[Economic Report of the President (1996)]
[Administration of William J. Clinton]
[Online through the Government Publishing Office, www.gpo.gov]

[DOCID: f:erp_c5._]
Economic Report of the President - - - - - - - - - - - - H. Doc. 104-161
[From the online service of the U.S. Government Printing Office]
[wais.access.gpo.gov]

CHAPTER 5

Economic Efficiency and Regulatory Reform

OUR LIVING STANDARDS depend on more than just our monetary income.
We benefit from open spaces and clean rivers and lakes. We gain a sense
of security from safer airplanes, cars, food, and toys for our children.
We benefit from safer workplaces and from safer financial institutions.
Over the years the U.S. Government has enacted a number of laws and
issued a number of regulations designed to protect consumers, workers,
and investors. These efforts are important for improving our
environment, public health, and safety. Reducing the corrosion of
factory equipment by polluted water, or the loss of agricultural
productivity due to air pollution, also lowers business costs. In some
cases, efforts to correct environmental or safety problems may stimulate
other productivity improvements.
But regulation also inevitably imposes costs, and these can be
substantial. They include not only direct expenditures to enforce and
comply with regulation, but also indirect costs, such as loss of
flexibility and choice for consumers and businesses, diversion of
investment from other productive activities, and delays in redeveloping
inner cities where hazardous waste sites are located.
To best serve the public interest, regulation should impose the
least burden necessary to achieve its objective, and its benefits should
justify its costs. A major theme of this Administration has been
reinventing regulation: taking a new look at regulation and the
regulatory process to ensure that regulations meet legitimate social
needs, and where necessary changing both content and process to improve
efficiency and effectiveness.
This chapter begins by surveying the broad and continuing debate
over the scope and design of regulation. It identifies the rationales
for regulation and the basic principles of effective and efficient
regulation of threats to human health, safety, and the environment. The
balance of the chapter then illustrates the application of these
principles in the context of ongoing efforts to restructure regulations
affecting the environment and natural resources.

RATIONALES FOR GOVERNMENT REGULATION

The fundamental strength of a market economy is that the pursuit of
private gain serves the public interest by stimulating efficiency and
innovation. But private gain and public interest are not always so
firmly tethered: they can and do diverge. In the absence of regulation,
polluters do not have an incentive to pay adequate attention to the
environmental damage they cause. Workplaces may be unsafe. Consumers may
be unwittingly exposed to defective or unsafe products and services.
Economists refer to such divergences between public and private
interest as externalities, because in each case the amount paid for a
good or service fails to reflect its full cost to society--some costs
remain ``external'' to the transaction. Externalities are a form of
market failure. Government action is needed to correct this market
failure, by confronting economic actors with the full costs of their
behavior. Correcting externalities improves economic efficiency and the
quality of life. The United States has long used regulations as a way of
better aligning public and private interests within the market. For
example, legislation in the area of food and drug safety was enacted in
the 1930s. Internalization of externalities is an important role of
government in modern society, to be set alongside the provision of
public goods like national defense and the maintenance of a social
safety net.
Although this chapter focuses on regulation, governments have a
variety of other tools to address market failure. These include direct
changes in incentives through subsidies or fees; changes in legal
liability standards; provision of information about products, markets,
and technologies; support for the development of new technologies; and
voluntary, cooperative ventures with the private sector.
Changes in our economy and our society call for changes in
regulatory policies. When pressures mount for both land development and
the preservation of undeveloped natural areas, new tensions in land use
and resource protection policies will have to be addressed. As States
demand a greater say over their own affairs, Federal-State partnerships
grow, leading to tensions between the objectives of consistency and
flexibility. Regulation also must adjust to reflect changes in
technology. For example, it is important to focus on the risks posed by
contaminants, not just the ability to measure their concentrations in
human tissues and the environment.
The Administration's strategy of reinventing regulation addresses
these varied and sometimes conflicting concerns. It encompasses not just
deregulation and reform of the content of regulation, but also a
rethinking of how government regulates. The goal is to devise a
regulatory system that both works better and is more responsive to
public concerns.
Efforts to reinvent regulation are taking a variety of forms. One
important step is better targeting of regulatory efforts to where the
need is greatest. Another is a shift in emphasis from prescribing
methods of compliance to specifying desired outcomes. Still another is
harnessing economic incentives through market-based regulatory
mechanisms. The process of regulating can be improved through reduced
paperwork burdens and streamlined reporting requirements, better
dissemination of information to the public, and increased opportunities
for public participation in the regulatory process.

