UNITED STATES ENVIRONMENTAL PROTECTION AGENCY WASHINGTON. D.C. 20460 OFFICE OF SOLID WASTE AND EMERGENCY RESPONSE OSWER Directive No. 9355.3-20 MEMORANDUM SUBJECT: Revisions to OMB Circular A-94 on Guidelines and Discount Rates for Benefit-Cost Analysis FROM: Henry L. Longest II, Director L%J|.K f Office of Emergency and Remedial Response TO: Waste Management Division Directors Regions I, IV, V, VII Emergency and Remedial Response Division,Director Region II Hazardous Waste Management Division Directdrs ., Regions III, VI, VIII, IX Hazardous Waste Division Director Region X PURPOSE This memorandum revises the discount rate used in cost estimation for Superfund activities to 7%. This discount rate should be used in estimating the present worth value for potential alternatives in the remedial investigation/feasibility study and for remedial actions. BACKGROUND The Office of Management and Budget (OMB) revised Circular A-94 which provides guidance on conducting benefit-cost, cost- effectiveness, and lease-purchase analyses. Circular A-94 also revises the discount rates to be used in conducting such analyses. The previous OMB guidance, issued in 1972, directed federal agencies to use a 10% discount rate; the current guidance, issued on October 29, 1992, directs agencies to use a 7% discount rate. In the preamble to the National Oil and Hazardous Substances Contingency Plan (March 8,1990), EPA stated that it would follow Recycled/Recyclable Printed with Soy/Canola Ink on paper that contains at least 50% recycled fiber ------- CIRCULPLR NO. A-94 Revised (Transmittal Memo No. 64) MEMORANDUM FOR HEADS OF EXECUTIVE DEPARTMENTS AND ESTABLISHMENTS SUBJECT: Guidelines and Discount Rates for Benefit-Cost Analysis - of Federal Programs Table of Contents 1. Purpose 2 2. Rescission 2 3. Authority 2 4. Scope 2 5. General Principles 3 a. Net Present Value and Related Outcome Measures b. Cost-Effectiveness Analysis c. Elements of Benefit-Cost or Cost—Effectiveness Analysis 6. Identifying and Measuring Benefits and Costs 5 a. Identifying Benefits and Costs b. Measuring Benefits and Costs 7. Treatment of Inflation 7 a. Real or Nominal Values b. Recommended Inflation Assumption 8. Discount Rate Policy 8 a. Real versus Nominal Discount Rates b. Public Investment and Regulatory Analyses c. Cost-Effectiveness, Lease—Purchase, Internal Government Investment, and Asset Sale Analyses 9. Treatment of Uncertainty 12 a. characterizing Uncertainty b. Expected Values c. Sensitivity Analysis d. Other Adjustments for Uncertainty 10. Incidence and Distributional Effects 13 a. Alternative Classifications b • Economic Incidence 11. Special Guidanc. for Public Investment Analysis 14 a. Analysis of Excess Burdens b. Exception. 12. Special Guidance for Rsgulatory Impact Analysis 14 13. Special Guidance for Lease-Purchase Analysis 15 a. Coverage b. Required Justification for Leases C. Analytical Requirements and Definitions 14. Related Guidance 19 15. Implementation 19 16. Effective Date 19 17. Interpretation 20 Appendix A: Definitions of Terms Appendix B: Additional Guidance for Discounting Appendix C: Discount Rates for Cost-Effectiveness, Lease— Purchase, and Related Analyses ------- —2— 1. Pi p u. The goal of this Circular is to promote efficient resource allocation through veil-informed decisionmaking by the Federal Government. It provides general guidance for conducting benefit—cost and cost-effectiveness analyses. It also provides specific guidance on the discount rates to be used in evaluating Federal programs whose benefits and costs are distributed over time. The general guidance will serve as a checklist of whether an agency has considered and properly dealt with all the elements for sound benefit—cost and cost-effectiveness analyses. 2. I pci.sio . This Circular replaces and rescinds Office of Management and Budget (0MB) Circular No. A—94, “Discount Rates to Be Used in Evaluating Time-Distributed Costs and Benefits,” dated March 27, 1972, and Circular No. A—104, “Evaluating Leases of Capital Assets,” dated Jun. 1, 1986, which has been rescinded. Lease-purchase analysis is only appropriate after a decision has been made to acquire the services of an asset. Guidance for lease-purchase analysis is provided in Section 8 • c. (2) and Section 13. 3. This Circular is issued under ths authority of 31 U.S.C. Section 1111 and the Budget and Accounting Act of 1921, as amended. 4. D.c u. This Circular does not supersede - agency practices which are prescribed by or pursuant to law, Executive Order, or other relevant Circular’s. The Circular’s guidelines are sug- gested for use in the internal planning of Executive Branch agencies. The guidelines must be followed in all analyses submitted to 0MB in support of legislative and budget programs in compliance with 0MB Circulars No. k -il, “Preparation and Submis- sion of Annual Budget Estimates,” and No. A- ’19, “Legislative Coordination and Clearance.” These guidelines must also be followed in providing estimates sub—itted to 0MB in compliance with Executive Order No. 12291, “Federal Regulation,” and the President’s April 29, 1992 memorandum requiring ben.f it—cost analysis for certain legislativ, proposals. a. Aside from the exceptions listed below, the guidelines in this Circular apply to any analysis used to support Govern- ment decisions to initiate, rsnev, or expand program or projects which would result in a s.ri.s of: aasurable bene- f it. or - costs extending for three or more years into the future. Th. Circular applies specifically to: (1) Benefit—cost or cost-effectiveness analysis of Federal programs or policies. (2) Rgulatory impact analysis. ------- —3— (3) Analysis of decisions whether to lease or purchase. (4) Asset valuation and sale analysis. b. Specifically exempted from the scope of this Circular are decisions concerning: (1) Water resource projects (guidance for which is the approved Economic and Environmental PrinciDles afl4 Guidelines for Water and Related Land Resources ImDlementation Studies) . (2) The acquisition of commercial—type service, by Govern- ment or contractor operation (guidance for which is 0MB Circular No. A-76). (3) Federal energy management programs (guidance for which can be found in the Federal Reaister of January 25, 1990, and November 20, 1990). c. This Circular applies to all agencie. of the Executive Branch of the Federal Government. It do.. not apply to the Government of the District of Columbia or to non-Federal recipients of loans, contracts or grants. Recipients are encouraged, however, to follow the guidelines provided here when preparing analyses in support of Federal activities. d. For small projects which share similar characteristics, agencies are encouraged to conduct generic studies and to avoid duplication of effort in carrying out economic analysis. 5. 1n.ral Prineisl.s . Ben•f it-cost ma1ysis is recommended as the technique to use in a formal economic analysis of Government progr* . or projects. Cps*-s t.otjyan.s. analysis i a less corn- P* *SI VetchnjqU., but it C S be appropriat.Wh.n t s benefits from competing alternatives are the sam . or wh.