation or help obtain other societal benefits. For example, consider the following situations:
- Certain
markets may not be sufficiently competitive, thus potentially
subjecting consumers to the harmful exercise of market power
(such as higher prices or artificially limited supplies). Regulation
can be used to protect consumers by regulating prices charged
by natural monopolies or preventing firms from restricting competition
through mergers, collusion or creating entry barriers.
- In
an unregulated market, firms and individuals may impose costs
on others -- including future generations -- that are not reflected
in the prices of the products they buy and sell. They may pollute
streams, cause health hazards, endanger the safety of their workers
or customers, or subject consumers or the broader economy to
undue risks. Regulation can be used to reduce these harmful effects
by prohibiting certain activities or imposing the societal costs
of the activity in question on those causing the harm. One goal
of regulation is to induce private parties to act as they would
if they had to bear the full costs that they impose on others.
- Similarly,
in an unregulated market, firms and individuals may not have
incentives to provide individuals with accurate or sufficient
information needed to make intelligent choices. Firms may mislead
consumers or take advantage of consumer ignorance to market unsafe
or risky products. Regulation may be needed to require disclosure
of information, such as the possible side effects of a drug,
the contents of a food or packaged good, the energy efficiency
of an appliance, or the full cost of a home mortgage.
- Even
when consumers have full information, the Government may wish
to protect individuals, especially children, from their own actions.
Regulation may thus be used to restrict certain unacceptable
or harmful practices such as substance abuse.
- Regulation
can be an important -- indeed necessary -- corollary of some
other government policy. For example, federal deposit insurance
without supervision of those benefitting from it, could -- indeed
-- has encourag ed firms to take undue risks, leading to significant
costs to taxpayers and the economy. Similarly, government benefits
without eligibility determinations or documentation regulations
could run the risk of fraud and abuse.
- Regulation can also be beneficial in achieving goals that reflect our national values, such as equal opportunity and universal education, or a respect for individual privacy.
There are also many potential disadvantages of regulating -- to the Government, to those regulated, and to society at large -- that can give rise to significant costs.
- The
direct costs of administering, enforcing, and complying with
regulations may be substantial. Some of these costs may be borne
by the Government, while others are paid for by firms and individuals,
eventually being reflected in the form of higher prices, lower
wages, and foregone investment, research, and output.
- There are also disadvantages of regulation that are difficult to measure, such as adverse effects on flexibility and innovation, which may impair productivity and competitiveness in the global marketplace, and counterproductive private incentives, which may distort investment or reduce needed supporting activities.
In short, regulations (like other instruments of government policy) have enormous potential for both good and harm. Well-chosen and carefully crafted regulations can protect consumers from dangerous products and ensure they have information to make informed choices. Such regulations can limit pollution, increase worker safety, discourage unfair business practices, and contribute in many other ways to a safer, healthier, more productive, and more equitable society. Excessive or poorly designed regulations, by contrast, can cause confusion and delay, give rise to unreasonable compliance costs in the form of capital investments, labor and on-going paperwork, retard innovation, reduce productivity, and accidentally distort private incentives.
The only way we know to distinguish between the regulations that do good and those that cause harm is through careful assessment and evaluation of their benefits and costs. Such analysis can also often be used to redesign harmful regulations so they produce more good than harm and redesign good regulations so they produce even more net benefits. The next section describes how regulatory analysis has evolved to do just that.
2. Development of the U.S. Regulatory Analysis Program
As discussed above, the late 1960's and early 1970's marked a period in U.S. history of major expansion of health, safety and environmental regulation. Numerous new government agencies were set up to protect the American workplace, the environment, highway travelers, and consumers. As with almost every political development, the significant growth in the amount and kinds of regulation created a counter political development that ultimately produced a companion program to evaluate the regulatory system.
The Nixon and Ford Review Programs
The Nixon Administration established in 1971 a little known review group in the White House called the "Quality of Life Review" program. The program focused solely on environmental regulations to minimize burdens on business. These reviews did not utilize analysis of the benefits and costs to society. The controversy that resulted from the program began a debate about both Presidential review of regulations and the use of benefit-cost analysis that would continue for two decades and to some extent continues today.