EVALUATING REGULATORY PERFORMANCE: PRINCIPLES AND PRACTICE

Evaluating regulatory reforms requires consideration of the benefits
and costs of alternatives. This can raise a number of questions. What
range of consequences from regulation should be considered? How does one
address benefits or costs that are uncertain or inherently difficult to
quantify? How should concerns about fairness be dealt with? How should
regulators balance the need for consistency in rulemaking with the
advantages of flexibility? How can the assessment process itself obtain
high-quality analysis without creating an excessive administrative
burden, and without imposing excessive societal costs from the delay of
necessary actions?

SETTING REGULATORY PRIORITIES

Executive Order 12866, which the President signed on September 30,
1993, reflects the Administration's basic philosophy and principles for
regulatory planning and review. The order stipulates a number of
criteria that should apply both to assessments of ``significant'' new
regulations (including but not limited to regulations with an expected
annual economic effect of $100 million or more) and to reevaluations of
existing regulations. The order requires that Federal regulations
address real needs while avoiding undue economic burdens. In assessing
the need for regulation, agencies should consider a variety of
alternatives, including alternatives to new regulation. The assessment
should use the best reasonably available information, including
information about risks and costs and the uncertainties surrounding
them, and it should encompass both quantitative and qualitative benefits
and costs. To the extent compatible with existing statutes, agencies
should show that the chosen regulatory approach maximizes net benefits
(including economic, environmental, public health and safety, and other
advantages, as well as distributional impacts and equity), and that
those benefits justify the costs. The means of regulating should be
cost-effective, imposing the least possible cost on society to achieve
the objective (after taking into account the potential for technical
innovation, requirements for verifying compliance, and equity concerns).
Federal agencies should also reduce regulatory inconsistency and
overlap; they should coordinate their activities with State, local, and
tribal governments; and they should provide significant opportunities
for contribution by the public to regulatory review.
The criteria for regulatory planning and review established in the
order recognize that some benefits and costs are difficult to quantify
but nevertheless important. The order acknowledges the importance and
limitations of benefit-cost evaluations for obtaining good regulatory
outcomes. The Administration opposes legislative changes that would
burden the regulatory system with rigidly prescribed assessment methods,
unnecessary costs and delay, and excessive opportunities for litigation.

DESIGNING EFFECTIVE REGULATORY POLICIES

To make regulation less burdensome, the order states that, wherever
possible, agencies specify regulatory goals in terms of performance
standards, which specify desired outcomes, rather than design standards,
which prescribe methods of compliance. Performance-based regulation
lowers the cost of compliance by allowing a variety of compliance
options and encouraging technical innovation. In contrast, the input-
oriented, design standards approach tends to raise the cost of achieving
regulatory objectives by limiting flexibility. For example, standards
for atmospheric pollutants could specify a desired reduction in
emissions or in the damages caused by emissions, and a means for
determining whether that reduction has been achieved. This obviates the
need to mandate investment in specific pollution abatement technology
such as scrubbers for power plants.
Performance standards may require greater effort on the part of
regulators to ascertain the level of compliance. They also require
public confidence in the approach. The applicability of performance
standards in practice is limited by constraints on the ability to
monitor compliance and public acceptance. Improved measurement
capacities and increased confidence in the approach can be expected to
increase its applicability, yielding significant improvements in the
cost-effectiveness of regulation.
Even with performance standards in place, the total cost to the
economy of complying with regulation may be higher than necessary. The
total cost can be reduced if those who face lower compliance costs
undertake more of the total effort required. Regulations can employ
economic incentives toward this end, rather than rigid requirements.
Society further benefits from incentive-based policies because they can
provide a strong inducement to the development of new technologies that
reduce the cost of compliance for all.
Tradeable emissions allowances for pollution control illustrate
these points. A tradeable emissions regime sets a limit on total
emissions from all sources and a nominal emissions limit for each
source. Sources can then vary their actual emissions above or below that
limit through voluntary exchange of emissions allowances with other
emitters. Those that can comply at lower cost can cheaply cut emissions
below their nominal limit, then sell their unused allowances to emitters
with higher costs, who can then exceed their nominal emissions levels. A
further advantage of allowances is that they essentially put a price on
allowed emissions, providing an incentive for the development of lower
cost options for pollution control and prevention.
Although regulation is necessary to curb negative externalities such
as pollution, in some cases government policy itself contributes to
externalities. Then the challenge to designing effective policies
includes reducing these government-induced distortions. For example,
ill-designed subsidies can contribute to environmental harm. These
include agricultural commodity programs that encourage overuse of soil,
water, and chemical fertilizers, and access to forests on government
land at less than their opportunity cost. Reducing or eliminating
distorting subsidies offers an opportunity to improve the environment
and market performance simultaneously.