çe a pqUcy dect.jOfl he. been mada that the benefits must be provided. (Appendix £ provides a glossary of technical terms used in this Circular; technical terms are bolded when they first appear.) a • Bet Present Value and 1 .lat.d Outc ap Beaavras • The standard criterion for deciding whether a Government program can be justified on Scononic principles is net present value - — the discounted monetized value of expected net benefits (i.e., benefits minus costs). Net present value is computed by assigning monetary values to benefits and costs, dis- counting future benefits and costs using an appropriate discount rate, and subtracting the sum total of discounted costs from the sum total of discounted benefits. Discount- ing benefits and costs transforms gains and losses occurring ------- —4— in different time periods to a common unit of meat Programs with positive net present value increase resources and are generally preferred. Programs wi negative net present value should generally be avoid (Section 8 considers discounting issues in more detai. Although net present value is not always computable (an does not usually reflect effects on income distribution) efforts to measure it can produce useful insights even wh the monetary values of some benefits or costs cannot be determined. In these cases: (1) A comorehensive enumeration of the different types of benefits and costs, monetized or not, can be helpful in identifying the full range of program effects. (2) ouant .fving benefits and costs is worthwhile, even when it is not feasible to assign monetary values; bicL] 1 measuremqflt s may be possible and useful. Other n arv effectiveness measures can provide useful supplementary information to net present value, and analysts are encouraged to report them also. Examples include the number of injuries prevented per dollar of cost (both measured in present value terms) or a project’s internal rate of return. b. Cpst-Effectiveflesa Analysis . A program is costeffSCti’1 if, on the basis of life cycle’ coat analysis Of competing alternatives, it is determined to have, the lowest costs expressed in present value terms for ,a given amount of benefits. Cost—effectiveness analysis is appropriate when ever it is unnecessary or impractical to consider the doubt v a1ue of the b.n.f its provided by the alternatives under consideration. This is the case whenever (i) each alter- native has the same annual benefits expressed in monetarY terms; or (ii) each alternative has the same annual effects, but dollar values cannot be assigned to their benefits. Analysis of alternative defense systems often falls in this category. - Cost—effectiveness analysis can also be used to compare programs with identical costs but diffezi119 benefits.’ In this case, the decision criterion is the discounted present value of benefits. The alternative program with the largest benefits would normally be favored. - C. I1 1 uti- rT. 4ç -rT1 ) cn An SlVIiI . (1) Policy lationala . The rational. for the Government program being examined should be clearly stated in the analysis. Progrk may be justified on efficienCY ------- -5- grounds where they address market failure, such as public goods and externalities. They may also be justified where they improve the efficiency of the Government’s internal operations, such as cost-saving investments. (2) ExDlicit klsuaDtions . Analyses should be explicit about the underlying assumptions used to arrive at estimates of future benefits and costs. In the case of public health programs, for example, it may be neces- sary to make assumptions about the number of future beneficiaries, the intensity of service, and the rate of increase in medical prices.- The analysis should include a statement of the assumptions, the rationale behind them, and a review of their strengths and weak- nesses. Key data and results, such as year-by-year estimates of benefits and costs, should be reported to promote independent analysis and review. (3) Evaluation of ltsrnativss . Analyses should also consider alternative means of achieving program objectives by examining different program different of provision, and 4ifferent degrees of Government jpvolvement . For example, in evaluating a decision to acquire a capital asset, the analysis should generally consider: Ci) doing nothing; (ii) direct purchase; (iii) upgrading, renovating, sharing, or converting existing Government property; or (iv) leasing or contracting for services. (4) Verification. Retrospective studies to determine whether anticipated benefits and costs have been realized are potentially valuable. Such studies can be used to determine necessary corrections in existing programs, and to improve future estimates of benefits and costs in these program. or related ones. Agencies should have a plan for periodic, results- oriented evaluation of program effectiveness. They should also discuss the results of relevant evaluation studies when proposing reauthorizations or increased program funding. 6. Idantifvina and X.a.urinp Benefits and Cost. . Analyses should include comprehensive estimates of the sxpe ed benefits and costs to based on established definitions and prac- tices for program and policy evaluation. Social net benefits, and not the benefits and costs to the Federal Government, should be the basis for evaluating Government programs or policies that have effects on private citizens or other levels of Government. Social benefits and costs can differ from private benefits and ------- —6— costs as measured in the marketplace because of imperfections arising from: (i) external •cone iaS or diseconemies where actions by one party impose benefits or costs on other groups that are not compensated in the market place; (ii) monopoly power that distorts the relationship between marginal costs and market prices; and (iii) taxes or subsidies. a. Identifying Benefits and Costs . Both intangible and tan- gible benefits and costs should be recognized. The relevant cost concept is broader than private-sector production and compliance costs or Government cash expenditures. Costs should reflect the opportunity cost of any resources used, measured by the return to those resources in their most productive application elsewhere. Mlow ar. some guidelines to consider when identifying benefits and costs. (1) incremental B•n•f its and Costs . Calculation of net present value should be based on incremental benefits and costs. Bunk costs and realized benefits should be ignored. Past experience is relevant only in helping to estimate what the value of future benefits and costs might be. Analyses should take particular care to identify the extent to which a policy such as a subsidy program promotes substitutes for activities of a similar nature that would occur without the policy. Either displaced activities should be explicitly recorded a. costs or only incremental gains should be recorded as benefits of the policy.