The federal government is about to upend how regulations are imposed on businesses and citizens. The White House Office of Management and Budget is quietly proposing to phase out from federal regulatory analysis one of the most important concepts in economics: opportunity cost.
Opportunity cost is what would have happened with resources had they not been used for a certain purpose—like complying with federal regulations. Consider a business that spends $1 million obeying a regulation by making an upgrade, installing new equipment, hiring lawyers and whatever else compliance entails.
The opportunity cost is what the $1 million would have been used for absent the regulation. It might have been spent on research and development, hiring, increasing output or paying bonuses to employees, who in turn would spend it on something else.
An accountant would say the cost of this regulation is $1 million, and this is basically how President Biden’s OMB wants regulators and the public to think as well. A good economist knows better and would account not only for the dollars spent but also the forgone rate of return on activities never taken up due to regulatory compliance.
Determining this lost return isn’t easy, but economists can make good estimates. They can assume that, on the margin, people devote some fraction of spending to consumption and some to investment, and that investments earn some marginal rate of return in the marketplace. Economists can estimate the corresponding “elasticities” on these activities—how responsive one economic factor is to changes in another—and work out reasonable approximations of what has been given up.
This exercise is far from perfect. There’s no way of confirming a counterfactual state of the world, but if we want to be confident that regulations improve the situation, we must try.
The Biden OMB is making a big change by revising its regulatory analysis guidance, known as Circular A-4. It is the first such update in 20 years, and it can redefine the federal government’s entire approach to cost-benefit analysis, altering the foundation for thousands of future regulatory actions.
Before this proposed update, the federal government assumed that displaced investments would earn 7% a year, which is reasonable given market returns. For technical reasons, the government was incorporating this rate into regulatory analysis incorrectly, however, applying it to all benefits and costs and not solely to investments. Because of this mistake, the Biden administration is now able to suggest somewhat credibly that the rate should be dropped.
But that will lead executive agencies to underestimate systematically the opportunity costs of their rules, thereby introducing a fresh error. Now the Biden administration simply wants to assume virtually no investment displacement from regulations, brushing opportunity cost under the rug. A regulation necessitating an expenditure of $1 million will be considered to have an opportunity cost practically equivalent to that amount.
Read the full article on Wall Street Journal.