REGULATION AND DEVOLUTION

The question of who should regulate can be as important as how to
regulate. This question has no easy answer. Many of the arguments
parallel those raised in Chapter 4 on the devolution of expenditure
programs. If regulatory authority goes to that level of government whose
jurisdiction best corresponds to the scope of the externality, this can
help ensure a solution that is tailored to the problem. For example,
plans to clean up and rehabilitate contaminated industrial sites might
be better made at the State or the local level. State and local
decisionmakers may be better able to assess the benefits and costs of
additional cleanup--greater public safety, cleaner sites, but increased
expense and delay--and to ensure that resources are used most
efficiently.
Devolution of regulatory responsibility may not be appropriate,
however, for several reasons. Broader, cross-jurisdictional
environmental interests may be at stake. For example, protecting
wetlands and endangered species habitats is a national as well as a
local issue. The impacts of pollution may transcend local boundaries.
Federal regulation of air and surface water pollution is intended in
part to address the fact that some of these problems spill over city
limits and State lines. State or local authorities might have a weak
interest in preventing or containing damages outside their
jurisdictions. Devolution of regulatory authority might also compromise
protection because of limits on local regulatory capacity (such as
inadequate resources for monitoring or lack of enforcement experience),
or because States or localities are in competition with each other for
economic development opportunities. In addition, disparate State or
local regulatory standards can increase costs of compliance by, for
example, requiring excessive product differentiation.
Problems can arise when the impacts of externalities are felt by one
group of people, but political decisions are made by others. By the same
token, however, problems can arise when the beneficiaries of policies to
address externalities do not have a stake in balancing the costs and
benefits of policy intervention. This can happen when decisions are made
by States or localities but costs are borne at the Federal level.
Conversely, the imposition of requirements on State and local
governments without the funding to meet those requirements--so-called
unfunded mandates--has become a point of contention. Some mandates could
be seen as undue restrictions on local discretion, but others may
appropriately compensate for market or policy failures at the State or
local level. For example, if a mandate restricts the ability of States
or localities to impose externalities on others, it can be justified on
the same economic grounds that apply to the regulation of private
entities that generate externalities. It can be difficult in practice to
ascertain into which category a particular mandate falls. In any case,
the Federal Government should be aware of the costs it imposes on other
levels of government. As noted in Chapter 4, legislation passed in 1995
ensures that this information will be available during congressional
debates.