— (2) ! nt.rsctive If f.cta . Possible interactions between the benefits and costs being analyzed and other Government activities ‘should be considered. For example, policies affecting, agricultural output should reflect real economic values, as opposed to subsidized prices. (3) int.rmational If f.cts . Analyses should focus on benefits and costs accruing to the citizens of the United Stats in determining net present value. Where progra or projects have effects outside the United States, these effects should be reported separately. (4) Tx.udBu. There are no economic gains from a pure transfer payment because the benefits to those who receive such a transfer are matched by the costs borne by those who pay for it • Therefore, transfers should be excluded from the calculation of net present value. Transfers that aris, as a result of the program or project being analyzed should be identified as such, however, and their distributional effscts discussed. It should also be recognized that a transfer program may have benefits that are less than the program’s real ------- —7— economic costs due to inefficiencies that can arise in the program’s delivery of benefits and financing. b. X.asurina B.n.f it. and Cost. . The principle of willingness- to-pay provides an aggregate measure of what individuals are willing to forgo to obtain a given benefit. Market prices provide an invaluable starting point for measuring willing- ness-to-pay, but prices sometimes do not adequately reflect the true value of a good to society. Externalities, monop- oly power, and taxes or subsidies can distort market prices. Taxes, for example, usually create an .me... burden that represents a net loss to society. (The appropriate method for recognizing this excess burden in public investment analyses is discussed in Section 11.) In other cases, market prices do not exist for a relevant benefit or cost. When market prices are distorted or unavailable, other methods of valuing benefits may have to be employed. Measures derived from actual market behavior are preferred when they are available. (1) Inframarainal B.m.f its and Costs . Consumers would generally be willing to pay more than the market price rather than go entirely without a good they consume. The economist’s concept of consumer surplus measures the extra value consumers derive from their consumption compared with the value measured at market prices. When it can be determined, consumer surplus provides the -best measure of the total benefit to society from a Government program or project • Consumer surplus can sometimes be calculated by using econometric methods to estimate consumer demand. (2) Indirect Xa •s of En. it. anCostp. Willingness- to-pay can sometimes be estimated indirectly through changes in land values, variations in wage rates, or other methods • Such methods ar. most reliable when they ar. based on actual market transactions. Measures should be consistent with basic economic principles and should be r.plicable. (3) n1tinlir If feats . Generally, analyses should treat reaources as if they were likely to be fully employed. Employment or output multipliers that purport to measure the secondary effects of government expendi- tures on employment and output should not be included in measured social benefits or costs. 7. Tr.ata.nt of Inflation . Future inflation is highly uncer- tain. Analysts should avoid having to make an assumption about the general rate of inflation whenever possible. ------- —8— a. Real or Mominal Values . Economic analyses are often most readily accomplished using real or constant-dollar values, i.e., by measuring benefits and costs in units of stable purchasing power. (Such estimates may reflect expected future changes in relative prices, however, where there is a reasonable basis for estimating such changes.) However, where future benefits and costs are given in nominal terms, i.e., in terms of the future purchasing power of the dollar, the analysis should use these values rather than convert them to constant dollars as, for example, in the case of lease-purchase analysis. Nominal and real values must not be combined in the same analysis. Logical consistency requires that analysis be conducted either in constant dollars or in terms of nominal values. This nay require converting some nominal values to real values, or vice versa. b. R.con.nded Inflation IssunDtion . Wh.n a general inflation assumption is needed, the rate of increase in the Gross Domestic Product deflator from the Administration’s economic assumptions for the period of the analysis is recommended. For projects or programs that extend beyond the six-year budget horizon, the inflation assumption can be extended by using the inflation rate for the sixth year of the budget forecast. The Administration’s economic forecast is updated twice annually, at the time the budget is published in Janu- ary or February and at the time of-the Mid-Session Review of the Budget in July. . Alternative inflation estimates, based on credible private sector forecasts, may be used for sensitivity analysis. - - - 8. Discount late Policy . - In order to compute net present value, it is necessary to discount future benefits and costs. This discounting ref lscts.the time value of money. Benefits and costs are worth more if they are experienced sooner • All future benefits and costs, including nonmonetized benefits and costs, should be discounted. The higher the discount rate, the lower is the present value of future cash flows. - For typical investments, with costs concentrated in early periods and benefits following in later p.riods, raising the discount rate tends to reduce the net present value. (Technical guidance on discounting and a table of discount factors are provided in Appendix B.) a • Real versus Nn& al Discount Rates • The proper discount rate to use depends on whether the benefits and costs are measured in real or nominal terms. (1) A real discount rate that has been adjusted to elimi- nate the effect of expected inflation should be used to discount constant-dollar or real benefits and costs. A ------- —9— real discount rate can be approxin ated by subtracting expected inflation from a nominal interest rate. (2) A nominal discount rate that reflects expected infla- tion should be used to discount nominal benefits and costs. Market interest rates are nominal interest rates in this sense. b. Public Investment and Reaulatory Analyses . The guidance in this section applies to benefit—cost analyses of public investments and regulatory programs that provide benefits and costs to the general public. Guidance related to cost- effectiveness analysis of internal planning decisions of the Federal Government is provided in Section B.c. In general, public investments and regulations displace both private investment and consumption. To account fort this displacement and to promote efficient investment and regu- latory policies, the following guidance should be observed: (1) Base—case )nalysJs . Constant-dollar benefit-cost analyses of proposed investments and regulations should report net present value and other outcomes determined using a real discount rate of 7 percent. This rate approximates the marginal pretax rate of return on an average investment in the private sector in recent years. Significant changes in this rate will be re- flected in future updates of this Circular. (2) Other Discount Rates . Analyses should show the sensi- tivity of the discounted net present value and other outcomes to variations in the discount rate. The im- portance of these alternative calculations will depend on the specific economic characteristics of the program under analysis. For example, in analyzing a regulatory proposal whose main cost is to reduce business invest- ment, net present value should also be calculated using a higher discount rate than 7 percent. Analyses may include among the reported outcomes the imt.rnal rat. of return implied by the stream of benefits and costs. The internal rate of return is the discount rate that sets the net present value of the program or project to zero. While the internal rate of return does not