Public Finance, 10th Edition

David N. Hyman Chapter 6

COST-BENEFIT ANALYSIS AND

GOVERNMENT INVESTMENTS
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 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

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 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.

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 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
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 Cost-Effectiveness Analysis

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 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

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 Cost-Benefit Analysis
A three-step process for determining the relative
merits of alternative government projects over
time:
1. Enumerate all costs and benefits of the proposed
project
2. Evaluate all costs and benefits in dollar terms
3. Discount future net benefits

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 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)

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 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

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 Discounting Future Net Benefits
• 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:

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 Discount Rates and Projects
• Project 1 yields $90 in benefits immediately,
Project 2 yields $100 in two years, $0 until then

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 ECONOMIC ANALYSIS
Incremental Economic Net Benefit Flow Statement
(in thousands Peso)

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 10 Year 15 Year 16

Benefits:
Port revenues - local - - - - 1,359 2,276 6,895 8,120 -
Port revenues - foreign - - - - 249 280 488 520 -
Total Port Revenues - - - - 1,608 2,556 7,383 8,639 -
Benefit to ship owners due to
reduction in ships' waiting time - - - 25,484 31,264 33,539 35,444 36,491 -
Benefit to shippers due to reduction
in animal weight loss - - - - 13,331 13,906 16,204 19,715 -
Rental income from Container Yard I - 3,000 3,000 3,000 3,000 3,000 3,000 3,000 -
Rental income from Container Yard II - 0 0 0 1,000 2,000 6,000 9,000 -
Other Income 69 69 69 69 69 69 69 69 -
USAID Grant and Gov. Contribution - - - - - - - - -
Liquidation Values: - - - - - - - - 316,916
Total Benefits 69 3,069 3,069 28,553 50,272 55,070 68,100 76,914 316,916
Costs:
Investment cost-non tradable 21,818 96,550 141,822 45,422 - - - - -
Investment cost-tradable 2,596 87,515 130,373 54,059 - - - - -
Operating Cost: - - - - 9,044 9,044 9,044 9,044 -
Loss of rental income from term. shed 1,100 1,100 1,100 1,100 1,100 1,100 1,100 1,100 -
Change in Cash balance - - - - 80 55 65 20 (397)
Change in Accounts Receivable - - - - 160 111 130 39 (793)
Change in Accounts Payable - - - - (1,329) (121) (121) (121) 1,208
Total Costs 25,514 185,165 273,295 100,581 9,056 10,190 10,219 10,082 19
NET CASH FLOW (25,445) (182,096) (270,226) (72,028) 41,216 44,880 57,881 66,832 316,898
NET PRESENT VALUE (at 10.3%) (131,259)
INTERNAL RATE OF RETURN 5.88%
 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)
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 Social Rate of Discount

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 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.

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 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:

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 Ranking Projects

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 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.

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 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
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 Cost-Benefit Analysis

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 Benefits of Widening a Highway

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