Two common pitfalls to be avoided in benefit-cost analysis are:
Although these pitfalls may seem obvious, they sometimes assume subtle forms.
To avoid including transfer payments, focus on whether or not there is consumption or savings of real resources with economic value (time, land, materials, clean air, etc.). When resources are consumed or saved, that generally indicates a true cost or benefit. This applies whether or not there is an actual market for those resources. (For example, while there is a market for land, there is no market for cleaner air.) When money is merely moved around among members of the society on whose behalf a project is proposed or to/from their government(s), these movements are usually just transfer payments.
The viewpoint of the analysis helps identify transfer payments. If the purpose of a benefit-cost analysis is to evaluate a private sector investment, its viewpoint would be that of the individual firm, where revenues and expenditures on taxes are properly counted as costs and benefits. In this narrow viewpoint, anything that affects company profitability matters. For government investments, however, accepted practice evolved from the US Flood Control Act of 1936, which states that "benefits to whomsoever they may accrue" should exceed estimated costs (Grant et al, Chapter 7). The correct approach for public investments is therefore "to take a viewpoint at least as broad as those who pay the costs and those who receive the benefits" (Newnan et al, p. 578). This avoids the classic errors in evaluation of local infrastructure proposals where analysts ignore the federally funded portions of costs (regarded as "free money") or environmental consequences "exported" to far outside the local region. In the broad viewpoint properly used to evaluate public investment decisions, we seek to identify net differences among alternatives as they impact the overall society. In such cases, many financial outcomes are actually internal transfers and therefore irrelevant to the decision at hand.
A complicating factor for some public sector investment decisions occurs when the project under consideration might also be a viable candidate for private investment as a for-profit enterprise. In such cases, the loss of tax revenues might properly be treated as a cost component of the project (Fabrycky et al, p. 153). Typically, however, public investment does not directly compete for projects which are appropriate private sector investments, and tax impacts (which include fuel tax expenditures) should be ignored.
The key to avoid double counting is to make sure that, once transfers are set aside, each dollar of impact on society is counted only once, either as a benefit or a cost. In categorizing a particular dollar of impact as a benefit or a cost, it may be helpful to focus on the basic distinction that costs are impacts on those who provide a project, and benefits are impacts on its users and others who might be affected.
Grant, E. L., W. G. Ireson, R. S. Leavenworth. Principles of Engineering Economy. Eighth Edition. John Wiley & Sons. New York. 1990.
Fabrycky, W. J., G. J. Thuesen, D. Verma. Economic Decision Analysis. Third Edition. Prentice Hall. Upper Saddle River, NJ. 1998.
Newnan, D. G., J P. Lavalle, T. G. Eschenbach. Engineering Economic Analysis. Eighth Edition. Engineering Press. Austin TX. 2000.
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