A Call to Reconsider the Foundations of Economic Analysis

Many economists believe that the US federal regulatory system is built on solid ground. Over the last few decades, government agencies have developed processes to analyze and quantify the anticipated costs and benefits of their proposed rule changes, helping policymakers understand the economic impacts of regulations.

At least, that is the theory. But a new body of research spearheaded by Mercatus Center senior research fellow James Broughel finds that although the mathematical formulas of benefit-cost analysis (BCA) have the veneer of a disinterested scientific endeavor, upon further examination, these quantitative methods are riddled with subjectivity and internal contradictions.

Although analysis is often characterized as value-neutral, the outputs of BCA actually reflect policy analysts’ conceptions of distributional equity and fairness. By accident or by design, a bias is built into BCA that steers conclusions towards the analysts’ concerns and goals. This bias emanates from a surprising place—the technical decision about the appropriate discount rate used in policy analysis.

Academics in the market process tradition should lend their talents towards strengthening the foundations of our regulatory analysis institutions. There is fertile ground for enterprising scholars to plant the seeds of a new body of research. In fact, the integrity of our methods, and therefore our policies, depends on it.

The Problem, in a Nutshell

The normative choice of what’s called the “social discount rate” (SDR) has a dramatic impact on whether a regulation is found to pass or fail a benefit-cost test. There are two major approaches to calculating a social discount rate. Amazingly, in addition to disagreeing about what number is the correct rate, adherents of each method also disagree about the proper role that the discount rate plays in analysis and even about the welfare measure that BCA evaluates.

One method uses the SDR to account for the opportunity cost of capital. A second method uses the SDR to represent a rate of time preference for “society.” Both methods attempt to maximize some version of the “good,” but they disagree on what exactly this means. The opportunity cost approach seeks to maximize a version of efficiency, while the time preference approach attempts to maximize broader social welfare. As such, the debate about the SDR forms part of a much larger, more important debate about what measure of human welfare that underlies policy analysis.

Oddly, however, neither method even measures what it purports to measure. The time preference approach assumes a social welfare function can describe the aggregated preferences of all individuals in society (or alternatively, the welfare function is sometimes said to describe the preferences of a mysterious social planner who organizes the economy). But the idea that individual preferences can be so aggregated has no grounding in neoclassical economics, while the claim that a social planner organizes our economy borders on the supernatural.

Advocates of the opportunity cost approach pay lip service to efficiency, but they make interpersonal comparisons of utility, allowing the analyst’s preference for an equitable distribution of wealth to enter into analysis through the discount rate. Maximizing wealth, irrespective of its distribution, is the very essence of allocative efficiency, but the opportunity cost approach is inconsistent with this most basic of economic principles.

A Path to Fortification

It is problematic enough that there is such disagreement over the bedrock of our regulatory procedures. It is particularly problematic that these normative debates take place in the shadows, as part of highly technical debates about the appropriate discount rate used in policy analysis, without broader public discussion.

Scholars from the market process tradition have a great opportunity to engage with the administrative state and to improve the quality of our regulatory institutions. Many academics in the mainline economic tradition are fond of envisioning ideal governance alternatives. In the case of the BCA, there is unique potential to actually build new theoretical foundations from the ground up.

The SDR forms not only the foundation of benefit-cost analysis; the selection of this rate has implications that stretch beyond BCA into the theory of market failure that justifies government interventions and into the machinery that holds together modern macroeconomic modeling. Economists that take up the call to reconsider these topics have the opportunity to revolutionize the tools of contemporary policy analysis, and to revisit the very foundations of modern economic theory itself.