Social vs. Private Costs in Cost-Benefit Analysis

I am currently working on a cost-benefit analysis on policy options to improve water quality in Ohio. At this point in the process, I’ve spent a few weeks thinking about how to approach this question and even have some preliminary models built out. There is one specific part of these models that has made me stop and think and I want to talk about it briefly. 

All of the policy alternatives I am considering for this cost-benefit analysis involve some amount of government spending to improve agricultural practices on private farms. Essentially, the government subsidizes certain farm practices that while slightly more expensive, can improve water quality and provide benefits for people who use lakes and streams. The question then for the analyst is what should count between public costs, private costs, and private time and labor.

The case for including all these impacts in this analysis is that under most circumstances, the subsidy won’t cover all of the upfront costs associated with the program, and instead farmers would be spending a smaller amount in the short term to get additional long-term benefits in the form of reduced spending on fertilizer. If farmers are trading short-term costs for long-term benefits, then the model should try to capture that. The case against including both measures relies on the fact that the program of interest is voluntary and farms that participate in it are profit maximizing firms. 

Consider for a moment that this cost-benefit analysis did not involve any government subsidy, and we were just concerned about farmers implementing these practices themselves. In this case, we would include the upfront costs in our model. With government subsidies, the intuition might be to just subtract the subsidy from the total cost in order to avoid double counting. 

However, acknowledging the fact that in order to spend money the government needs to tax its citizens, the marginal excess burden of taxation is the social cost of a subsidy (read more in the Ohio Handbook of Cost-Benefit Analysis). In short, we are measuring the lost economic activity that comes with raising taxes, not the transfer of funds from the government to a farm, which is itself a net zero transfer payment. 

If farmers are choosing to enter into this program, then there should not be any lost economic activity. The upfront costs of this program are just a transfer of funds from the farmer to the scientists they need to perform soil tests. Whatever portion of these funds comes from the subsidy is largely irrelevant, because the only economic loss is through the marginal excess burden of taxation. If this was a mandatory program, then we would consider the lost value of however else the farmers would have spent their time because it would be mandated changes that would not have happened otherwise. Voluntary compliance suggests the costs and benefits are internalized by the farmer. 

This detail is an illustration of the fact that cost-benefit analysis is not a tool for measuring private costs, but rather social costs. Without additional information about value added or lost from transferring funds between parties, there should not be an economic effect. 

This blog post is part of a series of posts on conducting cost-benefit analysis for newcomers by Scioto Analysis Policy Analyst Michael Hartnett.