REGULATORY ASSESSMENT IN PRACTICE

The capacity to estimate the consequences of regulation has grown
enormously since the early days of benefit-cost analysis. And even
imprecise analyses can at least be useful in placing bounds around
potential benefits and costs. Nevertheless, a number of methodological
questions persist and are addressed in newly updated guidelines issued
by the Office of Management and Budget. The following examples
illustrate these issues and the means available to address them.
The primary purpose of much regulation is to reduce an identified
threat to human health, safety, or the environment. However, there are
gaps in current knowledge about the nature and magnitude of the hazards
that different substances and practices pose to different parts of the
population, and about the costs of reducing those hazards. With limited
information, analysts will be able to describe only a few possible
scenarios; in other cases a more complete characterization of outcomes
and probabilities may be possible. Such information may include measures
of central tendency (e.g., the median risk), upper and lower bounds,
measures of the uncertainty of possible outcomes, and effects on
different populations. Where the level of risk depends on more than one
factor (e.g., both exposure and toxicity), statistical techniques can
combine these factors in a way that accurately describes the overall
risk without putting excessive emphasis on those outcomes that are very
unlikely.
The valuation of risk reduction is an important element of many
regulatory assessments. It is complicated, however, by the fact that
typically there are no markets that directly value the reductions in
risk achieved through regulation. Instead, indirect methods must be
employed. For example, the assessment of many health and safety
regulations centers on the question, By how much will this regulation
reduce the risk of illness or premature death? It is possible in
principle to assign an economic value to the reduced risk of premature
mortality by posing the question, How much would members of the affected
public willingly pay for this reduction in the probability of earlier
death? This makes the issue analogous to the willingness to pay for
insurance--and quite different from placing a monetary value on a
specific person's life. (Even the notion of putting a monetary value on
risk reductions of this kind remains controversial for many.) The
question can be approached by examining, for example, how much more
people pay for safer but costlier products, or by estimating the wage
premiums offered for riskier occupations. However, debate continues
about the reliability and applicability of this information to the
assessment of other kinds of risks. Among the questions at issue are the
degree to which the risks in question are assumed voluntarily or
involuntarily, and the extent to which valuations should reflect the age
of those affected and the latency of the risk (that is, the lag with
which any ill effects are likely to occur).
Discounting future benefits and costs is another complicated
methodological issue. Benefits received now or soon are generally worth
more to people--have higher present value--than the same benefits
received later. An important question here is the extent to which the
costs of regulation displace private consumption or investment.
Displacement of investment implies a loss of future consumption
possibilities. Higher market returns on investment imply a larger
consumption displacement. The weighing of long-term benefits and costs
should also attempt to account for changes in the relative scarcity of
resources and the potential for irreversible losses that result in a
sacrifice of future as well as current benefits.
Analysis of issues with very long-term consequences, such as climate
change and depletion of the stratospheric ozone layer, involves yet
another complicated issue: tradeoffs among the interests of different
generations that may give rise to ethical considerations. One way to
introduce ethical elements into the analysis is through
intergenerational discount rates that explicitly reflect assumptions
about society's attitudes toward such tradeoffs. Discount rates derived
from ethical considerations about fairness to future generations were
calculated in one study to range between 0.5 and 3.0 percent (in real
terms) for an advanced industrial economy. This range is generally below
rates of return to private capital, but not necessarily below real
short-term yields on government bonds.

SETTING REGULATORY PRIORITIES FOR THE ENVIRONMENT AND NATURAL RESOURCES

Over the past 25 years environmental regulation has succeeded in
reducing a number of threats to human health and the environment. For
example, emissions of lead into the air, which pose serious threats to
human health, have fallen sharply (Table 5-1), and lead paint has been
banned. As a consequence, blood lead levels have dropped sharply. Air
quality in many cities has improved considerably (Chart 5-1). The past
quarter century has also seen efforts to protect valuable natural
resources such as wetlands, and the ban on the pesticide DDT has reduced
serious threats to species like the bald eagle. The agreement to phase
out the production of substances that deplete stratospheric ozone is an
important first step toward greater international cooperation in
protecting the global environment. Nevertheless, concerns about local
environmental quality remain. For example, the frequency with which
concentrations of fecal coliform bacteria in rivers and streams are
found to exceed standards shows little decline. And other regional and
global problems have come to the fore, such as the global loss of
biodiversity, marine pollution, stress on fisheries, and the threat of
global warming.
It is important to consider the costs of environmental policies as
well as their benefits. Direct public and private expenditures
associated with the regulations of the Environmental Protection Agency
(EPA) have been estimated to be between 1.6 and 1.8 percent of GDP since
the mid-1970s, a small but significant share of total economic activity.
In absolute terms, current-dollar expenditures in 1992 and 1993 were
slightly over $100 billion, or almost as much as total personal
expenditures for religious and philanthropic activities. These estimates
exclude indirect costs associated with environmental regulations, and
the costs of other regulations to restrict land and natural resource
use. They also do not indicate the marginal cost of stricter regulation.

