C h a p t e r 6 COST-BENEFIT ANALYSIS AND GOVERNMENT INVESTMENTS Public Finance, 10th Edition David N. Hyman C h a p t e r 6 COST-BENEFIT ANALYSIS AND GOVERNMENT INVESTMENTS

The Budget Process Discretionary programs: those that Congress must renew funding for each year Entitlement programs – spending for transfers (Social Security, Medicare, veteran’s benefits) that are determined by the number of individuals eligible for payments and are automatically funded Budget resolution: passed by Congress, it indicates funding levels for 19 broad federal spending categories for the next 5 years Budget authority: agencies allowed to spend in each of the 19 categories

Program Budgeting Program – a combination of government activities producing a distinguishable output Program budgeting – a system of managing government expenditures by attempting to compare program proposals of all government agencies authorized to achieve similar objectives Program budgeting seeks to measure the outputs of agencies in quantitative terms. The goal is to find the minimum cost combination, or cost-effective program mix, that still achieves the mission.

Cost-Effectiveness Analysis A technique for determining the minimum-cost combination of government programs to achieve a given objective Choose an objective that alternative government programs can achieve E.g., reduce deaths by disease, accidents by 5,000 people per year Provision of free smoke detectors Free inoculations against the flu Choose the mix of those programs that achieves the objective at minimum possible cost

Cost-Effectiveness Analysis

Incremental Budgeting Basing the current budget on the previous year’s budget with only minor changes in funding levels for various programs included in the budget In fact, the approach many governments actually use follows this view of budgeting as an incremental process Seeks to minimize resources that go into the budgetary process each year and make it easier to enact budgets

Cost-Benefit Analysis A three-step process for determining the relative merits of alternative government projects over time: Enumerate all costs and benefits of the proposed project Evaluate all costs and benefits in dollar terms Discount future net benefits

Enumerating Costs and Benefits List not only direct resource costs but also any costs not reflected in the prices of inputs (such as a loss of output from another program or industry) Enumerating Benefits: Divided into direct and indirect benefits Only real increases in output and welfare are considered (double counting benefits should be avoided)

Evaluating Costs and Benefits Valuing output requires an estimate of the demand for increased production and calculation of consumer surplus Because this is difficult for outputs not sold in markets, surrogate measures of the willingness of beneficiaries to pay for outputs that are not sold must be obtained In some cases, prices must be adjusted to reflect the actual marginal social cost or benefit

Discounting Future Net Benefits Need to discount stems from the existence of positive interest rates – the present value must be calculated In general, the present value of X dollars to be receive n years from now at simple interest rate r is obtained by solving the equation: For a project that yields benefits over a number of years:

Discount Rates and Projects Project 1 yields $90 in benefits immediately, Project 2 yields $100 in two years, $0 until then

ECONOMIC ANALYSIS Incremental Economic Net Benefit Flow Statement (in thousands Peso) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 10 Year 15 Year 16 Benefits: Port revenues - local - 1,359 2,276 6,895 8,120 Port revenues - foreign 249 280 488 520 Total Port Revenues 1,608 2,556 7,383 8,639 Benefit to ship owners due to reduction in ships' waiting time 25,484 31,264 33,539 35,444 36,491 Benefit to shippers due to reduction in animal weight loss 13,331 13,906 16,204 19,715 Rental income from Container Yard I 3,000 Rental income from Container Yard II 1,000 2,000 6,000 9,000 Other Income 69 USAID Grant and Gov. Contribution Liquidation Values: 316,916 Total Benefits 3,069 28,553 50,272 55,070 68,100 76,914 Costs: Investment cost-non tradable 21,818 96,550 141,822 45,422 Investment cost-tradable 2,596 87,515 130,373 54,059 Operating Cost: 9,044 Loss of rental income from term. shed 1,100 Change in Cash balance 80 55 65 20 (397) Change in Accounts Receivable 160 111 130 39 (793) Change in Accounts Payable (1,329) (121) 1,208 Total Costs 25,514 185,165 273,295 100,581 9,056 10,190 10,219 10,082 19 NET CASH FLOW (25,445) (182,096) (270,226) (72,028) 41,216 44,880 57,881 66,832 316,898 NET PRESENT VALUE (at 10.3%) (131,259) INTERNAL RATE OF RETURN 5.88%

Social Rate of Discount Should reflect the return that can be earned on resources employed in alternative private use; opportunity cost of funds invested by the government Discount rate set equal to social opportunity cost of funds, which depends on the rate at which savers or investors are willing to give up consumption or investment to finance the project Net return for savers often different than that earned by investors (because of corporate income tax, for example)

Social Rate of Discount

Treatment of Inflation Benefits and costs could be measured through time in nominal values by estimating rate of inflation over time and inflating future benefits and costs accordingly. In this method, the nominal interest rate, or sum of real interest rate and rate of inflation, must be used. Similarly, if benefits and costs are measured over time in real terms, one must use the real interest rate to discount future benefits and costs.

Ranking Projects Projects usually ranked according to present value of their discounted net benefits or according to the ratio of the present value of the benefits (B) to the present value of costs (C) Two criteria:

Ranking Projects

Government Investments Government heavily invests in a nation’s physical infrastructure, or its transportation and environmental capital, such as schools, power and communication networks, and health care. Government-provided infrastructure accounts for about one-fifth of U.S. nonresidential capital stock. Governments also invest in human capital through programs designed to improve the skills and education of its citizens.

Cost-Benefit Analysis in Budgeting Cost-benefit analysis can be used to organize information in a way that aids citizens, politicians, and bureaucrats. This makes it valuable for evaluating benefits of proposed government projects. Is difficult, however, to measure benefits accurately. Difficult to measure social costs Difficult to reduce selection of government goods and services to a few simple, objective criteria

Cost-Benefit Analysis

Benefits of Widening a Highway