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Canadian Cost-Benefit Analysis Guide: Regulatory Proposals (view source)
Revision as of 18:14, 22 July 2021
, 18:14, 22 July 2021no edit summary
A recent study by Health Canada provides an example of a cost-benefit analysis and a stakeholder analysis of a regulation to address the public safety and health problems resulting from fires started by cigarettes.<ref>See ''The Canada Gazette'', Part II, Vol. 139, No. 13 ( June 29, 2005 ), ''Tobacco Act'', ''Cigarette Ignition Propsensity Regulations''; Industrial Economics, Incorporated, "Economic Evaluation of Health Canada's Regulatory Proposal for Reducing Fire Risk from Cigarettes." Paper prepared for the Economic Analysis and Evaluation Division, Healthy Environments and Consumer Safety Branch, Health Canada, March 2004 .</ref>
A recent study by Health Canada provides an example of a cost-benefit analysis and a stakeholder analysis of a regulation to address the public safety and health problems resulting from fires started by cigarettes.<ref>See ''The Canada Gazette'', Part II, Vol. 139, No. 13 ( June 29, 2005 ), ''Tobacco Act'', ''Cigarette Ignition Propsensity Regulations''; Industrial Economics, Incorporated, "Economic Evaluation of Health Canada's Regulatory Proposal for Reducing Fire Risk from Cigarettes." Paper prepared for the Economic Analysis and Evaluation Division, Healthy Environments and Consumer Safety Branch, Health Canada, March 2004 .</ref>
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'''<big>Cigarette Ignition Propensity Regulations</big>'''
'''Issues'''
* Over the period from 1995 to 1999, more than 14,000 fires started from smokers' materials, including cigarettes, cigars, and pipes. These fires killed 356 people, injured 1,615 others, and caused more than $200 million in property damage. Most of the victims were children, the elderly, and low-income families.
'''Proposed Regulations'''
* To address the problem resulting from fires started by cigarettes, a regulation was proposed to reduce the ignition propensity of cigarette paper. Beginning October 1, 2005 , all manufacturers and importers of cigarettes are required to ensure the cigarettes they supply will burn the full length no more than 25 per cent of the time when tested on 10 layers of filter paper using the ASTM E2187‑04 Standard Test Method for Measuring the Ignition Strength of Cigarettes.
* It is a performance standard that prescribes an objective established by the regulatory authority.
'''Cost-Benefit Analysis'''
* Two alternative approaches were undertaken by the research team to estimate the amount of compliance costs to the private sector and their impacts on the economy: a modelled estimate based on a representative cigarette manufacturer and an estimate based on an industry outreach survey.
* The costs include capital and operating costs. They are expenses of purchasing and operating new equipment, changing production processes or inputs, undertaking additional quality assurance checks, and conducting toxicity tests to ensure compliance with the standard. On average, the cost of compliance was estimated at $0.126 per carton using the modelled estimate and at $0.257 per carton using the survey method. Using the annual production of 206.5 million cartons in 2002, this translates into annual costs of $26 million and $53 million, respectively.
* The benefits include three major categories, i.e. the reduction of deaths, injuries, and property damages. It is, however, important to estimate the annual incremental benefits of the proposed regulation against the baseline situation. The empirical estimates were mainly based on annual reports of the Canadian Council of Fire Marshals and Fire Commissioners, and data from Alberta and Ontario. The benefits are briefly described below:
** reduction in property damages: the estimates are based on the estimated loss expressed in monetary values at markets;
** reduction in fatalities: the analysis uses the VSL approach and adopted a benefit of $5.8 million in 2002 dollars; and
** reduction in injuries: the analysis relies on benefit transfer techniques. The benefits include reduction costs such as emergency transportation and care, hospital stays, medication, and doctors' visits. However, it does not include WTP to avoid pain and suffering, the loss of work time, and the value of leisure time. It is a lower bound estimate.
** The annual net benefits are obtained from the estimated amounts of the benefits in excess of the costs. The stream of net annual benefits is then discounted by the discount rate to obtain the net present value to see if the proposed regulation would generate a positive benefit to Canadians as a whole.
'''Stakeholder Analysis'''
* The impact of the regulation on stakeholders depends on who bears the costs of complying with it, which, in turn, depends on the extent to which the cost can be shifted forward by manufacturers or importers of cigarettes to consumers.
* The stakeholders in this case include cigarette manufacturers, consumers, tobacco growers, paper suppliers, distributors, retailers and importers, and governments.
* The impact on each stakeholder should be examined independently with respect to the supply and demand of their individual market and their financial capability. For example, whether the compliance cost can be shifted to consumers will depend largely upon the demand elasticities for cigarettes and the available substitutes for cigarettes.