Table 5-1.--Atmospheric Emissions of Lead, by Source, 1970-94
[Thousand short tons]
----------------------------------------------------------------------------------------------------------------
Non-
transportation                  Industrial
Year                              Total         fuel       Transportation   processes
combustion
----------------------------------------------------------------------------------------------------------------

1970.....................................................      219.5          10.6           180.3          28.6

1975.....................................................      158.5          10.3           135.2          13.0

1980.....................................................       75.0           4.3            65.5           5.1

1985.....................................................       20.1            .5            16.2           3.4

1990.....................................................        5.7            .5             1.9           3.3

1994.....................................................        5.0            .5             1.6           2.9
----------------------------------------------------------------------------------------------------------------
Note.--Detail may not add to totals because of rounding.

Source: Environmental Protection Agency.



Satisfying public concern for protection of the environment and
natural resources without imposing an undue burden on the economy is a
challenge. Part of the Administration's response is through programs
like EPA's Common Sense Initiative. This program is a pilot
collaborative effort among government, business, and the public to
identify areas for improvement in how regulations are structured and
implemented, and how technologies can be improved to help protect the
environment. Another new initiative is EPA's Project XL, which invites
companies to propose their own environmental performance standards, to
increase flexibility and improve environmental performance. The Army
Corps of Engineers has streamlined permitting procedures related to
protection of wetlands to reduce regulatory burdens on activities
involving small tracts of land.
Beyond these efforts, resources devoted to regulation can be used
more efficiently through careful evaluation of benefits and costs,
keeping in mind the uncertainties inherent in such evaluations and the
need to consider qualitative or subjective factors such as
distributional equity and environmental justice, as noted above. Three
recent regulatory reform initiatives--the reauthorization of the Safe
Drinking Water Act, the reform of waste management programs, and shifts
in the focus of agricultural land retirement programs--illustrate
efforts to target regulation better.

THE SAFE DRINKING WATER ACT

The unanimous reauthorization by the Senate of the Safe Drinking
Water Act in the fall of 1995 is a good example of bipartisan
legislative reform to increase the role of benefit-cost assessments in
setting more rational priorities. The previous version of the act put
EPA on a regulatory treadmill, requiring new standards for 25 substances
every 3 years, regardless of the threat they posed. A study by the
Congressional Budget Office estimated the cost of reducing cancer risk
under standards that various administrations have been required to
promulgate for different contaminants under the act. The estimates
ranged from less than $1 million to over $4 billion per expected cancer
death avoided. Although other important health benefits besides reduced
risk of cancer are also tied to drinking water standards, a range this
wide suggests that much could be gained from better targeting of
regulatory efforts on those substances that pose the greatest risk.
The Senate revisions to the act would explicitly allow EPA to
consider the balance between potential public health benefits and the
costs when establishing drinking water standards. EPA would be able to
target those threats to public health that scientific assessments
indicate are more important. EPA could also modify standards whose
benefits do not justify the costs, so long as the alternative standard
chosen maintains or increases health benefits. This general approach--
protecting public health and environmental values, but also providing
greater latitude for balancing benefits and costs--is an instructive
example of how such balancing provisions could be incorporated in other
environmental laws and regulations.

