Comments to the Office of Management and Budget on the proposed draft update to Circular A-4: Regulatory Analysis
The Competitive Enterprise Institute (CEI) is a non-profit public interest organization committed to advancing the principles of free markets and limited government. CEI has a longstanding interest in applying these principles to the rulemaking process, and has frequently commented on issues related to Office of Management and Budget oversight of rulemaking and regulatory analysis. I am pleased to provide comments on OMB’s effort to update its Circular A-4: Regulatory Analysis guidelines.[1]
This draft update reflects the first changes made to OMB’s economic analysis guidance to executive branch agencies in 20 years, as the current Circular A-4 guidance was put in place in 2003.[2] The 2003 version of the guidance did have many good attributes, however it was also flawed in many respects. As such, the OMB should be commended for making a good faith effort at updating the guidance. That said, there are significant shortcomings with the new draft guidelines as they currently are being proposed. The following comment describes ways in which the Circular A-4 update could be improved. The comment is organized by topic area.
The social discount rate
The “social discount rate” found in cost-benefit analysis reflects a normative policy choice made by the analyst.[3] It represents, in lay terms, a measure of how much weight the analyst places on the future. In economics jargon, it is a “social rate of time preference,” or, equivalently, the rate at which a unit of present consumption is exchanged for a unit of future consumption.
It should be obvious that this is an ethical choice, not an objective one, and therefore depends on the preferences and ideology of the analyst. The OMB has decided to base its recommended social discount rate on “the real (inflation-adjusted) rate of return on long-term U.S. government debt.”[4] Over the last 30 years, OMB estimates this rate has averaged 1.7 percent. However, the OMB’s selection of this number is based on an arbitrary method. Equally defensible, from a scientific perspective, would be drawing a number out of a hat. While it is true that the method OMB is using is the same as the method reflected in the 2003 version of Circular A-4 (which is how OMB arrived at the 3 percent social discount rate used in many regulatory analyses in the past), that method was equally problematic and arbitrary then.
In fact, use of the 3 percent social discount rate represented, if anything, a worst practice on the part of OMB and federal regulatory agencies. By relying on objective market data, they concealed the normative nature of the discounting decision, making it appear as though the question of how much consideration the future should receive is a scientific one rather than an ethical one. That worst practice should not be repeated in the OMB’s update.
In short, there is no economic basis for the OMB’s recommendation that agencies use a 1.7 percent social discount rate. While that rate may reflect particular interest rates in the economy during a particular time period, it in no way reflects anything objective about “society’s” rate of time preference.[5] Indeed, it is doubtful “society” has time preference, because society is not an individual, but rather a collection of individuals with unique values, tastes, and concerns, living at distinct intervals in time. The social discount rate concept itself arguably constitutes an unnecessary normative assumption that adds little value to the analysis and furthermore conceals the true impacts of a regulation on society.
Recommendation: OMB should make clear that the selection of the social discount rate is a normative policy choice that reflects an ideological decision made by analysts. The 1.7 percent rate should be dropped from the Circular A-4 guidance.
The opportunity cost of capital
The “opportunity cost of capital” refers to the rate of return earned on capital investment that is displaced as a result of government or private actions. This rate is sometimes confused with the social discount rate. For example, the 2003 version of Circular A-4 directed agencies to incorrectly account for the opportunity cost of capital using a social discount rate of 7 percent. The correct approach, as the updated draft guidance recognizes, is to apply a “shadow price” to capital investment (which is an adjustment made to the value of benefits and costs coming in the form of capital investment).[6] This shadow price accounts for deviations between the market price of capital and its social opportunity cost.
The use of the 7 percent social discount rate was, at best, a crude rule of thumb. In most cases, it probably led agencies to undervalue the social benefits of capital investment, relative to consumption, since all benefits and costs were treated as if they were growing in value at the same rate, regardless of whether they came in the form of consumption or investment. In this sense, the Office of Management and Budget is now correct to cease recommending agencies use the 7 percent social discount rate.