* The assumptions made in the stakeholder analysis should be properly assessed and clearly documented.</blockquote>
=== Discount rates ===
For each option under consideration, the stream of costs and benefits will usually not occur in the same year but is spread over several years. Discounting allows for the systematic comparison of costs and benefits that occur in different time periods by allowing one to calculate the net present value of the intervention. If the costs and benefits are expressed in current prices or nominal dollars, they should be deflated to become real prices or prices expressed in terms of the price level of a specific year. In this way, the changes in the reported values of benefits and costs over time that are due purely to inflation are removed.
The discounted present value of net benefits is the algebraic sum of the present values of the expected incremental net benefits of the policy option over and above the baseline scenario during the policy's anticipated impact time period. If the net present value (NPV) is greater than or equal to zero, then the policy is expected to generate more benefits than costs and should be recommended for implementation. However, if the NPV is less than zero, the policy should not be recommended for implementation on efficiency grounds.
==== Rational approaches to discount rates ====
Choosing a discount rate has been one of the most contentious and controversial aspects of the cost-benefit analysis of regulatory policies. The term ''discount rate'' refers to the time value of the costs and benefits from the viewpoint of society. It is similar to the concept of the private opportunity cost of capital used to discount a stream of net cash flows of an investment project, but the implications can be more complex.
With costs and benefits expressed in real values, people prefer to make payments later and receive benefits sooner. This is due to the fact there is a time preference for current consumption over future consumption. Similarly, there is an opportunity cost of the resources invested in any given activity, as they could have been invested elsewhere if they had not been spent on the activity being evaluated.
One approach to discounting is based on the fact that present consumption is valued differently from future consumption. Following this approach, all benefits and costs are first converted into quantities of consumption equivalents before being discounted. In this case, the discount rate is the rate of time preference at which individuals are willing to exchange consumption over time.
Another approach considers what society forgoes in terms of pre-tax returns of displaced investment in the country. Using this approach, no account is made for time preference in terms of present versus future consumption. The discount rate is based purely on the opportunity cost of forgone investments.
An approach that captures the essential features of both these two alternatives uses a weighted average of the economic rate of return on private investment and the time preference rate for consumption.<ref>See e.g. Agnar, Sandmo and Jacques H. Dreze, "Discount Rates for Public Investment in Closed and Open Economics." In: ''Economica'', November 1971 ; Harberger, Arnold C., "On Measuring the Social Opportunity Cost of Public Funds." In: Arnold C. Harberger, ed., ''Project Evaluation-Collected Papers'', Chicago: University of Chicago Press, 1972.</ref> Many professionals have chosen to use a discount rate that follows this weighted average opportunity cost of funds concept.
A natural place to look for the relative weights to place on the rate of time preference and the gross rate of return on investment is the response of the capital market to extractions or injections of funds. On the cost side, the marginal source of funds for both the public and private sectors is usually from borrowing either domestically or from abroad. Likewise, if benefits arise that create income, it will be in the first instance deposited in financial institutions, where it is available to finance other activities.
While this approach is not without its restrictions, these pale in comparison to the practical problems that arise if the rate of time preference is used as the rate of discount for such interventions.<ref>For an extensive theoretical discussion of these alternative methods of economic discounting, see Sjaastad, Larry A. and Daniel L. Wisecarver, "The Social Cost of Public Finance." In: ''The Journal of Political Economy'', Vol. 85, No. 3, June 1977 .</ref>
Other questions have been raised as to whether a lower rate should be used for intergenerational discounting because many of the people affected by some policy or regulation may no longer be alive in the distant future. However, there is little consensus in the literature on discounting for intergenerational policies. There are several reasons for not favouring the use of variable discount rates in the analysis. First, no genuine rationale can be found for use of different discount rates over the policy impact period, unless the opportunity cost of funds is abnormally high or low from one period to another. Second, applying one discount rate to the streams of costs and another to the streams of benefits can be tricky and empirically difficult for each policy because of the requirements for converting all the streams of costs into consumption equivalents in a consistent manner.
Moreover, a risk-adjusted discount rate has also been suggested elsewhere to account for the systematic risk of future uncertainty. Since the streams of uncertain future costs and benefits are mainly related to the input variables themselves, they are best dealt with in the Monte Carlo risk analysis rather than the adjusted discount rates.
==== Discount rates ====
When a program requires funds that are extracted from the capital markets, the funds are drawn from three sources. First, funds that would have been invested in other investment activities have now been displaced by expenditures required by the policy action. The cost of these funds is the return that would have been earned on the alternative investments. Second, funds come from different categories of savers in the country who postpone their consumption in the expectation of getting a return on their savings. The cost of this part of the funds is reflected in the interest rate that the savers earn net of personal income tax. Third, some funds may come from abroad, that is from foreign savers. The cost of these funds would be the marginal cost of foreign borrowing. At the margin, the cost associated with incremental foreign borrowing is measured by the interest expense on the incremental borrowings plus the marginal change in the cost of foreign borrowing times the quantity of the stock of foreign debt negotiated at variable interest rates.
The discount rate will be a weighted average of the costs of funds from the three sources outlined above: the rate of return on postponed investment, the rate of interest (net of tax) on domestic savings, and the marginal cost of additional foreign capital inflows. The weights are equal to the proportion of funds sourced from domestic private-sector investors, domestic private-sector savers, and foreign savers.