HAZARDOUS WASTE

There are several important Federal programs for disposal of
hazardous wastes and cleanups of waste contamination. The Comprehensive
Environmental Response, Compensation, and Liability Act (CERCLA,
otherwise known as the Superfund program) established a program to clean
up major disused contaminated sites. CERCLA also requires those
responsible to restore, replace, or provide compensation for the loss,
injury, or destruction of natural resources (Box 5-1). The Resource
Conservation and Recovery Act (RCRA) established a program that
regulates ongoing management of hazardous and solid wastes, as well as
cleanups of facilities covered by the permitting requirements of the
act. The Federal Government also is subject to these laws and cleans up
sites managed by Federal agencies or contractors.
CERCLA and RCRA require that cleanups and waste management protect
human health and the environment. To achieve this goal, CERCLA currently
contains a strong preference for remedies that are permanent and involve
treatment of contaminants, as opposed to lower cost alternatives that
contain the contamination and limit human exposure or environmental
damage, without a full long-term cleanup. CERCLA currently puts only
limited weight on cleanup costs as one of a number of factors to be
balanced in selecting remedies. In addition, remedies must satisfy a
variety of other Federal and State statutory requirements directly or
indirectly related to site cleanups; these can impose stricter standards
than CERCLA itself would require. Some standards for hazardous waste
disposal under RCRA require threats to human health and the environment
to be ``minimized,'' regardless of the level of risk posed by the waste
or the cost of compliance. This requirement could imply the need for
waste management efforts to intensify as technical capacity improves,
regardless of background environmental quality or the hazard posed by
the material.
The advantages of reform in waste cleanup could be substantial. The
Administration estimated that its 1994 CERCLA reform proposals
(discussed below) could reduce cleanup costs by 19 to 25 percent
(including savings at Federal facilities). A review of CERCLA cleanup
decisions by researchers at the University of Tennessee found that
increasing the flexibility of remedy selection could reduce the cost of
actual site cleanup by anywhere from 20 percent to more than 50 percent
without compromising the basic statutory goal of protecting human health
and the environment. Since governments and private parties spend several
billion dollars each year on CERCLA site remediation, the total savings
could be substantial. Significant cost savings could also be realized
from reforms of RCRA. For example, EPA has estimated that billions of
dollars in cumulative cost savings could be obtained by increasing the
flexibility with which one category of materials--contaminated materials
excavated during site cleanups--is handled, without an unacceptable
increase in risk.
Improving the balance between the benefits of risk reduction, on the
one hand, and the costs of cleaning up old waste and managing new waste,
on the other, calls for both legislative and administrative changes.
These should build upon the basic principles laid out earlier in this
chapter. Cleanup remedies and regulations for managing new wastes should
protect human health and the environment. Policies should reflect sound
assessments of the risks involved. Decisionmakers should have greater
flexibility in designing remedies and waste management policies, and
greater weight should be given to costs than in the past. Decisions
should take into account the concerns of affected communities and the
potential for redevelopment of contaminated sites. And regulatory
actions should be able to proceed without bogging down in red tape. The
policy debate seems to center not so much on these basic principles as
on how reforms should be implemented and how tradeoffs should be
structured to achieve the stipulated goals.
During the 1994 debate on CERCLA reform, the Administration proposed
legislation that would have given more weight to cleanup costs in
choosing remedies, limited requirements for more stringent cleanups due
to other statutes, and required greater consideration of the likely
future uses of the site (e.g., residential versus industrial) in
assessing risks and selecting remedies. The reforms would have limited
the preference for permanent treatment to so-called ``hot spots,'' such
as portions of sites with high concentrations of contaminants. Under
this approach, greater use could be made of remedies that prevent the
spread of contaminants or avoid human exposure without requiring the
more expensive removal or destruction of contaminants. Although this
legislation was supported by industry and environmental interests, the
103d Congress failed to vote on it before adjourning.
Legislation introduced in the 104th Congress proposes more sweeping
changes to the remediation process. The Administration opposes changes
to the remediation process that provide inadequate protection, fail to
give due weight to State and community interests, or pose an excessive
administrative burden. Meanwhile the Administration is pursuing a number
of administrative reforms to strengthen the reliability of risk
assessments, put greater emphasis on sites of greater risk, and compare
the potential risk reductions and costs of alternative remedies. For
example, high-cost remedies will be subject to additional review to
determine whether a lower cost remedy would meet the cleanup goals. A
finding of high cost and limited risk reduction would provide a
rationale for waiving more restrictive remedy requirements.
The Administration organized public discussions on reinventing RCRA.
These generated a variety of suggestions for the management of newly
created wastes: disposal restrictions could be made more risk-based,
barriers to economically and environmentally sound recycling could be
lowered, and there could be more flexibility in determining what
substances will be regulated as hazardous wastes. The Administration
currently supports carefully targeted legislative efforts to relax
restrictions on certain low-risk types of waste disposal. Through
rulemaking, EPA is attempting to exclude certain low-risk materials from
RCRA hazardous waste requirements.
As indicated previously, cost savings also can be obtained from
increased regulatory flexibility in handling materials produced in the
course of cleanups. Even if these materials have low levels of
contamination, under current law they must be treated the same as the
most hazardous industrial process wastes. When large volumes of these
materials become subject to strict cleanup standards, they can pose a
significant cost burden. Reform can be achieved without jeopardizing
human health and the environment by combining some relaxation of waste
disposal requirements with a requirement that a cleanup plan be approved
by Federal or State regulators.