generally provide an acceptable deci- sion criterion, it does provide useful- i ornation, particularly when budgets are constrained or there is uncertainty about the appropriate discount rate. (3) Using the shadow price of capital to value benefits and costs is the analytically preferred means of capturing the effects of Government projects on resource ------- — 10 — allocation in the private sector. TO use this iiiethod accurately, the analyst must be able to compute how the benefits and costs of a program or project affect the allocation of private consumption and investment. OliB concurrence is required if this method is used in place of the base case discount rate. c. Cost-if fsctiVsnell L.a.s-PUrCh&I. Intsrnal Government Ii v.,t*.flta and Ms t Sal. ja1yiI . The Treasury’s borrowing rates should be used a. discount rates in the following cases: (1) C. .t-iff .CtiUfl• 51 ns1vsii . Analyses that involve constant-dollar costs •hould use the real Treasury borrowing rate on marketable secu’ities of comparable - - maturity to the period of analysis. This rate is com- puted using the Administration’s •‘conomic assumptions for the budget, which are published in January of each year. A table of discount rates based on the expected interest rates for the first year of the budget f ore- cast is presented in Appendix C of this Circular. Appendix C is updated annually and is available upon request from 0MB. Real Treasury rates are obtained by removing expected inflation over the period of analysis from nominal Treasury interest rates. (Analyses that involve nominal costs should use nominal Treasury rates for discounting, as described in the following para- graph.) - (2) L.a..—PUrCb* 5S analysis . Analyses of nominal lease payments should us. th. nominal Treasury borrowing rate on marketable securities of comparable maturity to the period of analysis. Nominal Treasury borrowing rates should be taken from the economic assumptions for the budget. A table of discount rates based on these as- sumptions is presented in Appendix C of this Circular, which is updated annually. - (Constant dollar lease- purchas. analyses should use the real Treasury borrowing rate, described in the preceding paragraph.) (3) _____________. Some Federal investment. provide intsrnal 5 benefits which take the form of increased Federal r.venues or decreased Federal costs • An .‘ ple would be an investment in an energy- efficient building system that reduces Federal op.rating costs. Unlike the cas, of a Federally funded highway (which provides U terp.alU benefits to society as a whole), it is appropriate to calculate such a project’s net present value using a comparable-maturity Treasury rate as a discount rate. The rate used may be either nominal or real, depending on how benefits and costs ar. measured. i •f !A4) t)1 \iI I - ------- — 11 — Some Federal activities provide a mix of both Federal coat savings and external social benefits. For example, Federal investments in information technology can produce Federal savings in the form of lower administrative costs and external social benefits in the form of faster claims processing. The net present value of such investments should be evaluated with the 7 percent real discount rate discussed in Section Lb. unless the analysis is able to allocate the investment’s costs between provision of Federal cost savings and external social benefit.. Where such an allocation is possible, Federal cost savings and their associated investment costs may be discounted at the Treasury rate, while the external social benefits and their associated investment costs should be discounted at the 7 percent real rate. (4) Asset Sale Analysis . Analysis of possible asset sales should reflect the following: (a) The net present value to the Federal Government of holding an asset is best measured by discounting its future earnings stream using a Treasury rate. The rate used may be either nominal or real, depending on how earnings are measured. (b) Analyses of Government asset values should explicitly deduct the cost of expected defaults or delays in payment from projected cash flows, along with Government administrative costs. Such analyses should also consider explicitly the prob- abilities of events that would cause the asset to become nonfunctional, impaired or obsolete, as well as probabilities of events that would increase asset value. (C) Analyse. of possible asset sales should assess the gain in social efficiency that can result when a Government asset is subject to market discipline and private incentive.. Even though a Government asset may be used more efficiently in the private sector, potential private-sector purchasers will generally discount such an asset’s earnings at a rate in excess of the Treasury rate, in part, due to the cost of bearing risk. When there is evidence that Government assets can be used more efficiently in the privat. sector, valuation analyses for these assets should include sensi- tivity comparisons that discount the returns from such assets with the rate of interest earned by assets of similar riskiness in the private sector. ------- — 12 — 9. Treatment of nc.rtaintY . Estimates of benefits and costs are typically uncertain because of imprecision in both underlying data and modeling assumPtions. Because such uncertainty is basic to many analyses, its effects should be analyzed and reported. Useful information in such a report would include the key sources of uncertainty; expected value estimates of outcomes; the sensi- tivity of results to important sources of uncertainty; and, where possible, the probabilitY distributions of benefits, costs, and net benefits. a. Q1iaracteri1i ncert*intV . Analyses should attempt to characterize the sources and nature of uncertainty. Ideally, probabilitY distributiOns of potential benefits, costs, and net benefits should be presented. It- should be recognized that many phenomena that are treated as deter- ministic or certain are, in fact, uncertain. In analyzing uncertain data, objective estimates of probabilities should be used whenever possible. Market data, such as private insurance payments or interest rate differentials, may be useful in identifying and estimating relevant risks. Sto- chastic simulation -methods can be useful for analyzing suCh phenomena and developing insights into the relevant probability distributions In any case, the basis for the probability distribution assumptions should be reporte4. Any limitations of the analysis because of uncertainty or biases surrounding data or assumptions should be discussed. b. m .ct.d Values . The expected values of-. the distributions of benefits, costs, and net benefits can:be obtained by weighting each outcome by its probability of occurrence, and then s” ing across all potential outcomes. it estimated benefits , - costs, and net benefits are characterized by point estimates rather than as probability distributions, the expected value (an unbiased estimate) is the appropriate estimate for use. Estimates that differ from expected values (such as worst case estimates) may be provided in addition to expected values, but the- rationale for such estimates must be clearlY presented. For any such estimate, the analysis should iden- tify the nature and magnitude of any bias • For example, studies of past activities have documented tendencies for cost growth beyond initial .xpectations analyses