Soon after Gerald Ford became President in 1974, he held an economic summit that included top industry leaders and economists to seek solutions to the stagflation and slow growth that the nation was then facing. Out of that summit came proposals to establish a new government agency in the Executive Office of the President, called the Council on Wage and Price Stability (CWPS), to monitor the inflationary actions of both the government and private sectors of the economy. It also led President Ford to issue Executive Order 11821, requiring government agencies to prepare inflation impact statements before they issued costly new regulations. The innovative aspect of the Ford program was the creation of a specific White House agency to review the inflationary actions, mainly regulations, of other government agencies. CWPS was staffed primarily by economists drawn from academia and had little authority beyond the influence of public criticism.
The economists at CWPS quickly concluded that a regulation would not be truly inflationary unless its costs to society exceeded the benefits it produced. Thus the economists turned the inflation impact statement into a benefit-cost analysis. This requirement, that agencies do an analysis of the benefits and costs of their "major" proposed regulations -- generally defined as having an annual impact on the economy of over $100 million -- was adopted in modified form by each of the four next Presidents.
The Administrative Procedure Act requires agencies to give the public and interested parties a chance to comment on proposed regulations before they are adopted in final form. The agency issuing the regulation must respond to the comments and demonstrate that what it is intending to do is within its scope of authority and is not "arbitrary or capricious." CWPS used this formal comment process to file its critiques of the agencies' economic analyses of the benefits and costs of proposed regulations. CWPS would also issue a press release summarizing its filing in non-technical terms. The CWPS analyses attracted considerable publicity. But while this system was effective in preventing some unsupportable regulations from becoming law, it had little success in preventing the issuance of poorly thought out regulations that had strong interest group support.
Nevertheless, one of the legacies of this approach was that it slowly built an economic case against poorly conceived regulations, raising interest particularly among academics and students who began to use the publicly available analyses in their textbooks and courses. When benefit-cost analysis was first introduced, it was not welcomed by the political establishment, especially the lawyers and other non-economists who comprised many agencies and congressional staffs. But over time, as these analyses became standard fare in textbooks, the value and legitimacy of benefit-cost analysis became evident, and it slowly gained acceptance among the public.
After President Carter came to office in 1977, the regulating agencies argued that the Executive Office of the President should not have a role in reviewing their regulations. On the other hand, the President's chief economic advisers argued that a centralized review program based on careful economic analysis was necessary to assure that regulatory burdens on the economy were properly considered and that the regulations that were issued were cost effective. Rapidly escalating inflation in 1978 convinced President Carter of the need to act. In March of 1978, he issued Executive Order 12044, "Improving Government Regulations." It established general principles for agencies to follow when regulating and required regulatory analysis to be done for rules that "may have major economic consequences for the general economy, for individual industries, geographical regions or levels of government."
President Carter also set up a new group, called the Regulatory Analysis Review Group (RARG), with instructions to review up to ten of the most important regulations each year.
The RARG was chaired by the Council of Economic Advisors (CEA) and was composed of representatives of OMB and the economic and regulatory agencies. It relied on the staff of CWPS and the CEA to develop evaluations of agency regulations and the associated economic analyses and to place these analyses in the public record of the agency proposing to issue the regulation. The analyses were reviewed by the RARG members and reflected the views of the member agencies, including the agency that proposed the regulation.
In this way, the Carter Administration helped to institutionalize both regulatory review by the Executive Office of the President and the utility of benefit-cost analysis for regulatory decision makers. Also, in an important legal ruling, the U.S. Court of Appeals for the District of Columbia in Sierra Club v. Costle (657 F. 2d 298 (1981)) found that a part of the President's administrative oversight responsibilities was to review regulations issued by his subordinates.
The Reagan/Bush Review Program
During the Presidential campaign of 1980, the issue was not whether to continue a regulatory review oversight program, but whether to strengthen it. President Reagan had made regulatory relief one of his four pillars for economic growth -- in addition to reducing government spending, tax cuts, and steady monetary growth. He specifically used the term "regulatory relief" rather than "regulatory reform" to emphasize his desire to cut back regulations, not just make them more cost effective. One of his first acts as President was to issue Executive Order 12291, "Federal Regulation" (February 17, 1981).
The Reagan regulatory oversight program differed from the Carter Program in a number of important respects. First, it required that agencies not only prepare cost-benefit analyses for major rules, but also that they issue only regulations that maximize net benefits (social benefits minus social costs). Second, OMB, and within OMB the Office of Information and Regulatory Affairs (OIRA), replaced CWPS as the agency responsible for centralized review. Third, agencies were required to send their proposed regulations and cost-benefit analyses in draft form to OMB for review before they were issued. Fourth, it required agencies to review their existing regulations to see which ones could be withdrawn or scaled back. Finally, President Reagan created The Task Force on Regulatory Relief, chaired by then-Vice President Bush, to oversee the process and serve as an appeal mechanism if the agencies disagreed with OMB's recommendations. Together these steps established a more formal and comprehensive centralized regulatory oversight program.