AGRICULTURAL LAND RETIREMENT PROGRAMS

Over the last decade, agricultural policies have reflected a
broadening of priorities to include concerns for environmental quality
and market efficiency as well as farm income. This can be seen in
changes in commodity programs that give farmers greater planting
flexibility and provide greater incentives to respond to market prices
rather than government support prices. Removal of market price
distortions and planting restrictions can stem the overuse of chemicals
and fertilizers on program crops and can encourage the adoption of
environmentally beneficial crop rotations.
Concern for environmental quality is also reflected in government
programs to idle cropland. These programs have been used since the 1930s
both to control agricultural output and to achieve environmental goals.
Program eligibility guidelines requiring the removal of land from
production impose costs on society by reducing output, raising consumer
prices, and distorting agricultural input markets. But idling certain
tracts of land can also provide environmental benefits, for example by
maintaining soil productivity through erosion control, reducing water
pollution from sediment and chemical runoff, and increasing area for
wildlife habitat. The net benefits of land retirement programs depend on
whether they are designed primarily to control agricultural production
or to protect the environment.

Box 5-1.--Natural Resource Damages

In addition to authorizing the cleanup of contaminated sites,
CERCLA provides authority for certain ``trustees'' (Federal agencies,
State governments, and Indian tribes) to seek compensation on behalf of
the public for damages to public natural resources and ecosystems caused
by contamination with hazardous substances. The 1990 Oil Pollution Act
provides similar authority to address damages from oil spills. The laws
require trustees to restore, replace, or acquire the equivalent of the
damaged or destroyed resources. Trustees must also obtain compensation
for interim losses incurred by the public while recovery, restoration,
or replacement is taking place.
Natural resources and ecosystems support recreation and commercial
ventures (such as fisheries) and provide a variety of important
ecological functions such as waste absorption and species habitat.
Beyond these more or less tangible benefits, the very existence of
natural areas can be a source of value for people. However, quantifying
the economic value of natural resource damages can be challenging. Even
where the physical effects on ecosystems (such as fish kills or beach
contamination) can be measured with some precision, the corresponding
loss of benefits to people may be much more uncertain. The EPA and the
National Science Foundation are supporting a research program to improve
our understanding of the value of ecological resources, as part of the
Administration's larger effort to expand and strengthen environmental
research. The Administration has also issued revised rules for assessing
damages under the Oil Pollution Act. Under these rules, economic
assessment would determine the scale of investment when direct
comparisons are not possible between the damaged resources and the
resources being provided to compensate for the damages.
The Department of Agriculture's annual acreage reduction programs
(ARPs) have historically required farmers to set aside a portion of
their assigned crop base acreage in order to receive direct government
payments and other benefits. Current law, however, gives the Secretary
of Agriculture limited discretion over how and when planting
restrictions are imposed. In many years, over 10 percent of U.S.
cropland has been idled under the ARPs. By limiting supply and raising
market prices, ARPs reduce deficiency payments and shift the cost of
farm income support from taxpayers to consumers. The use of acreage
restrictions to limit supply can also cause overuse of other inputs. By
raising prices, ARPs create incentives to farm the land remaining in
production more intensively. This can have unfortunate environmental
consequences if more fertilizer and pesticide are applied to the
remaining acreage.
The Conservation Reserve Program (CRP), established in 1985, allows
farmers to enter into long-term land retirement contracts with the
Agriculture Department. Farmers receive ``rental payments'' from the
government for taking environmentally sensitive land out of production.
The primary goal of the legislation was to reduce soil erosion and its
adverse environmental consequences, although control of agricultural
output was also a key objective at the time (about one-quarter of the
land enrolled in CRP may not be highly erodible, although much of this
land provides wildlife habitat and other environmental benefits).
Landowners bid competitively for CRP contracts. Bid selection is based
on the cost of the rental payments and on an environmental benefit
index. Tracts of land receive an index score that indicates the
potential environmental benefits of idling those acres.
Agricultural land idled under all Federal programs has declined
considerably since the late 1980s, and the CRP has supplanted annual
ARPs as the main land retirement program. The 1990 Farm Bill extended
the CRP, placing greater emphasis on curbing water pollution and other
environmental problems. It also established the Wetlands Reserve Program
(WRP) to protect and restore wetlands through long-term and permanent
easements. These targeted programs complement the conservation efforts
of private land trusts (Box 5-2).
Recent Administration initiatives have continued to emphasize the
goal of environmental protection over that of controlling agricultural
supply. For the current Farm Bill the Administration recommended that
ARPs be made a discretionary tool to be used only when supply and demand
are critically out of balance. Eliminating annual ARPs could also reduce
the costs of operating the CRP and the WRP if the annual set-aside
programs bid up the price of agricultural land, making environmental
easement contracts more costly to acquire. In 1995 the Department of
Agriculture allowed the early release of over 683,000 acres from CRP
contracts, using a new bid selection system to replace those acres with
more environmentally sensitive cropland.
How costs and environmental benefits are weighed in ranking CRP bids
also affects the geographic distribution of land enrolled in the
program. Most CRP acreage is currently in the Great Plains, the Mountain
States, and the Corn Belt. But as more recent signups have placed more
weight on water quality and habitat protection, enrollment has shifted
toward the Great Lakes States, with the Corn Belt also still accounting
for a large share. If funding for the CRP is reduced, decisionmakers may
face more difficult tradeoffs between targeting the program for greater
environmental benefit and maintaining income support for current
beneficiaries. Research to estimate the economic value of environmental
improvements from land retirement can provide better information on the
nature of these tradeoffs.