should consider whether past experience suggests that initial estimates of benefits or costs are optimistic. C. InILtLVitV )ni lYsiC . Major assumptions should be varied and net present value and other outcomes recomputed to determine how sensitive outcomes are to changes in the assumptions. The assumptions that deserve the most atten- tion will depend on the dominant benefit and cost elements and the areas of greatest uncertainty of the program being ------- - 13 — analyzed. For examp]e, in analyzing a retirement program, one would consider changes in the number of beneficiaries, future wage growth, inflation, and the discount rate. In general, sensitivity analysis should be considered for esti- mates of: (i) benefits and costs; (ii) the discount rate; (iii) the general inflation rate; and (iv) distributional assumptions. Models used in the analysis should be veil documented and, where possible, available to facilitate independent review. d. Other Adluitmanti for Unc.rtaintv . The absolute variability of a risky outcome can be much less significant than its correlation with other significant determinants of social welfare, such as real national income. In general, vari- ations in the discount rate are not the appropriate method of adjusting net present value for the special risks of particular projects. In some cases, it may be possible to estimate c.rtainty -eguival.nts which involve adjusting uncertain expected values to account for risk. 10. Incidenc, and Distributional If facts . The principle of maximizing net present value of benefits is based on the premise that gainers could fully compensate the losers and still be better of f. The presence or absence of such compensation should be indicated in the analysis. When benefits and costs have sig- nit icant distributional effects, these effects should be analyzed and discussed, along with the analysis of net present value. (This will not usually be the case for cost—effectiveness analysis where the scope of Government activity is not changing.) a. Alternative Classifications . Distributional effects may be analyzed by grouping individuals or household. according to incom, class (e.g., income quintile .), geographical region, or demographic group (e.g., age). Other classifications, such as by industry or occupation, may be appropriate in some circumstances. Analysis should aim at identifying the relevant gainers and losers from policy decisions. Effects on the preexisting assignment of property rights by the program under analysis should be reported. Where a policy is intended to benefit a epsoified subgroup of the population, such as the poor, the analysis should considar how effective the policy is in reaching it. targeted group. b. Iconomic Incidence . Individuals or households are the ulti- mate recipients of incoze; business enterprises are merely intermediaries. Analyses of distribution should identify economic incidence, or how costs and benefits are ultimately borne by households or individuals. ------- — 14 — Determining economic incidence can be difficult because benefits and costs are often redistributed in unintended and unexpected ways. For example, a subsidy for the production of a commodity will, usually raise the incomes of the com- modity’s suppliers, but it can also benefit consumers of the commodity through lover prices and reduce the incomes for suppliers of competing products. A subsidy also raises the value of specialized resources used in the production of the subsidized commodity. As the subsidy is incorporated in asset values, its distributional effects can change. ii. •peçipl Gu anCS for P” lia I v.Itatflt k a1yIiI. This gui- dance applies only to public investments with social benefits apart from decreased Federal costs. It is not required for cost- effectiveness or lease-purchase analyses. Because taxes gener- ally distort relative prices, they impose a burden in excesS of the revenues they raise. Recent studies of the u.s. tax system suggest a range of values for the marginal excess burden, of which a reasonable estimate is 25 cents per dollar of revenue. a. na1 .ii of c.u Burden. . The presentation of results for public investments that are not justified on cost—saving grounds should include a supplementary analysis with a 25 percent excess burden. Thus, in such analyses, costs in the form of public expenditures should be multiplied by a factor of 1.25 and net present value recomputed. b. lircoptiona. . Where specific - information’ clearly suggests that the excess- burden is lower. (or higher) than 25 percent, analyses may use a different figure. -When a different figure is used an explanation should be. provided for it. An example of such an exception is an investment funded by user charges that function like market prices;, in this case the excess burden would be zero • Another example would be a project that provides both cost savings to the Federal Government and external social benefits.. If it is possible to make a quantitative determination of the portion of this project’s costs that givs rise to Federal savings, that portion of the costs may be .xeaptsd from multiplication by the factor of 1.25. 12. ip.cial inidanos for I.aulaterv Immeot An 1V5iS . Additional guidance for analysis of regulatory policies is provided in E 1 ] tQry Prpgram of th U 4 ed Stases Go !ern! eflt which is published annually by 0MB. (see “Regulatory Impact Analysis Guidance, Appendix V of R.aulatorV Proaram of the United States Government for April 1, 1991 to March 31, 1992.) ------- — 15 — 13. BD.cial Quidanc. for L•ase-purphpi. Malv.j . The special guidance in this section does not apply to the decision to acquire the use of an asset. In deciding that, the agency should conduct a benefit—cost analysis, it possible. Only after the decision to acquire the services of an asset has been made is there a need to analyze the decision whether to lease or purchase. a. The Circular applies only when both of the following tests of applicability are satisfied: (1) The lease-purchase analysis Concerns a capital asset, (including durable goods, equipment, buildings, facil- jties, installations, or land) which: - (a) Is leased to the Federal Government for a term of three or more years; or, (b) Is new, with an economic life of less than three years, and leased to the Federal Government for a term of 75 percent or more of the economic life of the asset; or, (c) Is built for the express purpose of being leased to the Federal Government; or, (d) Ii leased to the Federal Government and clearly has no alternative commercial use (e.g., a special-purpose government installation). (2) The lease—purchase analysis Concerns a capital asset or a group of related assets whose total fair market value exceeds $1 million. b. All leases of capital assets must be justified as preferable to direct government Purchase and ownership. This can be done in one of three ways: (1) By conducting a separate lease-purchase analysis. This is the only acceptable method for major acquisitio . A lease represents a major acquisition if: (a) The acquisition represents a separate line-item in the agency’ s budget; (b) The agency or 0MB determines the acquisition is a major one; or (c) The total purchase price of the asset or group of assets to be leased would exceed $500 million. ------- — 16 — (2) By conducting periodic lease-purchase analyses of re- current decisions to lease similar assets used for the same general purpose. Such analyses would apply to the entire class of assets. 