Free Minds & Free Markets

Concealed Costs/Bloated Benefits

Your federal tax dollars at work

In fiscal 1981, the Federal Railroad Administration will waste $90 million in taxpayers' funds on Local Rail Service Assistance projects. This waste will occur despite the requirement that the costs and benefits of a subsidy plan be toted up—with a plus on the bottom line—before funding can be awarded.

How could this be? With cost/benefit analyses, we are supposed to get the best of all possible worlds: waste will be unmasked; only efficient and productive government programs will be supported, marking a leap forward from the old, political ways of deciding how to disburse the public kitty. But this picture is more wishful thinking than anything else. While the cost/benefit approach has some attractive attributes in theory, the existing evidence shows that in practice this analytical tool is abused for the purpose of providing so-called economic justification for the same old government boondoggles.

And think of it—the FRA is only one, relatively obscure, government agency. A hard look at its assistance projects shows how it's done, but it's happening all across the vast spectrum of government largess.

To understand how cost/benefit studies go wrong, you have to understand why they're necessary in the first place. The marketplace, of course, employs something like them, even if the process is not formalized. If the benefits of whatever a firm is producing, as approximated by sales revenues, do not exceed the costs of producing it, the firm will earn nothing for its investors, and those investors will take their funds elsewhere—to some firm that is producing something consumers value highly enough to cover the costs of production, including a return on the investment.

The users of government-provided goods and services, however, are not generally required to pay their full cost, and those who must ultimately make up the deficits—the taxpayers—are not given the choice of declining to pay. So the typical government product lacks the fairly clear signals provided by ordinary market transactions concerning the benefits of that product. "Not to worry," say the advocates of government cost/benefit analysis. "Our studies will allow us to estimate the answers that would be given by the market if a market for the product were permitted to exist."

The first problem with this is the task of estimating the benefits enjoyed is, at best, prone to measurement errors. After all, individuals vary enormously in the value they attach to things. The marketplace itself only gives an approximation of the minimum value of a product or service at a given point in time. Many purchasers might have been willing to pay more than the going price if they had to. Take away the marketplace, as the government typically does in embarking upon its operations, and we have even less basis for estimating values.


Beyond the difficulty of the task, however, is the fact that, as presently constituted, all government cost/benefit analyses systematically overstate the benefits and understate the costs of government spending. This systematic bias is accomplished by loading up the benefit side of the equation with all manner of gains over and above those directly concerned with the proposed spending. At the same time, these types of side effects are studiously ignored when it comes time to consider the costs of the government activity.

One way to load the benefit side of the equation is to transform some of the costs of the proposed program into an increment to the benefits. In the railroad subsidy program, for example, a typical cost/benefit technique is to count the wages paid and the inputs purchased as additions to the value of the service performed. In any reasonable approach to evaluating the viability of investments, such expenses are part of the stream of cash outflow necessary to produce a product or service. Surely it is a good thing that people will be employed and suppliers kept in business. But that costs, and by putting these into the benefits column, any project can be made to look good. Furthermore, this approach is an open invitation to a skillful petitioner for government funds to pump up the amount of benefits by incurring outrageous expenses for labor and supplies.

This inflation-of-benefits technique can be taken even further, as it is in the FRA guidelines, by factoring in secondary wage and employment losses that can be forestalled by rail subsidy. As such, the FRA methodology can show the "need" to subsidize a losing rail line in order to continue service to an unprofitable shipper, because the shipper's shut-down would eliminate jobs.

To place the methodology in perspective, suppose that Chrysler were located on the rail line under review. The monumental losses achieved by Chrysler would constitute a source of benefit streams that could be used to justify federal subsidy. The expenses Chrysler would incur in keeping its plant open would be summed into the benefit portion of the ratio. The less efficient the rail user's operation or the less its product is desired by consumers, the more it has to spend in order to keep the plant open, and hence the larger the benefit/cost ratio will be.

Another virtually unbounded element of value that can be used to pad the benefit portion of the analysis is the so-called consumer surplus that exists in the consumption of any product or service. To understand the concept of consumer surplus, imagine yourself an economist. If you were such a creature, you would illustrate the point by drawing a graph plotting the two relevant variables—price and quantity. With price on the vertical axis and quantity on the horizontal, you would draw in a hypothetical demand "curve," sloping downward from left to right to show that, the lower the price of a product, the greater the quantity bought.


ReasonReasonNow, suppose that in the picture you have drawn, A is the price/quantity arrived at in the market, given the cost of producing various quantities (we won't mess up our picture with a supply curve). Price X quantity, of course, equals the total amount paid out by consumers for this product, represented graphically by the shaded area. This is the "calculation" of the minimum value of this product to consumers—minimum, because some people value it highly enough to pay more if they had to. How much more, in toto, is represented by the triangle lying above the area of actual sales. And that is the famous "consumer surplus."

ReasonReasonGovernment cost/benefit analysts, naturally enough, like to count that surplus among the benefits of their projects. The trouble is, however, that they don't know what the demand curve looks like in the real world. And by playing around with the curve, you can see what a difference it makes. If you assume that demand looks like D2, rather than D1, you will come up with a much larger consumer surplus.

The FRA's suggestions for estimating this curve are ludicrous. One idea is to assume that all rail shipments would be replaced by truck hauling if the rail line were to close. This was the premise of a cost/benefit study done for a project in Texas, for example. But since, in the nature of things, it costs more to transport some commodities by truck than by rail, this amounts to an assumption that the quantity of transportation service demanded is totally unaffected by its price. Even though such an assumption is quite clearly absurd, it was labeled "conservative," on the grounds that the FRA guidelines would've permitted even more ridiculous assumptions.

A second FRA suggestion for estimating the consumer surplus is to ask shippers what price they would be willing to pay for rail service and to use this to calculate the amount of consumer surplus. There's nothing like the real marketplace for getting people to put their money where their mouths are. The problems with this approach to estimation can be seen in this example: Patrons of an emergency flood train service in Arizona avowed a great willingness to pay several times the $1.00 fare for continued rail passenger service. A consumer surplus figure based on this data would have amounted to $5 to $10 million per year. The fly in the ointment was that when the flood-damaged freeway bridge was repaired, train ridership at the $1.00 fare dropped by 80 percent.

The whole consumer surplus ploy is but a means of inflating the apparent benefits of rail subsidies. The surplus cannot be measured by any known methods. The FRA's proposals merely place the stamp of official approval on estimation techniques that are certain to result in gross distortions and unconscionable overestimates of the benefits of the subsidy program.

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