In 1985, President Reagan issued Executive Order 12498, "Regulatory Planning Process," that further strengthened OMB's oversight role by extending it earlier into the regulatory development process. The Order required that agencies annually send OMB a detailed plan on all the significant rules that they had under development. OMB coordinated the plans with other interested agencies and could recommend modifications. It also compiled these detailed descriptions of the agencies' most important rules -- usually about 500 -- in one large volume called the Regulatory Program of the U.S. Government.
The Bush Administration continued the regulatory review program of the Reagan Presidency. Nonetheless, the pace of new health, safety, and environmental regulations that had begun to increase at the end of the Reagan Administration continued during the first two years of the Bush Administration. In 1990, President Bush responded to expressions of concern about increasing regulatory burdens by returning to the approach used by the Reagan Task Force on Regulatory Relief. Vice President Quayle was placed in charge of a task force -- now called the Competitiveness Council -- whose mission was to provide regulatory relief.
On September 30, 1993, President Clinton issued Executive Order 12866, "Regulatory Planning and Review." The Order reaffirmed the legitimacy of centralized review but reestablished the primacy of the agencies in regulatory decision making. It retained the requirement for analysis of benefits and costs, quantified to the maximum extent possible, and the general principle that the benefits of intended regulations should justify the costs. In addition, while continuing the basic framework of regulatory review established in 1981, it made several changes in response to criticisms that had been voiced against the Reagan/Bush programs.
One of the changes was to focus OMB's resources on the most significant rules, allowing agencies to issue less important regulations without OMB review. OMB had been reviewing about 2,200 regulations per year with a staff of less than 40 professionals. This change enabled OMB to add greater value to its review by focusing on the most important rules.
A second change was the establishment of a 90-day period for OMB review of proposed rules. Executive Order 12291 contained no strict limit on the length of review, and some reviews had dragged on for several years before resolution. The Clinton Executive Order also set up a mechanism for a timely resolution of any disputes between OMB and agency heads.
A third change was to increase the openness and accountability of the review process. All documents exchanged between OIRA and the agency during the review are made available to the public at the conclusion of the rulemaking. The Executive Order also requires that records be kept of any meetings with people outside of the Executive branch on regulations under review by OMB, that agency representatives be invited to attend the meetings, and that all written communications be placed in the public docket and given to the agency.
OMB has produced three reports on its implementation of this Executive Order. On May 1, 1994, OMB published a six month assessment of the Executive Order that the President had requested when he issued the Order (Report to the President On Executive Order No. 12866, 1994). The report concluded that many initial improvements in the regulatory review system had been made, but that in some areas it was taking longer to show results than expected. Among other things, the report documented that the new Executive Order was resulting in increased selectivity. The 578 rules reviewed by OMB over the six-month period was about one half the rate of review under the previous Executive Order. Freeing up limited staff resources to concentrate on the more significant rules resulted in a higher percentage of changes to the rules reviewed. Second, the new time limits for OMB review were for the most part being met. Of the 578 reviews completed in the first six months of the Executive Order, only three had gone beyond 90 days and those delays were requested by the agencies. Third, the report concluded that the new requirements for openness and accountability were being met. During the six-month period, 36 meetings were held with outsiders about specific rules under review. These meetings were disclosed to the public and agency representatives were always invited.
In October 1994, OIRA produced a second report entitled, The First Year of Executive Order No. 12866, that basically confirmed the findings of the first report. The number of significant rules that OIRA was reviewing fell to a rate of about 900 per year, 60 percent lower than the 2200 per year average reviewed under the previous Executive Order, and the number of rules that were changed continued to increase. About 15 percent of the rules were "economically significant"-- meaning in general that the regulation was expected to have an effect on the economy of more that $100 million per year. The 90-day review period was generally observed, and there were about 70 meetings during the first year, to which agency representatives were invited. The report concluded that the new openness and transparency policy had served to defuse, if not eliminate, the criticism of OIRA's regulatory impact analysis and review program.
