Paul L. Caron

Friday, May 3, 2024

Weekly SSRN Tax Article Review And Roundup: Eyal-Cohen Reviews Efficiency vs. Welfare In Benefit-Cost Analysis — The Case Of Government Funding By Liscow & Sunstein

This week, Mirit Eyal-Cohen (Alabama; Google Scholar) reviews Zachary D. Liscow (Yale; Google Scholar) & Cass R. Sunstein (Harvard; Google Scholar), Efficiency vs. Welfare in Benefit-Cost Analysis: The Case of Government Funding, 15 J. Benefit-Cost Analysis ___ (2024).


Benefit-Cost Analysis (“BCA”) is a methodical approach to assessing the economic advantages and disadvantages of different options that fulfill transactions, activities, or functional needs for businesses or individuals. Whether we are aware of it or not, we widely employ this method in everyday life as a tool for making decisions when assessing the viability of a project and comparing its strengths and weaknesses. Whether it is investing in higher education, buying a new appliance, or implementing a new business strategy, BCA enables us to evaluate the financial and practical consequences of our choices and efficiently optimize the allocation of our resources.

This Article critically examines the use of BCA in government funding decisions, particularly focusing on how its application has evolved to incorporate concerns for social welfare and equity.

Prior to providing funding for projects, the government may have a legitimate interest in acquiring information regarding both the costs and benefits associated with them. However, the appropriate course of action based on that knowledge is not completely apparent compared to the affected communities’ available resources. The Authors highlight a significant shift from the traditional efficiency-driven model by the Office of management and Budget towards a more welfare and equity-oriented approach in the 2023 revised Circular A-94. Simultaneously, the newly implemented Circular A-94 introduces new uncertainties regarding the most effective methods to advance welfare and address equity in practical terms. Pressing concerns revolve around the utilization of distributional weights in determining funding allocations, as well as the application of population averages, which can be perceived as a type of distributional weighting. The importance of this Article lies in outlining the trajectory BCA in the U.S. government and shedding light on the fundamental difficulties and conflicts within BCA, both historically and in the future.

For many years, Circular A-94 was remarkably transparent in its purpose and rationale. The objective was to optimize efficiency by assuming that the winners would be able to compensate the losers. By excavating this foundation and comprehending the rationale behind previous BCA, the Authors provide a historical overview of BCA, emphasizing the lack of attention to BCA in government funding compared to regulation. They illustrate this evolution with a critical examination of the revisions in OMB Circular A-94, which now incorporate welfare and equity considerations more explicitly. The 1993 version of Circular A-94 stated that its objective was to facilitate the efficient allocation of resources, highlighting the significance of formal benefit-cost analysis and referring to it as the preferred method for conducting a comprehensive economic evaluation of government programs or projects. The old Circular emphasized the need for thorough assessments of the anticipated advantages and disadvantages, specifically focusing on the principle of willingness to pay. It also acknowledged the significance of market prices as a valuable initial reference point and the possibility of substantial distributional effects while instructing agencies to examine these effects based on income class, geographical region, or demographic group. Yet, the Authors use examples on point to demonstrate how the previous efficiency-driven BCA could neglect important welfare implications, particularly in scenarios involving poor communities facing climate-related risks. It did not include equity considerations such as prioritizing poor communities that are often more vulnerable to risks but receive less funding because of low property values.

The 2023 revised Circular A-94 presents an alternative perspective on the objective of the BCA as it aims to advance social welfare, aligning with the growing scholarly focus on the fundamental principles of welfare or well-being as the ultimate objective. The shift to incorporate welfare considerations involves questioning the traditional reliance on the Kaldor-Hicks efficiency criterion, which the Authors argue does not necessarily lead to welfare maximization, especially without actual compensation for the losers. The new version of Circular A-94 somewhat detaches from this empirically dubious assumption that winners will always compensate losers. Moreover, it no longer prioritizes efficiency as its primary objective, although it acknowledges that greater efficiency is still preferable, all other factors being equal.  It provides agencies with the choice of income-averaging, which entails using an average value for a specific benefit or cost across the entire population. The updated Circular, however, still maintains its commitment to thorough and precise quantitative analysis. It unequivocally does not disregard BCA as the objective is to repair it, rather than terminate it.