However, this does not mean that the OMB is now free to completely ignore the issue of opportunity cost as it pertains to capital. Critically, the opportunity cost of capital is represented by an interest rate. It should not be accounted for with a shadow price such as 1 or 1.2,[7] which are the shadow price of capital factors the draft Circular recommends.[8] A useful opportunity cost interest rate can be found in Broughel and Baxter (2022).[9] The relevant shadow price interest rate arrived at in that analysis depends on two factors: 1) the marginal rate of return to private capital in the economy net of depreciation (ROI), as well the fraction of the investment return reinvested each period (f). Broughel and Baxter estimate f*ROI = 0.8(0.07), yielding a shadow price of capital rate of return of 5.6 percent. This is the opportunity cost of capital interest rate OMB should recommend to executive agencies.
In addition, it is critically important that the risk premium be included when incorporating information about interest rates into regulatory economic analysis. This is not being done in the calculations OMB is relying on for its shadow price of capital estimates (see footnote 7). If anything, OMB should consider including a larger risk premium for federal agency regulations, relative to those found on similar private sector investment returns. Most federal regulations are all but irreversible once enacted. By contrast, private sector investments usually terminate if they turn out not to be profitable.[10]
For these reasons, as a robustness test,[11] a rate of 10 percent, or even higher, could be used alongside the recommended 5.6 percent rate reflecting the opportunity cost of capital. An upper bound as high as 20 percent might even be reasonable given such hurdle rates are common in the private sector.
Recommendation: The opportunity cost of capital must be accounted for in every economic analysis conducted by the government. The opportunity cost of capital should be represented by an interest rate, not a shadow price such as 1 or 1.2. The OMB should use, on the low end, an opportunity cost of capital rate of return of 5.6 percent, based on Broughel and Baxter (2022). For robustness purposes, an upper bound in the range of 10 to 20 percent is reasonable. Investment rates of interest must include risk premia.
There are two interest rates in cost-benefit analysis
As the preceding sections hopefully make clear, there are two interest rates that arise in cost-benefit analysis. These are: 1) the consumption rate of interest, and 2) the investment rate of interest. Contrary to traditional OMB and federal agency practices—where the two rates are applied as discount rates one at a time—a correctly-conducted cost-benefit analysis will actually incorporate both interest rates simultaneously.
There are various ways in which this can be done. The most popular option is to convert all of the benefits and costs that come in the form of capital investment into their consumption equivalent before discounting at “society’s” consumption rate of interest (i.e., the social rate of time preference).[12] However, this approach is sometimes criticized for assuming agents in the economy are myopic because they don’t anticipate future investment income.[13] An alternative approach,[14] which assumes perfect foresight on the part of economic agents, assigns consumption to the benefits side of the ledger and investment to the cost side. Each side of the ledger is then discounted at its corresponding rate of interest. Finally, costs are multiplied by the “marginal cost of funds” (which is another name for the shadow price of capital, only in this case it is applied to a present value of investment). Whichever approach is taken, analysts incorporate two interest rates in the cost-benefit analysis.
Recommendation: A properly-conducted cost-benefit analysis incorporates two interest rates: 1) the consumption rate of interest and 2) the investment rate of interest. Both interest rates should be used in cost-benefit analysis simultaneously.
Implications of a low social rate of time preference
The OMB may be recommending a lower social discount rate than used in the past in part because this would increase the present value of regulations with benefits accruing in the distant future. This is particularly relevant to climate change regulations, such as those with analysis that incorporates the benefits of carbon dioxide emissions reductions using the “social cost of carbon” (SCC). The SCC is an estimate of the value, in “social welfare” terms, of a ton of carbon dioxide emissions reductions. If this is the reason for the recommendation, then the recommendation is pretextual.
