‘Coz it Benefits me Analysis !

‘Coz it Benefits me Analysis !

Ganga Prasad Rao

For decades, cost-benefit analysis (CBA), or benefit-cost analysis (depending on your perspective!) has ruled the roost among policy makers who use and advocate it for evaluating the economic attractiveness of policy alternatives and options. The principle is simple: evaluate all incremental economic costs and all incremental economic benefits of alternatives over the baseline or status quo and choose the one that yields the highest incremental net benefits. In reality however, the application of CBA has been clouded by a myriad issues. These concern the definition of costs, measurement of benefits, discount rates, social preferences, compensation to ‘losers’ and so on. All impact studies recognize costs and benefits spread across space and time, first round and second round effects, as well as distributional impacts. Yet, not many studies examine the performance of CBA under various administrative, constitutional, political and electoral systems.

One concern is that few authors recognize the consequences of the fact that the government, more precisely, the incumbent party (and its political appointees) is a major beneficiary of its own policy-making decisions. Howzzat? The incumbents (whether ruling or in the opposition) are an ‘interested party’ to the deliberations and outcomes of mega project proposals because employment generation, higher production and income growth that accompany them are either poll promises, goals on assumption of power, or, factors that decide elections. They are not unaware that doling out a large number of contracts could bring in campaign contributions come election time. The larger the campaign funding needs, the larger must be the value of contracts doled out! Indeed, modern day politics, especially in majoritarian democracies, revolves around appeasing the industry who fund campaigns and implicitly subsidize the poor masses who serve as vote banks.

An immediate implication is that no incumbent will voluntarily accept a net-benefits maximizing option. In fact, incumbents will pitch for those project alternatives that generate employment and contracts that they can dole out in return for favor come election time. Given the dynamics of majoritarian politics and the location/specialization of these contractors, incumbents may prefer projects concentrated in certain regions or industries over other, perhaps more beneficial, projects located elsewhere. Projects will be scaled-up beyond the benefit-maximizing point to generate higher employment and to gain the power to dole out more number of higher value contracts (Pork-barrel spending? Never heard of it!). This will, of course, cause inefficiency from a reduction or reversal of net benefits. Incumbents will also prefer options that are so structured that they provide immediate, concentrated benefits to themselves and their benefactors but impose broadly distributed costs at a future point in time, sometimes in to the next generation. Political appointees may even pre-empt a full cost-benefit analysis by acting early to prune the list of alternatives for which costs and benefits are to examined, ostensibly on grounds of transactions cost or budgetary pressures. Thus, even purists may be misled when incumbents (the ruling and the opposition benches) apparently rely on cost-benefit methodology to motivate mutually agreeable pork-barrel spending within a ‘local domain’ excluding options from the broader domain. For example, a larger than optimum-sized dam may be proposed in Region A (where the incumbent party or representative stands a chance in the next elections) when the benefit-maximizing choice should have been an education or drinking water project in Region B (where voters have rejected the incumbents).

There are at least three issues of interest to the economist here. First, whether cost-benefit analysis should consider the electoral gains to the incumbents, corruption aside, as a benefit while evaluating the project. The second issue is efficiency. And the third, conflict of interest. Let’s start with the first. The incumbent party undoubtedly benefits at the polls if it obtains on one hand, the goodwill of voters delighted with higher employment and income, and on the other hand, the monetary and political support from the industry in exchange for the contracts received from ‘pork-barreled’ public projects. These ‘benefits’ are at the cost of the society at large, particularly the future generation; they are more properly classified as a ‘extra-regulatory or extra-constitutional distributional impacts or rents’ . As real as they are, these rents cannot be included within the ambit of cost-benefit analysis; including such rents would be analogous to causing an endogeneity problem in econometrics. They must however be taken cognizance of by those with stake in good governance.