The updated circular relies on the notion that redistributing wealth through taxation, rather than through spending or regulation, optimizes welfare. This is because individuals universally perceive a dollar as having a value of one dollar, while higher-income individuals generally assign a higher value to goods and services compared to lower-income individuals (in monetary terms). Non-cash redistribution often leads to inefficiency as it denies things to those who highly value them and provides them to those who value them less. According to this reasoning, it is possible that the ultimate objective has always been well-being. However, if that is the case, efficiency is merely a means to achieve the maximization of social welfare. The strategy aims to allocate tax funds in a manner that disproportionately benefits the wealthy, by safeguarding their costly residences, and subsequently imposing higher taxes on them in order to redistribute more wealth to the less affluent. Put simply, increase the magnitude of the economic pie to enable a greater amount to be redistributed through taxation. However, the Authors emphasize that these transfers are never observed. While there is some logic to that argument, it is important to consider that without proper compensatory taxes and transfers for each spending project, it is necessary to have an optimal tax code that redistributes the socially optimal amount. Alas, our tax code is not realistically structured in this manner.

One of the most innovative aspects discussed in this Article is the application of distributional weights in BCA to account for the varying marginal utilities of income across different income groups. Distributional weighting operates by quantifying the overall advantages of a project throughout the income distribution. Subsequently, in accordance with a predetermined formula, the benefits for individuals with lower incomes (measured in terms of efficiency) are given greater importance, while the benefits for individuals with higher incomes are given less importance. This approach aims to prioritize projects that, while perhaps not the most economically efficient, provide greater welfare benefits to lower-income populations. The cases the Authors present in the paper illustrate the potential for BCA to yield outcomes that, while efficient in a narrow sense, might not enhance overall welfare or equity.

While the updated Circular A-94 suggests the use of distributional weighting as an alternative to modify the assessment of costs and benefits, alas, it is not mandatory. Fairness considerations such as supporting high-cost projects that yield modest yet concentrated benefits in low-income communities, thus, are not supported by the updated Circular A-94 if it does not enhance overall welfare. Accordingly, the Authors propose mandatory distributional weights and other adjustments to the BCA methodology to better reflect social welfare. They point out that the disparity between efficiency and welfare could be improved in the context of distributional weights, which aim to increase the importance of benefits for individuals with limited financial resources (as measured by the efficiency metric) and decrease the significance of benefits for those with substantial wealth.  

The Authors provide a comprehensive and rigorously argued case for rethinking BCA in light of welfare considerations. Their argument is well-supported by both theoretical insights and practical examples, which helps bridge the gap between abstract economic theory and real-world policymaking. The Article does not shy away from addressing the controversies and challenges associated with revising BCA practices. These include potential legal and administrative hurdles, the practical difficulties in implementing new BCA procedures such as measuring impacts and income, and policy debates over the validity of comparing utilities across individuals, including the incidence of spending. Yet, while the move towards incorporating welfare considerations is laudable, the Authors might have explored further the potential biases and practical difficulties in implementing these changes. For instance, determining the appropriate distributional weights and even defining the borderlines of each affected community could be highly contentious and subject to political manipulation.

Lastly, the shift to a welfare-oriented BCA framework rests on normative assumptions about the role of government in redistributing resources and managing equity. However, this perspective is not universally accepted and often sparks debate among various political ideologies. Proponents of market efficiency argue that government interventions distort economic signals and inhibit the efficient allocation of resources. They favor minimal government involvement, believing that markets are better at determining the allocation of resources and that income inequality is a natural outcome of differing levels of talent, effort, and investment. Conversely, supporters of a welfare-oriented approach argue that without government intervention, market failures and social inequities will persist and worsen, necessitating robust policies for redistribution and social welfare. This ideological divide should be recognized as it underscores the complex interplay between economic efficiency and social equity, highlighting the intrinsic challenges in applying a BCA framework that satisfactorily addresses both the economic and moral dimensions of policy decisions when considering the feasibility of the proposed framework.

Overall, the Article makes a compelling case for rethinking the application of BCA in government funding to better address issues of social welfare and equity. It challenges readers to consider not only the economic but also the ethical dimensions of policy analysis, making it a significant contribution to the literature on public policy and economics. An efficient and beneficial read! (pun intended).

Here's the rest of this week's SSRN Tax Roundup:

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