0MB approval should be sought in determining the scope of any such generic analysis. (3) By adopting a formal policy for smaller leases and submitting that policy to the 0MB for approval. Following such a policy should generally result in the same lease—purchase decisions as would conducting separate lease-purchase analyses. Before adopting the policy, it should be demonstrated that: (a) The leases in question would generally result in substantial savings to the Government that could not be realized on a purchase; (b) The leases are so small or so short—term as to make separate lease-purchase analysis impractical; and (c) Leases of different types are scored consistently with the instructions in Appendices B and C of 0MB Circular No. A-li. C. 1’ 1yticaj l.quirmantg pn4 Def4 ions. Whenever a Federal agency needs to acquire the use of a capital asset, it should do so. in the way that is least expensive fur the Government as a whole. . . . .. - - - (1) Life Cycle Cost . Lease-purchase analyses should compare the net discounted present value of the hf a- cycle cost of leasing with the full costs of buying or constructing an identical asset. The full costs of buying include the asset’s purchase price plus the net discounted present value of any relevant ancillary services connected with the purchase. (Guidance on the discount rat. to use for lease-purchase analysis is provided in Section B.C.) (2) Isonissic Life . For purposes of lease—purchase analy- sis, the economic life of an asset is its remaining physical or productiv, lifetime. It begins when the asset is acquired and ends when the asset is retired from service. The economic life is frequently not the same as the useful life for tax purposes. (3) Purchase Pric. . The purchase price of the asset for purposes of lease—purchase analysis is its fair market value, defined as the price a willing buyer could rea- sonably expect to pay a willing seller in a competitive market to acquire the asset. ------- — 17 — (a) In the case of property that is already Owned by the Federal Government or that has been donated or acquired by condemnation, an imputed purchase price should be estimated. (Guidance on making imputations is provided in Section 13.c.(6).) (b) If public land is used for the site of the asset, the imputed market value of the land should be added to the purchase price. (C) The asset’s estimated residual value, as of the end of the period of analysis, should be subtract- ed from its purchase price. (Guidance on estimat- ing residual value is provided in Section l3.c.(7).) (4) lizu. In analyzing the cost of a lease, the normal payment of taxes on the lessor’s income from the lease should not be subtracted from the lease costs since the normal payment of taxes will also be reflected in the purchase .- The cost to the Treasury of special tax benefits, if any, associated with the lease should be added to the cost of the lease. Examples of such tax benefits might include highly accelerated depreciation allowances or tax—free financing. (5) Ancillary Services . If the terms of the lease include ancillary services provided by the lessor, the present value of the cost of obtaining these services separ- ately should be added to the purchase price. Such costs may be excluded if they are estimated to be the same for both lease and purchase alternatives or too small to affect the comparison. Examples of ancillary services include: (a) All costs associated with acquiring the property and preparing it for use, including construction, installation, site, design, and management costs. (b) Repair and improvement costs (if included in lease payments). (c) Operation and naintenanc. costs (if included in lease payments). (d) Imputed property taxes (excluding foreign property taxes on overseas acquisitions except where actu- ally paid). The imputed taxes approximate the costs of providing municipal services such as water, sewage, and police and fire protection. (See Section (6) below.) ------- — 18 — (e) Imputed insurance premiums. (See Section (6) below.) (6) ! stiaatin Imnuted Costs . Certain costs associated with the Federal purchase of an asset may not involve a direct monetary payment. Some of these imputed costs may be estimated as follows: (a) p”cha e Pr .0e. An imputed purchase price for an asset that is already owned by the Federal Govern- ment or which has been acquired by donation or condemnation should be based on the fair market value of similar properties that have been traded on commercial markets in the same or similar localities. The same method should be followed in estimating the imputed value of any Federal land used as a site for the asset. (b) Prom•rtv Taz•s . Imputed property taxes may be estimated in two ways. (i) Determine the property tax rate and assessed (taxable) value for comparable property in the intended locality. If there is no basis on which to estimate future changes in tax rates or assessed values, the first-year tax rate and assessed value (inflation adjusted for each subsequent year) can be applied to • all years.:’ Multiply the— assessed- value by the tax rate to determine the annual imputa— •tion for property taxes. - (ii) As an alternative to step (i) above, obtain an estimate of the current local effective property tax rate from the Building Owners and Managers Association’ s Regional Exchange Reports. Multiply the fair market value of the Government-owned property (inflation adjusted for each year) by the effective tax rats. (C) Insurance Premiums . Determine local estimates Of standard commercial coverage for similar property from the Building Owners and Managers Associa- tion’s Regional Exchange Reports. (7) issidual Value . A property’s residual value is an estimate of the price that the property could be sold for at the end of the period of the lease-purchase analysis, measured in discounted present value terms. ------- — 19 — (a) The recommended way to estimate residual value is to determine what similar, comparably aged prop- erty is currently selling for in commercial markets. (b) Alternatively, book estimates of the resale value of used property may be available from industry or Government sources. (C) Assessed values of similar, comparably aged prop- ertie. determined for property tax purposes may also be used. (8) Renewal Omtion. . In determining the term of a lease, all renewal options shall be added to the initial lease period. 14. R•lat•d Guidance . a. 0MB Circular No. A-il, “Preparation and Submission of Annual Budget Estimates.” b. 0MB Circular No. A-19, “Legislative Coordination and Clearance.” - c. 0MB Circular No. A-70, “Federal Credit Policy.” d. 0MB Circular No. A-76, “Performance of Commercial Activities.” e. 0MB Circular No. A-109, “Policies to Be Followed in the Acquisition of Major Systems.” f. 0MB Circular No. A-130, “Management of Federal Information Resources.” g. “Joint 0MB and Treasury Guidelines to the Department of Defense Covering Lease or Charter Arrangements for Aircraft and Naval Vessels.” h. Executive Order 12291, “Federal Regulation.” i. “Regulatory Impact Analysis Guidance,” in Reaulatory Program of the United States Government . j. “Federal Energy Management and Planning Programs; Life Cycle Cost Methodology and Procedures,” Federal R.ai.ter , Vol • 55, No. 17, January 25, 1990, and Vol. 55, No. 224, November 20, 1990. k. Presidential Memorandum of April 29, 1992, “Benefits and Costs of Legislative Proposals.” 