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COST-BENEFIT ANALYSIS AND GOVERNMENT INVESTMENTS
C h a p t e r 6
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
Enumerating Costs:
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
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:
Discounting Future Net Benefits
Discount Rates and Projects
Project 1 yields $90 in benefits immediately, Project 2 yields $100 in two years, $0 until then
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

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