The third report, More Benefits Fewer Burdens: Creating a Regulatory System that Works for the American People, was issued in December 1996. The report provided a series of examples of how the agencies and OMB had worked together to produce regulations that adhered to the principles of Executive Order 12866. The examples were organized around six broad themes, several of which emphasize economic analysis and efficiency:
- properly
identifying problems and risks to be addressed, and tailoring
the regulatory approach narrowly to address them;
- developing
alternative approaches to traditional command-and-control regulation,
such as using performance standards (telling people what goals
to meet, not how to meet them), relying on market incentives,
or issuing nonbinding guidance in lieu of rules;
- developing
rules that, according to sound analysis, are cost-effective and
have benefits that justify their cost;
- consulting
with those affected by the regulation, especially State, local,
and tribal governments;
- ensuring
that agency rules are well coordinated with rules or policies
of other agencies; and
- streamlining, simplifying, and reducing burden of Federal regulation.
The report included examples of incremental improvements in the regulatory systems across the government. Although few major eliminations or reforms of regulatory programs were listed, the sum of the improvements indicated that significant benefits were attained with lower costs. A key recommendation of this report was the continued use by the agencies, and vigorous promotion by OMB, of the principles of the Executive Order.
An appendix to More Benefits Fewer Burdens contained information on the costs of regulations issued between 1987 and 1996, which we use below to estimate the aggregate costs of regulation. Another appendix included a discussion of regulatory reform legislation that President Clinton had supported and was passed by Congress during the three-year period, including three statutes that require agencies to follow certain procedures and/or consider various economic impacts before taking regulatory action: the Unfunded Mandates Reform Act of 1995, the Paperwork Reduction Act of 1995, and the Small Business Regulatory Enforcement Fairness Act of 1996.
3. Basic Principles for Assessing Benefits and Costs
In order to help agencies prepare the economic analyses required by Executive Order 12866 or the various statutes enacted by the Congress in the last few years, OMB developed, through an interagency process, a "Best Practices" document that was issued on January 11, 1996. Best Practices sets the standard for high quality economic analysis (EA) of regulation -- whether in the form of a prospective regulatory impact analysis of a proposed regulation, or in the form of a retrospective evaluation of a regulatory program. The principles that are described in detail in Best Practices are summarized here because they can serve as an introduction to how we have evaluated the studies on the costs and benefits of regulation discussed in the following chapters. We discuss those principles in Best Practices that are general in nature, then those that pertain to benefits, and then those that pertain to costs.
Costs and benefits must be measured relative to a baseline. Best Practices states that "the baseline should be the best assessment of the way the world would look absent the proposed regulation." Typically, the baseline should start with the world before the action taken, be consistent with other pending government actions, and applied equally to benefits and costs. In some instances where the likelihood of government actions are uncertain, analysis with multiple baselines is appropriate.
Costs and benefits should be presented in a way to maximize their consistency or comparability. Costs and benefits can be monetized, quantified but not monetized, or presented in qualitative terms. A monetized estimate is one that either occurs naturally in dollars (e.g., increased costs by a business to purchase equipment needed to comply with a regulation) or has been converted into dollars using some specified methodology (e.g., the number of avoided health effects multiplied by individuals' estimated willingness-to-pay to avoid them). A quantitative estimate is one which is expressed in metric units other than dollars (e.g., tons of pollution controlled, number of endangered species protected from extinction). Finally, a qualitative estimate is one which is expressed in ordinal or nominal units or is purely descriptive. Presentation of monetized benefits and costs is preferred where acceptable estimates are possible. However, monetization of some of the effects of regulations is often difficult, if not impossible, and even the quantification of some effects may not be easy. As discussed below, aggregating costs and benefits is particularly difficult, if not impossible, where they are not presented in consistent or comparable units.
An economic analysis cannot reach a conclusion about whether net benefits are maximized -- the key economic goal for good regulation -- without consideration of a broad range of alternative regulatory options. To help decision-makers understand the full effects of alternative actions, the analysis should present available physical or other quantitative measures of the effects of the alternative actions where it is not possible to present monetized benefits and costs, and also present qualitative information to characterize effects that cannot be quantified. Information should include the magnitude, timing, and likelihood of impacts, plus other relevant dimensions (e.g., irreversibility and uniqueness). Where benefit or cost estimates are heavily dependent on certain assumptions, it is essential to make those assumptions explicit, and where alternative assumptions are plausible, to carry out sensitivity analyses based on the alternative assumptions.
The large uncertainties implicit in many estimates of risks to public health, safety or the environment make treatment of risk and uncertainty especially important. In general, the analysis should fully describe the range of risk reductions, including an identification of the central tendency in the distribution; risk estimates should not present either the upper-bound or the lower-bound estimate alone.
