BENEFIT-COST ANALYSIS

Financial and Economic Appraisal using Spreadsheets

Accounting for Income Distribution

In the preceding chapters we assumed that each $ of net benefits of same value irrespective of sub-referent group We need to acknowledge and account for: Governments income distribution objectives projects distributional impacts

Ch. 11: Distributional Weighting

Harry Campbell & Richard Brown
School of Economics The University of Queensland

Accounting for Income Distribution

Atemporal vs. Intertemporal Distribution Atemporal how income (and income changes) distributed among individuals or groups at present; ie. within present generation Intertemporal how income (and income changes) distributed over time; ie. between present and future generations

Accounting for Income Distribution

Interpersonal distribution How income is distributed among individuals or households See Tables 11.1 and 11.2

Accounting for Income Distribution

Measuring Interpersonal distribution
Table 11.1 Distribution of Households by Annual Income % Households 30.7 42.9 13.4 5.8 2.7 4.5

Accounting for Income Distribution

Measuring Interpersonal distribution
Table 11.2 Income Distribution by Deciles Households Top 1 per cent Top 2 per cent Top 10 per cent 2nd decile 3rd decile 4th decile 5th decile 6th decile 7th decile 8th decile 9th decile Bottom decile % of Income 8.31 22.81 33.73 15.49 11.61 9.22 8.12 7.32 6.47 2.94 2.67 2.45

Annual Income ( Y = $189) Less than $100 $100 to 200 $200 to 300 $300 to 400 $400 to 500 More than $500

Accounting for Income Distribution

Measuring Inequality Income is obviously not equally distributed some individuals or groups earn more than others The degree of income inequality can vary considerably between countries and, within a country, over time. Economists have devised ways of measuring degree of inequality

Accounting for Income Distribution

Measuring Inequality
Figure 11.1 The Lorenz Curve
100

If income was equally distributed the Lorenz curve would lie on the diagonal

Cumulative % population

The flatter the Lcurve, the smaller the shaded area, the less the degree of inequality

0 0 Cumulative % income 100

GINI Coefficient = shaded area as a % of whole triangle

Measuring Inequality
Assume 20% population earns 80% of income Measure area outside the main triangle

Changing Income Distribution

government can affect the distribution of income between sectors and regions of the economy through the sectoral and regional spread of public investment projects the type of investment undertaken can influence the distribution of income among various categories of income-earners an investment that uses relatively more labour than capital will imply more employment, and perhaps, a larger share of income for the wage-earner versus the profit-earner, and vice versa different types of investment will have different implications for the employment (and income) of different types of labour

Cumulative % pop

Each triangle = 0.8x0.2)/2 = 0.08

Cumulative % income

0.2 0.8

Total =(0.08x2)+0.04 =0.2

Gini coeff. = (0.5-0.2)/0.5 = 0.3/0.5 = 0.6

Square = 0.2x0.2 =0.04

Changing Income Distribution

Distributional Weighting
Suppose that we are required to advise on the best choice of projects taking into consideration the government's commitment to the twin objectives of economic efficiency and improving income distribution In Table 11.5 we have before us 3 possible projects, A, B and C, of which only one can be undertaken. Each project affects income distribution differently How can we incorporate governments income distribution objective into project choice explicitly?

While one investment option could be superior to another from an economic efficiency viewpoint, it might be inferior to the other from a distributional perspective The final choice among projects will depend on the relative importance that the policy-makers attach to the economic efficiency objective versus the income distribution objective. It is to the explicit incorporation of distributional objectives in benefit-cost analysis that we now turn.

Distributional Weighting
Table 11.5 Comparing projects with different atemporal distributions Referent Group Net Benefits ($NPV) Project A B C Rich 60 50 20 Poor 40 30 80 Total 100 80 100

Distributional Weighting
What about choosing between D and E?
Table 11.6 Comparing projects with different aggregate benefits and distributions Referent Group Net Benefits ($NPV) Project D E Rich 60 40 Poor 40 50 Total 100 90

Project B can be rejected purely on economic efficiency grounds - its aggregate net referent group benefits are less than those of A and B, and the distribution of benefits among the rich and poor is less egalitarian than that of either A or C. the question is whether to choose A or C?