15. Immluantation . Economic analyses submitted to 0MB will be reviewed for conformity with items 5 to 13 in this Circular through the Circular No. A-li, budget justification and submis- sion process, and Circular No. A-l9, legislative review process. 16. Effective Date . This Circular is effective immediately. ------- — 20 — 17. xnt.r r.tation . QuestionS concerning interpretation of this Circular should be addressed to the Office of Econoaic Policy, Office of Manageaent and Budget (202—395—5873) or, in the case of regulatory issues and analysis, to the Office of Information and Regulatory Affairs (202—395—4852). ------- APPEEDIX A DEPIN ITtOw 07 TERMS Benefit-Cost Analysis -— A systematic quantitative method of assessing the desirability of Government projects or policies when it is important to take a long view of future effects and a broad view of possible side-effects. Tangible property, including durable goods, equipment, buildings, installations, and land. Certainty...aujyp lent -- A certain (i.e., nonrandom) outcome that an individual values equally to an uncertain outcome. For a risk—averse individual, the certainty-equivalent for an uncertain set of benefits may be less than the mathematical expectation of the outcome; for example, an individual may value a 50-50 chance of winning $100 or $0 as only $45. Analogously, a risk—averse individual may have a certainty equivalent for an uncertain set of costs that is larger in magnitude than the mathematical expectation of costs. Cost—Effectiveness Analysis —— A systematic quantitative method for comparing the costs of alternative means of achieving the same stream of benefits or a given objective. Consumer Surmius —— The maximum sum of money a consumer would be willing to pay to consume a given amount of a good, less the amount actually paid. It is represented graphically by the area between the demand curve and the price line in a diagram repre- senting the consumer’s demand for the good as a function of its price. -— The interest rate used in calculating the present value of expected yearly benefits and costs. Discount Factor -- The factor that translates expected benefits or costs in any given future year into present value terms. The discount factor is equal to 11(1. + i ) ’ where I is the interest rate and t is is the number of years from the date of initiation for the program or policy until the given future year. Excess Eurden —- Unless a tax is imposed in the form of a lump— sum unrelated to economic activity, such as a head tax, it will affect economic decisions on the margin. Departures from eco- nomic efficiency resulting from the distorting affect of taxes are called excess burdens, because they disadvantaç” society without adding to Treasury receipts. This concept is also sometimes referred to as deadweight loss. ------- External Economy or Diseconomy -— A direct effect, either posi- tive or negative, on someone’s profit or welfare arising as a by- product of some other person’s or firm’s activity. Also referred. to as neighborhood or spillover effects, or externalities for short. Incidence — The ultimate distributional effect of a tax, expend- iture, or regulatory program. Inflation -— The proportionate rate of change in the general price level, as opposed to the proportionate increase in a specific price. Inflation is usually measured by a broad-based price index, such as the implicit deflator for Gross Domestic Product or the Consumer Price Index. Internal Rate of Return —- The discount rate that sets the net present value of the stream of net benefits equal to zero. The internal rate of return may have multiple values when the stream of net benefits alternates from negative to positive more than once. Life Cycle Cost —— The overall estimated cost for a particular program alternative over the time period corresponding to the life of the program including direct and indirect initial costs plus any periodic or continuing costs of operation and maintenance. Multiøljer -- The ratio between the direct effect output or employment and the full effect,. including the effects of second order, rounds or spending. Multiplier effects greater than 1 • 0 require the existence of involuntary unemployment. Net Present Value -- The difference between the discounted present value of benefits and the discounted present value of costs. - - Nominal Values Economic units measured in terms of purchasing power of the date in question. A nominal, value reflects the effects of general price inflation. Nominal Interest Rat . An interest rate that is not adjusted to remove the effects of actual or expected inflation. Market interest rats. ar. generally nominal interest rates. Oi nortunity Cost -- The maximum worth of a good or input among possible alternativ, uses. Real or Constant Dollar Values - Economic units measured in terms of constant purchasing power. A real value is not affected by general price inflation. Real values can be estimated by deflating nominal values with a general price index, such as the implicit deflator for Gross Domestic Product or the Consumer Price Index. ------- Real Interest Rate -- An interest rate that has been adjusted to remove the effect of expected or actual inflation. Real interest rates can be approximated by subtracting the expected or actual inflation rate from a nominal interest rate. (A precise estimate can be obtained by dividing one plus the nominal interest rate by one plus the expected or actual inflation rate, and subtracting one from the resulting quotient.) Relative Price —— A price ratio between two goods as, for example, the ratio of the price of energy to the price of equipment. Shadow Price -- An estimate of what the price of a good or input would be in the absence of market distortions, such as exter- nalities or taxes. For example, the shadow price of capital is the present value of the social returns to capital (before corporate income taxes) measured in units of consumption. Sunk Cost -- A cost incurred in the past that will not be affected by any present or future decision. Sunk costs should be ignored in determining whether a new investment is worthwhile. Transfer Payment —— A payment of money or goods. A pure transfer is unrelated to the provision of any goods or services in exchange. Such payments alter the distribution of income, but do not directly affect the allocation of resources on the margin. Treasury Rates -— Rates of interest on marketable Treasury debt. Such debt is issued in maturities ranging from 91 days to 30 years willinaness to PaY -— The maximum amount an individual would be willing to give up in order to secure a change in the provision of a good or service. ------- APPENDIX S ADDITIONA& OtIIDJhNCI tOR DISCOUIITIWQ 1. Sam 1• Format for Diicountima D.f.rr.d Costi and Benef its Assume a 10-year proqram which will commit the Government to the stream of real (or constant-dollar) expenditures appearing in column (2) of the table below and which will result in a series of real benefits appearing in column (3). The discount factor for a 7 percent discount rate is shown in column (4). The present value cost for each of the 10 years is calculated by multiplying column (2) by column (4); the present value benefit for each of the 10 years is calculated by multiplying column (3) by column (4). The present values of costs and benefits are presented in columns (5) and (6) respectively. $106.40 $142.41 factor is calculated as 1f(1 + i ) ’ where L is rate (.07) and t is the year. The sum of column (5) is the total present value of costs and the sum of column (6) ii the tot ,], present value of benefits. Net present value is $36.01, the differ.nce between the sum of discounted benefits and the sum of discounted costs. 