Those who bear the costs of a regulation and those who enjoy its benefits often are not the same people. The term "distributional effects" refers to the distribution of the net effects of a regulatory alternative across the population and economy, divided in various ways (e.g., income groups, race, sex, industrial sector). Where distributive effects are thought to be important, the effects of various regulatory alternatives should be described quantitatively to the extent possible, including their magnitude, likelihood, and incidence of effects on particular groups. There are no generally accepted principles for determining when one distribution of net benefits is more equitable than another. Thus, the analysis should be careful to describe distributional effects without judging their fairness.
The analysis should state the beneficial effects of the proposed regulatory change and its principal alternatives. In each case, there should be an explanation of the mechanism by which the proposed action is expected to yield the anticipated benefits. As noted above, an attempt should be made to quantify all potential real benefits to society in monetary terms to the maximum extent possible, by type and time period. Any benefits that cannot be monetized, such as an increase in the rate of introducing more productive new technology or a decrease in the risk of extinction of endangered species, should also be presented and explained.
The concept of "opportunity cost" is the appropriate construct for valuing both benefits and costs. The principle of "willingness-to-pay" captures the notion of opportunity cost by providing an aggregate measure of what individuals are willing to forgo to enjoy a particular benefit. Market transactions provide the richest data base for estimating benefits based on willingness-to-pay, as long as the goods and services affected by a potential regulation are traded in markets.
Where market transactions are difficult to monitor or markets do not exist, analysts should use appropriate proxies that simulate willingness-to-pay based on market exchange. A variety of methods have been developed for estimating indirectly traded benefits. Generally, these methods apply statistical techniques to distill from observable market transactions the portion of willingness-to-pay that can be attributed to the benefit in question. Contingent-valuation methods have become increasingly common for estimating indirectly traded benefits, but the reliance of these methods on hypothetical scenarios and the complexities of the goods being valued by this technique raise issues about its validity and reliability in estimating willingness-to-pay compared to methods based on (indirect) revealed preferences.
Health and safety benefits are a major category of benefits that are indirectly traded in the market. The willingness-to-pay approach is conceptually superior, but measurement difficulties may cause agencies to prefer valuations of reductions in risks of nonfatal illness or injury based on the expected direct costs avoided by such risk reductions. The primary components of the direct-cost approach are medical and other costs of offsetting illness or injury; costs for averting illness or injury (e.g., expenses for goods such as bottled water or job safety equipment that would not be incurred in the absence of the health or safety risk); and the value of lost production.
Values of fatality risk reduction often figure prominently in assessments of government action. Reductions in fatality risks as a result of government action are best monetized according to the willingness-to-pay approach for small reductions in mortality risk, usually presented in terms of the value of a "statistical life" or of "statistical life-years" extended.
Another type of benefit can be characterized as "losses avoided." When our banking system and capital markets systems work well, providing capital and credit to the economy, it is easy to forget that effective supervision and regulation is needed to prevent disasters like the thrift crisis of the 1980s.
It is important to keep in mind the larger objective of consistency -- subject to statutory limitations -- in the estimates of benefits applied across regulations and agencies for comparable risks. Failure to maintain such consistency prevents achievement of the most risk reduction from a given level of resources spent on risk reduction.
The preferred measure of cost is the "opportunity cost" of the resources used or the benefits forgone as a result of the regulatory action. Opportunity costs include, but are not limited to, private-sector compliance costs and government administrative costs. Opportunity costs also include losses in consumers' or producers' surpluses, discomfort or inconvenience, and loss of time. The opportunity cost of an alternative also incorporates the value of the benefits forgone as a consequence of that alternative. For example, the opportunity cost of banning a product (e.g., a drug, food additive, or hazardous chemical) is the forgone net benefit of that product, taking into account the mitigating effects of potential substitutes. Note that since "costs" may be viewed as benefits foregone, the difficulties in estimating benefits described above in principle also apply to the estimation of costs.
All costs calculated should be incremental -- that is, they should represent changes in costs that would occur if the regulatory option is chosen compared to costs in the base case (ordinarily no regulation or the existing regulation) or under a less stringent alternative. As with benefit estimates, the calculation of costs should reflect the full probability distribution of potential consequences.
An important, but sometimes difficult, problem in cost estimation is to distinguish between real costs and transfer payments. As discussed below, transfer payments are not social costs but rather are payments that reflect a redistribution of wealth. As Best Practices states "While transfers should not be included in the EA's estimates of the benefits and costs of a regulation, they may be important for describing the distributional effects of a regulation."
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