The second issue, that of efficiency, deserves special mention. The implication here is that as long as elected officials and their appointees decide budgets and spending on public projects, they will rationally seek out labor-intensive projects that generate employment and income among voters. Further, there is an incentive to camouflage an increase in the scale of public projects beyond the economic optimum to favor public work contractors in the guise of addressing equity. Incumbents will also generally favor inefficient resource allocation involving spending in their constituency over spending on efficient projects elsewhere. These biases might eventually find their way, marginally or otherwise, in to productivity, prices, wages and inflation, thus skewing the economy off its growth-maximizing path.

As for the third, there is an obvious conflict of interest when incumbents decide on spending whose outcomes, in part, determine their political future. Clearly, the incumbents’ decisions will be biased toward self-preservation which may or may not be in the interest of efficiency or the good of the nation. One might argue that those facing the ruling benches will oppose such spending, bringing about a compromise closer to the economic optimum. While such may be the case in enlightened democracies, elsewhere, the opposition too has its axe to grind, its campaign needs, and certainly, its very own vote bank to feed. In fact, there is every incentive for the opposition to make mutually agreeable deals with the ruling incumbents on pork-barrel spending. The need to engage in pork-barrel spending depends on political realities, while the power to do so is limited by economic realities, the strength of the ruling incumbents relative to the opposition benches and (the existence and) enforcement of provisions aimed at the agency problem. Indeed, the ‘Principal-Agent’ problem is of particular concern on account of the power and resources vested with elected incumbents and the influence of their decisions on the future of the nation and its people.

To sum up, cost-benefit analysis presumes neutral decision-makers. When decision-makers find themselves potential beneficiaries of the policies they decide, cost-benefit analysis tends to be manipulated to support inefficient, pork-barrel spending some of which is returned as ‘rents’. Further, since such ‘rents’ motivate regulatory decision-making, their consideration in the design of administrative or constitution provisions seems necessary. Further, survival being the ‘mantra’ of politicians, truncated and biased analyses are likely to continue because no Principal-Agent contract can foresee all eventualities and because the transaction cost increases with the stringency of enforcement of the contract. In this context, economists should examine political incentives from a Principal-Agent perspective for the particular type of constitution/electoral system when advocating cost-benefit analysis, lest such analysis be manipulated to serve the interests of the power coterie and subvert the letter of the law.

There is no other easy solution to the Principal-Agent problem. Law-makers could conceivably volunteer to ‘bell the cat’ themselves by enacting regulations that tighten the monitoring and enforcement of the ‘Principal-Agent’ contract . Alternatively, a ‘carrot and stick’ policy could just do the trick. If the law were amended to apportion public funds as performance-based compensation to incumbents and funds for their elections using the yardstick of short-run and long-run measures of economic progress and fiscal prudence that include current and ‘projected’ GDP growth and budget deficit, long bonds or related instruments or constructs, then elected principals may have the incentive to act to maximize economic efficiency conditional on equity concerns. A panel of ‘economist expert-judges’ appointed to work with elected representatives with power to direct cost-benefit analyses, interpret results and recommend alternatives to political incumbents who would then make the efficiency-equity trade-off calls would work too. Administrative law concerning public spending could be repealed to mandate explicit examination of costs and benefits of different alternatives of different scales/configurations/qualities including status quo and the same required to justify the choice. Finally, the organizational structure of the government could be altered by devolving policy-making and public-spending authority to apolitical bureaucrats whose fortunes are not tied to election campaigns or political appointees. These neutral bureaucrats could be professionally and legally required to follow best practices as laid down by academics and law-makers.

And, yes, we could enact another law banning campaign contributions and corruption. Until that day, let’s close our eyes and preach cost benefit analysis as we always have.

Amen!



Post script, 5/7/6

This situation involving exploitation of cost-benefit analysis to further majoritarian political goals may be exacerbated when the activities/projects are subsidized by the government. Public investment in subsidized activities can be particularly ruinous because of the demand they generate. This can result in a ‘positive feedback loop’ in which politicians enrich themselves by doling out contracts on subsidized public projects that in turn generate higher demand, further investment and more contracts.