Project D would be preferred on purely economic efficiency grounds, whereas Project E might be preferred on purely distribution grounds. As long as there is a commitment to the objectives of economic efficiency and income distribution, a conflict arises. Choose D and we sacrifice distribution; choose E and we sacrifice efficiency

Distributional Weighting
This choice is a classic example of what economists call a trade-off. assume we weight each additional dollar of net benefit received by the poor by three times as much as each additional dollar received by the rich
Table 11.7 Applying distributional weights to project net benefits Referent Group Net Benefits ($NPV) Project D E Rich 60 40 Poor 40 50 Total 100 90 Weighted (Social) Benefits ($) Rich Poor Total

Distributional Weighting
If the government did not attach different distributional weights to the net benefits accruing to different groups, projects would be selected purely on the basis of their aggregate referent group net benefits. What would this imply about the government's objective concerning income redistribution? From what we have seen, it could mean one of two things: either (a) it does not regard project selection as an important means of redistributing income; or, (b) it does not care about income distribution; i.e. it attaches equal weight (1.0) to all sub-referent group members.

(60x1.0)+(40x3.0) = 180 (40x1.0)+(50x3.0) = 190

Deriving Distributional Weights

Theoretical Basis Diminishing marginal utility of consumption
Figure 11.2 Total U tility C urve

Deriving Distributional Weights

Theoretical Basis Diminishing marginal utility of consumption
F ig u re 11.3 M a rg in al U tility C u rve
12

32 Utility 23 12
M arginal Utility

11
9

Consumption level (units)

Con sump tion level (u nits)

Deriving Distributional Weights

The appropriate income distribution expressed in algebraic form as follows: weight can be

Deriving Distributional Weights

As an example of the use of such weights, suppose that a net beneficiary of a project is in an income group which has a level of income equal to, say, $750 per annum (Yi), and that the national average income is $1500 (); the distribution weight for that individual would then be:

d
di Yi = =

= (

Y Y
1

the distribution weight for income group I the average level of income for the economy the average income level of group I

Y bar =

di =(
= 2n

1500 n ) 750

n = the elasticity (responsiveness) of marginal utility with respect to an increase in income, expressed as the ratio of the percentage fall in marginal utility to the percentage rise in income

If n = 0.8, then an individual at consumption level $750 per annum will have her benefits weighted by a factor of 1.74

Deriving Distributional Weights

Someone at an income level of $2500 per annum will have his/her benefits weighted by a factor of 0.66 An additional $1.00 going, for example, to someone earning an income of $4250 per annum would be valued at only 43% of the value of an additional $1.00 going to someone at the average ($1500 per annum) income level.

Deriving Distributional Weights

Figure 11.4 W eighting Factors for E xtra Incom e

Weight 1.74

1.00 0.66

0.43

750

1550

2250

4250

Income level ($)

Deriving Distributional Weights

The higher the value of n, the faster the rate at which marginal utility falls.
Table 11.8 Responsiveness of distributional weights to changes in n

Deriving Distributional Weights

The formula for di expresses the point that the distributional weights we use are determined by two factors: (a) the relative income/consumption level of the project beneficiaries ; and, (b) the value-judgement that is made about the utility or satisfaction that is gained by project beneficiaries of different income levels; the value of n. If we do not apply distributional weights explicitly, we are implicitly assigning a value di = 1.00 to each and every project beneficiary, irrespective of how much (s)he earns In some circumstances we can infer from the choices the decision-maker makes what (s)he regards as the appropriate or threshold distributional weights, but, it does not provide any independent information about the appropriate weights.

Distributional Weight d i $/Annum 250 750 1250 1500 1750 2250 2750 3250 3750 4250 n=0 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 n=1 6.00 2.00 1.20 1.00 0.71 0.67 0.55 0.46 0.40 0.35 n=2 36.00 4.00 1.44 1.00 0.73 0.44 0.30 0.21 0.16 0.12 n=3 216.00 8.00 1.73 1.00 0.63 0.30 0.16 0.10 0.06 0.04

Using Distributional Weights

To apply distributional weights we would need to know the following about the project in question: (a) identification of the project's gainers and losers; (b) classification of the project's gainers and losers; i.e. to which particular income category they belong; and, (c) quantification of gains and losses, i.e. by how much do the net incomes of the gainers and losers increase or decrease? The relevant project level information about (a) and (c) already exists, for this is, in effect, what is contained in the Referent Group analysis

Using Distributional Weights

A bottom-up approach to derivation of distributional weights We prefer to consider benefit-cost analysis and distributional weighting from the perspective of it serving as a potentially powerful means of identifying the possible distributional implications of government project selection It thereby sharpens our understanding of the value judgements implicit in government decisions. In other words, through benefit-cost analysis we can make ourselves, as projects analysts, and the relevant policymakers more aware of the consequences of decisions concerning project selection.