2. End-of—Tsar and Bid-Year Discount Factors The discount factors presented in the table above are calculated on the implicit assumption that costs and benefits occur as lump—sums at year-end. When costs and benefits occur in a steady Year since value of value of initiation, Expected Expected Discount costs benefits renewal or yearly yearly factors Col. 2 x Col. 3 x ex ans ion (2) (3) (5) Col. 4 (6) (1) (4) 1 $10.00 $ 0.00 0.9346 $ 9.35 $ 0.00 2 20.00 0.00 0.8734 17.47 0.00 3 30.00 5.00 0.8163 24.49 4.08 4 30.00 10.00 0.7629 22.89 7.63 5 20.00 30.00 0.7130 14.26 21.39 6 10.00 40.00 0.6663 6.66 26.65 7 5.00 40.00 0.6227 3.11 24.91 8 5.00 40.00 0.5820 2.91 23.28 9 5.00 40.00 0.5439 2.72 21.76 10 5.00 25.00 0.5083 2.54 12.71 Total li : The discount the intsrest ------- stream, applying mid-year discount factors is more appropriate. For instance, the first cost in the table may be estimated to occur after six months, rather than at the end of one year to approximate better a steady stream of costs and benefits occur- ring over the first year. Similarly, it may be assumed that all other costs and benefits are advanced six months to approximate better a continuing steady flow. The present values of costs and benefits computed from the table above can be converted to a mid-year discounting basis by multiplying them by 1.0344 (the square root of 1.07). Thus, if the above example were converted to a aid-year basis, the present value of costs would be $110.06, the present value of benefits would be $147.31, and the net present value would be $37.25. 3. Illustrative fliscount Pactor. for a Discount Rat, of 7 Year since Beginning- Initiation, Year-end Mid-year of—year Renewal or Discount Discount Discount EXD fl jQfl 1 0.9346 0.9667 1.0000 2 0.8734 0.9035 0.9346 3 0.8163 0.8444 0.8734 4 0.7629 0.7891 0.8163 5 0.7130 0.7375 0.7629 6 0.6663 0.6893 0.7130 7 0.6227 0.6442- 0.6663 B 0.5820 0.6020 0.6227- 9 0.5439 0.5626 0.5820 10 0.5083 0.5258 0.5439 11 0.4751 0.4914 0.5083 12 0.4440 0.4593 0.4751 13 0.4150 0.4292 0.4440 14 0.3878 0.4012 0.4150 15 0.3624 0.3749 0.3878 16 0.3387 0.3504 0.3624 17 0.3166 0.3275 0.3387 18 0.2959 0.3060 0.3166 19 0.2765 0.2860 0.2959 20 0.2584 0.2673 0.2765 21 0.2415 0.2498 0.2584 22 0.2257 0.2335 0.2415 23 0.2109 0.2182 0.2257 24 0.1971 0.2039 0.2109 25 0.1842 0.1906 0.1971 26 0.1722 0.1781 0.1842 27 0.1609 0.1665 0.1722 28 0.1504 0.1556 0.1609 29 0.1406 0.1454 0.1504 30 0.1314 0.1359 0.1406 ------- APPEIIDIX C DISCOUNT RATES FOR COaT-EFFECTIVENESS, LEASE PURCIA8E, AND RELATED ANALYSES lffpotiv. Dates . This appendix is updated annually at the time of the President’s budget submission to Congress. This version of the appendix is valid only through February, 1993. Updates of this appendix will be available upon request from the Office of - Economic Policy in 0MB (202-395-3381). Copies of the appendix and the Circular may also be obtained from the 0MB Publications Office (202—395—7332). Nominal Discount Rates . Nominal interest rates based on the economic assumptions from the Fiscal Tear 1993 Budget are presented in the table below. These nominal rates are to be used for discounting nominal flows, as in lease—purchase analysis. / Nominal Xnter•st Rat.. on Tr.asurv Notes and Bonds of Sn.cifid Maturities (in orcent) 5-Year 10-Year 1Q X 6.1 6.5 6.7 7.0 7.1 Analyses of programs with terms different from those presented above may use a linear interpolation. For example, a four—year pr3ject can be evaluated with a 6.3 percent nominal rate. Pro- grams with durations longer than 30 years may use the 30-year interest rate. Real Discount Rat.. . Real interest rates based on the economic assumptions from the Fiscal Year 1993 Budget are presented below. These real rates are to be used for discounting real (constant- dollar) flow., as in cost-effectiveness analysis. Real Int.reat Rates on Treasury Notes and Bonds of Im.cifid Maturities (in n.rc.nt) 3-Year 5-Year 7-Year 2.7 3.1 3.3 3.6 3.8 Analyses of programs with term. different from those presented above may use a linear interpolation. For example, a four—year project can be evaluated with a 2.9 percent real rate. Programs with durations longer than 30 years may use the 30—year interest rate. ------- EXECUTIVE OFFICE OF THE PRESIDENT rilE DIRECTOR OFFICE OF MANAGEMENT AND BUDGET WASHINGTON. 0 C. O3 October 29, 1992 CIRCULAR NO. A-94 Revised Transmittal Memorandum No. 64 TO THE HEADS OF EXECUTIVE DEPARTMENTS AND ESTABLISHMENTS SUBJECT: Guidelines and Discount Rates for Benefit-Cost Analysis of Federal Programs Circular A—94 provides guidance on benefit—cost, cost— effectiveness, and lease—purchase analysis to be used by agencies in evaluating Federal activities. It includes updated guidance on the discount rates to be used in evaluating activities whose benefits and costs are distributed over time. It also contains expanded guidance on the measurement of benefits and costs, treatment of uncertainty, and related issues. This guidance must be followed in all analyses submitted to 0MB in support of legislative and budget programs. This Circular replaces and rescinds “Discount Rates to be Used in Evaluating and Benefits,” dated March 27, 1972. It No. A—104, “Evaluating Leases of Capital 1986, which was rescinded previously. 0MB Circular No. A-94, Time—Distributed Costs also replaces Circular Assets,” dated June 1, Richard Darman Director Attachment ------- Circular A-94 and that if 0MB revised Circular A-94, then EPA would address the matter in program guidance to ensure consistency with Circular A-94. Therefore, the Office of Emergency and Remedial Response (OERR) is revising the Guidance for Conducting Remedial Investigations and Feasibility Studies (1988) to reflect the use of the 7% discount rate instead of the 5% discount rate published in the 1988 guidance. OBJECTIVE OERR recommends that the 7% discount rate be adopted for the present worth calculations to determine the cost—effectiveness of potential remedies in the RI/FS to be consistent with the 0MB directive and other federal agencies. IMPLEMENTATION The 7% discount rate will apply to sites which have a Record of Decision (ROD) targeted for FY 94 and thereafter. Fiscal year 1993 is to be considered a transition year —— where the cost—effectiveness analysis is underway and the discount rate can be changed or for those cost—effectiveness analyses that have not yet been initiated, the 7% rate should be used. If a ROD is ready to be signed, then the cost—effectiveness analysis does not have to be revised. The revised 0MB Circular A-94 is enclosed for your reference. If you have any questions concerning the circular or the discount rate, please call Sherri Gill of the Remedial Operations Guidance Branch at (703) 603—9043. enclosure cc: Bruce Diamond Sally Mansbach David Bennett Superfund Regional Branch Chiefs Superfund Regional Section Chiefs Superfund Document Center ------- |