Note that there are important implications that follow from selecting a low social rate of time preference, implications that are not currently being considered by the OMB. For example, if the opportunity cost of capital is 5.6 percent, and the social rate of time preference is 1.7 percent, then any capital investments either displaced or induced by the regulation will come to dominate all other benefits and costs in the analysis. The intuition for this is that capital’s returns will be growing at a rate faster than the returns are discounted due to societal impatience. In the limit, the value of capital goes to infinity, suggesting the value of capital investment—no matter how initially small—will exceed the value of any finite gains in consumption.
This has important implications for the SCC, which is expressed in “consumption equivalent units” before discounting.[15] In the final determination of the regulation’s efficiency, the SCC will generally drop out of any economic analysis using a social rate of time preference as low as 1.7 percent, given most reasonable estimates of the opportunity cost of capital exceed this value by a significant amount. Put simply, it would generally be inefficient to displace even a dollar of capital investment in order to pay to reduce carbon dioxide emissions, under OMB’s assumption of a 1.7 percent social rate of time preference.
Recommendation: If the OMB proceeds with recommending a relatively low social discount rate, such as its recommended 1.7 percent rate in the new draft Circular, it must make clear to federal agencies that under reasonable assumptions about the opportunity cost of capital, any benefits or costs that come solely in the form of consumption will generally have no impact on the efficiency of the regulation. These benefits and costs can therefore be discarded in the final tabulation of net benefits, though they might be important for other reasons, such as for distributional reasons. This is relevant to the social cost of carbon.
What is OMB’s cost-benefit analysis measuring?
Arbitrary distributional weights are sometimes included in a cost-benefit analysis. These make adjustments to benefits and costs based on the analyst’s preferences about inequality. OMB must make clear that any analysis using such weights, as the draft guidance now allows,[16] is not measuring welfare but rather is reporting information on the analyst’s capricious preferences about how wealth should be distributed in society.[17]
The current draft guidance, allowing federal agencies to use distributional weights, moves federal regulatory analysis away from an objective grounding in economics. It is the equivalent of basing analysis on Scientology or some related pseudoscience. As such, any regulation based on this reasoning will lack rational basis.
It is sometimes argued that equal weighting of benefits is also arbitrary. However, valuing benefits and costs in dollars that are equally weighted across individuals is defensible because this is what occurs in reality. If John receives healthcare services worth $10,000 dollars, then this is reported as $10,000 in the analysis. Any other weighting of these dollars reflects an arbitrary judgment on the part of the analyst, based on ideology, politics, or other values. Even if such weighting is allowed, where for example $10,000 is instead reported as $20,000 or some other number, the OMB should require agencies to report unweighted figures for transparency reasons, and to make clear what they are measuring and the basis upon which such adjustments are made.
Additionally, OMB should also make clear in its guidelines that a wide variety of regulations (perhaps even the majority of all regulations) are regressive in the incidence of their cost, including many related to energy, labor, and goods and services regulations. Even if businesses make the initial expenditures on regulatory compliance, these costs will inevitably be passed on to workers in the form of lower wages, consumers in the form of higher prices, and shareholders in the form of lower investment returns than otherwise would be the case. In general, these kinds of costs represent a larger share of a low-income person’s budget compared to a high-income person’s budget.
It follows, therefore, that if OMB allows agencies to use arbitrary distributional weights, this must be done consistently across both benefits and costs. Any analysis that reports benefits higher than they occur in reality, and does not adjust costs correspondingly, risks tipping the scales in favor of the regulation. Moreover, it would be much more desirable to simply produce distinct cost-benefit calculations for different segments of the population, without applying weights to benefits or costs. This would be more transparent and help ensure that regulations actually pass a cost-benefit test for the various subgroups considered.[18]
Recommendation: No distributional weights should be used in regulatory analysis. Instead, benefits and costs should be assessed without weights for important subgroups that might be disproportionately impacted by particular regulations. If distributional weights are used, both benefits and costs should be weighted based on their incidence. Agencies should always explain what they are measuring and always report unweighted benefits and costs to ensure transparency.