Based on the above approach, the discount rate for Canada was re-estimated recently by Jenkins and Kuo (2007). It is found to be a real rate of approximately 8 per cent.<ref>Jenkins, Glenn and Chun-Yan Kuo, "The Economic Opportunity Cost of Capital for Canada-An Empirical update," QED Working Paper Number 1133, Department of Economics, Queen's University, Kingston, Canada, 2007.</ref> This rate is lower than the real rate of discount of 10 per cent recommended by the Treasury Board of Canada Secretariat in 1998 but is higher than the 7 per cent real rate proposed by Burgess in 1981 and the 7.3 per cent real rate recommended by Brean et al.<ref>See e.g. Burgess, David F., "The Social Discount Rate for Canada: Theory and Evidence." In: ''Canadian Public Policy'', Summer 1981; Jenkins, Glenn P., "The Public-Sector Discount Rate for Canada: Some Further Observations." In: ''Canadian Public Policy'', Summer 1981; Brean, Donald, David Burgess, Ronald Hirshhorn, and Joseph Schulman, ''Treatment of Private and Public Charges for Capital in a "Full-Cost Accounting" of Transportation: Final Report'', March 2005 .</ref> This rate of 8 per cent is consistent with the 10 per cent estimated earlier and used in the Treasury Board guidelines of 1976 and 1998.<ref>Jenkins, Glenn P., "Measurement of Rates of Return and Taxation from Private Capital in Canada." In: W. A. Niskanen et al., eds., Benefit-Costs Analysis, Chicago: Aldine, 1972.</ref> Over time, the effective rate of corporate income tax in Canada has been steadily decreasing. Furthermore, the introduction of the goods and services tax has removed much of the burden of the sales tax system from the value added of capital. Both these policy changes will tend to lower the required gross of tax rate of return on capital. We recommend that a real rate of 8 per cent be used as the discount rate for the evaluation of regulatory interventions in Canada.
In certain circumstances where consumer consumption is involved and there are no or minimal resources involving opportunity costs (such as certain human health and environmental goods and services), some federal departments, governments, and international organizations have taken into consideration factors other than the economic opportunity cost of funds when developing their recommendations for the value of the discount rate. Usually these social discount rates are lower than the 8 per cent recommended here. One approach is to estimate the social time preference rate, which is based on the rate at which individuals discount future consumption and projected growth rate in consumption.<ref>Policy Research Initiative, ''Social Discount Rates for Canada'', Ottawa, 2007.</ref> For Canada, the social time preference rate has been estimated to be around 3 per cent.<ref>Ibid.</ref> In these circumstances, the net present value of the results of the analysis can also be carried out using a social discount rate of 3 per cent accompanied by the use of a shadow price of investment that is applied to all the costs of the intervention that results in a postponement or reduction of investment activity. However, there is still controversy in the literature on the use of these social discount rates and further guidance will be needed in the future. Whatever rate is used, the costs and benefits should be discounted using the same rate.
The government has established the Centre of Regulatory Expertise that for a period of five years will help departments and agencies adjust to the new approach to regulating, including cost-benefit analysis, instrument choice, and performance measurement. This assistance will include the provision of specialist analytical services. Departments and agencies are expected to discuss their approach to cost-benefit analysis with their Treasury Board of Canada Secretariat analyst, including the need for and approach to discounting any longer-term costs and benefits associated with proposals involving, for example, health and environmental regulation.
==== Annualized costs and benefits ====
Cost-benefit analysis results should also be presented in terms of annualized values. This is especially the case when alternative policies have different time horizons. Comparing the net present value between two policies will not be valid unless further adjustments are made.<ref>One can adjust the costs and benefits of alternative options to the same length of periods. See e.g. Harberger, Arnold C. and Jenkins, Glenn P., ''Manual on Cost-Benefit Analysis for Investment Decisions,'' Queen's University, Kingston, Canada, 2002.</ref> However, once net benefits are annualized to become constant annual values, comparing annualized net benefits is equivalent to comparing the net present values of net benefits with further adjustments.
To annualize the net benefits of a policy, the following relationship holds between the present value of net benefits over the n policy impact periods and its annualized value:
<abbr>AV</abbr> <abbr>=</abbr> [<abbr>PV</abbr> <abbr>·</abbr> <abbr>ρ</abbr>]<abbr>/</abbr>[1 <abbr>-</abbr> (1<abbr>+ρ</abbr>)<abbr><sup>-n</sup></abbr>]<blockquote>where AV is the annualized value of net benefits over the n periods;
PV is the present value of net benefits over the n periods;
ρ is the economic discount rate; and
n is the duration of the policy impact periods.</blockquote>This approach allows us to express and compare net benefits that occur in different policy impact time periods on a consistent basis. Annualization simply spreads the net benefits smoothly through time. An example is given below.<references />