CPR Perspective: Estimating Regulatory Costs

By Thomas O. McGarity

The Issue Before the government asks industry to take steps to protect public health and the environment, it normally considers the costs of compliance with any new regulatory requirements. Industry knows that estimating costs is a critical step in the process, and generally produces very conservative (highest possible) numbers. How much does regulation actually cost? What does past experience tell us about the accuracy of the cost estimates that regulatory agencies rely upon? How can agencies avoid overestimating regulatory costs?

Under nearly every law enacted by Congress to protect health, safety and the environment, the cost of compliance is a crucial consideration in establishing regulatory requirements. If the estimates of regulatory costs systematically overstate those amounts, the regulators will promulgate less stringent health, safety and environmental requirements out of an unfounded fear that protective standards will raise consumer prices and possibly result in the loss of jobs. If broad, generic assessments of the economic effects of all health, safety and environmental regulation are consequently biased upward, the debate over the overall desirability of protective rules and legislation will become distorted in favor of industry profits and at the expense of public health.

Regulated industries constantly complain about the cost of complying with regulations designed to address the risks that their activities pose to the public from pollution, toxic substances, defective products, unsafe workplaces, and the like. The individual companies that will be subject to particular regulations nearly always raise the specter of debilitating costs when agencies consider how stringent the regulations should be. Industry-sponsored think tanks periodically publish eye-popping estimates of the overall costs of federal regulations with the tacit (and sometimes explicit) suggestion that society is paying far too high a price for health, safety and environmental protections. It’s not just industry that argues that case; these arguments have become a mainstay of anti-regulation conservatives as well.

Supporters of existing regulatory programs respond that the broad cost estimates produced by think tanks with ideological axes to grind have little or no empirical basis and are, in fact, the predictable product of crude economic models designed specifically to produce inflated estimates of regulatory costs. In the context of individual rulemaking proceedings, cost projections invariably depend upon the speculative predictions of the regulated companies themselves, hardly an unbiased source of information on the matter, since they have a clear incentive to inflate prospective regulatory costs. In addition, agency assessments typically include costs that companies would have incurred even in the absence of any regulatory intervention, thus leading to unjustified inflation of these estimates. All too often, global assessments of the overall costs that regulatory programs have imposed on regulated industries are based not on retrospective evaluations of the amounts that companies actually expended, but upon the cumulated total of exaggerated estimates made at the time that the regulations were being promulgated.

Moreover, when estimating prospectively the costs of individual rules, agencies tend to adopt conservative assumptions that lead to overestimates, because they know that regulated entities are likely to challenge agency cost estimates in court and they hope to preempt those arguments. The agencies sometimes fall into the trap of offering a single, inflated number rather than a range of cost estimates that would reflect the uncertainties inherent in speculative modeling exercises. The agencies seldom discuss the uncertainty surrounding their estimates of costs.

What's at Stake Whether grossly exaggerated cost estimates will continue to undermine the ability of regulatory agencies to promulgate regulations that protect health, safety and the environment. The ability of regulatory agencies to promulgate regulations that protect health, safety and the environment at a reasonable cost.

One reason prospective cost estimates of costs are uncertain is that regulation frequently inspires technological and operational innovations that lead to lower compliance costs. As American industry understandably tries to serve its self-interest by working to develop less expensive alternatives, initial, overstated estimates remain on the books and are never corrected in light of actual experience.

There are, in sum, strong reasons for concluding that prospective cost studies are biased upward:

• Agency analysts rely heavily upon the regulated companies for the empirical data and assumptions underlying those estimates.
• Because they know that regulatees are likely to challenge cost estimates in court, agencies tend to adopt conservative assumptions that lead to overestimates, and they do not offer a range of cost estimates or an assessment of the uncertainty surrounding their estimates of costs.
• Agency cost assessments typically include costs that companies would have incurred whether or not the regulations were promulgated.
• Most cost assessments fail to anticipate the dynamic and innovative ways in which regulatees react to regulations to minimize regulatory costs in the real world.

A Progressive Perspective

Both global and individual cost assessments fail to take into account the realities of company compliance with regulatory requirements. When retrospective cost assessments are undertaken, they nearly always conclude that the regulated companies expended far fewer resources in complying with health, safety and environmental regulations than the agencies predicted at the time they promulgated the regulations. Agencies should devote more resources to retrospective analyses aimed at correcting bad estimates and preventing inflated cost estimates in the future. They should also modify their day-to-day prospective cost estimates in the following ways:

• Agency-prepared cost estimates should include a "best case" analysis, in addition to the "worst case" analysis that currently dominates cost estimates, and they should include an "uncertainty analysis" that relates in an understandable way the confidence the agency has in the estimates.
• Agencies should include a "technology improvement" scenario in cost assessments in which companies are assumed to come up with innovative ways to comply with proposed standards.
• In the absence of solid empirical data on actual compliance costs, agencies should discount regulatory cost projections by a factor representing the probability that technological improvements will result in reduced costs.

In the meantime, policymakers who rely on industry- and agency-prepared cost assessments must take such assessments with a considerable several grains of salt. Courts should be less reluctant to allow agencies to "force technology" by promulgating stringent standards that may appear quite expensive when promulgated but usually prove much less costly once the engineers for the companies put pen to paper. Finally, the poor empirical basis for agency cost assessments and the reality of upward bias in those predictions should put to rest the idea, periodically raised by conservative think tanks, that federal agencies should be subject to a "regulatory budget" setting an overall cap on the costs that they may impose on regulated industries during any given year.

In Sum

When regulatory agencies promulgate standards and regulations to protect health, safety and the environment, the companies that will ultimately have to comply with those regulations frequently complain that they will cost too much. Surprisingly, the source of the cost estimates that the agencies typically rely upon is the regulated industry itself. Not surprisingly, these estimates tend to be seriously inflated. Agencies should take steps to control cost estimates, and they should not be deterred from promulgating stringent protections by industries crying "Wolf."