Using Distributional Weights

Table 11.9 Threshold Distributional Weights NPV A $360 $315 $270 NPV B $200 $150 $100 Threshold Distributional Weight (NPV[A] = NPV[B]) 1.8 2.1 2.7

Using Distributional Weights

Table 11.10 Distributional Weighting in the NFG Project Net Benefit(5%) ($000s) dI -173.2 1.00 33.2 0.6 53.2 4.0 -115.1 0.5 -201.9 Weighted Net Benefit ($000s) -173.2 19.92 212.8 -57.55 1.97

Discount Rate 10% 15% 20%

Government Landowners Wage Earners Downstream Users Aggregate

If the decision-maker considers it reasonable to value net benefits generated in the Southern Region (B) at roughly two to three times as much as those generated in the Central Region (A), (s)he would favour alternative B even if the discount rate were as high as 20%.

With this set of distributional weights, the weighted value of aggregate referent group net benefits is positive, indicating that from a social perspective, the project is worthwhile.

Intertemporal Distribution
what is not consumed by us today, is saved Savings finance investment, and investment today generates consumable output in the future. Therefore, the decision we make today, regarding how much income is spent now on immediate consumption and how much is saved now for future consumption, is a decision about how consumption should be distributed among those living today and those living in the future. The more that is consumed today, the less that is left for future generations, and vice versa. If the social time preference rate is lower than the market rate, the present value of the additional benefit that could be generated by one extra dollar of savings is greater than that of the additional benefit generated by one extra dollar of consumption.

Intertemporal Distribution
The lower social discount rate makes no allowance for the different effects of projects on saving and reinvestment of project net benefits. It then becomes important to establish what part of the referent groups net benefits are saved and what parts are consumed, with a view to attaching a premium on that part which is saved It cannot be assumed that all members of the referent group save the same proportion of any income gained or lost Once we introduce a premium (or shadow-price) on savings we need to make an additional adjustment to the raw estimates of referent group net benefits It is possible that the decision-maker will be faced with a tradeoff between a better atemporal and a better inter-temporal distribution of income. (See Example 11.2.)

Intertemporal Distribution
Example11.2: Incorporating distributional effects atemporal and inter-temporal Suppose that the effect of two projects can be summarized as follows: Project A generates a net referent group benefit of $100. $80 is saved and $20 is consumed by a group with above average income. Assuming that $1.00 saved is worth the same to the economy as $1.20 consumed (i.e. the shadow-price of savings is 1.2), and that the distributional weight for this group is 0.75 then: Net Benefit (in terms of Dollars of consumption) = = = $80(1.2) + $20(0.75) $96 + $15 $111

Intertemporal Distribution
Project B also has a net benefit of $100. Of this $40 is saved and $60 is consumed by members of the referent group who enjoy an average level of income. As the same shadow price of saving (1.2) applies, and the sub-groups distributional weight will have a value of 1.0, then: Net Benefit (in terms of Dollars of consumption) = = = $40(1.2) + $60(1.0) $48 + $60 $108

In this instance the combined effect of introducing both distributional weights is to favour the project that benefits the relatively richer group, Project A, whereas in the absence of a shadow-price of saving Project B would have been favoured.

Intertemporal Distribution
Example11.3: Deriving the premium on savings indirectly Consider the hypothetical example in Table 11.12 in which the consumption levels of the different income groups are shown in the first column and the atemporal distributional weights are given in the second column. In this example, the mean level of consumption is $1500
T a b le 11 .12 C o m p o site D istrib u tio n al W eig h ts

Intertemporal Distribution
If distribution objectives are to be accommodated by a system of atemporal and inter-temporal weights it will be necessary to disaggregate net benefit for each referent group gainer or loser into its consumption and savings components, and then weight the consumption component by the atemporal distributional weight and the savings component by the inter-temporal distributional weight (or savings premium). If we were to follow this procedure in the context of the NFG project it would be necessary to disaggregate each stakeholder groups net benefits into their consumption and savings components, and then apply the respective di to the consumption benefit and savings premium to the savings benefit of each referent group beneficiary or loser

C0 = critical consumption level

C o n s u m p tio n $ /an n u m ( C i) 25 0 75 0

D is trib u tio n a l W e ig h t (d i) 6.00 2.00 1.20 1.00 0.71 0.67 0.55

Implicit premium on savings = 1.2

C c = 12 5 0 C = 15 00
17 50 22 50 27 50