CREATING COST-EFFECTIVE POLICIES: ECONOMIC INCENTIVES FOR ENVIRONMENTAL
PROTECTION

Policymakers can create and enhance economic incentives for
protecting the environment in a number of ways. Laws that specify
liability for environmental damages, such as those in the Superfund
program, can create incentives for increased care before the fact.
Economic theory also has long advocated the use of charges or fees that
induce more sparing use of nonmarket environmental resources.
The use of tradeable allowances or harvest quota shares is another
approach for limiting the use of environmental resources (in this case
limiting pollution discharges) or the use of natural resources such as
ocean fisheries that are subject to excessive exploitation. As described
earlier, this approach sets a limit on total use of the resource (a
limit on the total fish harvest or waste discharge) and nominal limits
on individual users. Users can, however, exceed their nominal limit by
purchasing allotments from others, who then use less than their
allotments. The market price that emerges for the use of the resource
creates incentives to limit that use, just as a user fee does. Unlike a
fee, however, trading can be used without a revenue transfer from the
private sector to the government. The ability to trade allotments helps
to ensure a cost-effective outcome, since those who can comply with the
constraint on total resource use most economically--that is, those with
the most efficient harvesting operations or lowest pollution control
costs--assume the greatest share of responsibility for meeting the
limit. The approach also creates incentives to devise new technologies
that lower compliance costs, since all participants would like to reduce
their allowance purchases or increase their allowance sales. Finally,
regulators can use their flexibility in the initial allotment of
allowances or quota shares to treat distributional or equity concerns
that may arise from the limit on resource use.
This section discusses several examples of the use of pollution
trading or tradeable harvest quotas in practice. The discussion focuses
on the use of emissions trading for air pollution control and tradeable
fishing quotas for regulation of overfishing. However, the approach has
a number of other potential applications. For example, the
Administration's 1994 assessment of the Clean Water Act reauthorization
estimated compliance cost savings of several hun-

Box 5-2.--Land Trusts and the Tax System

Land trusts are private, voluntary, nonprofit conservation
organizations that complement Federal and State programs by preserving
14 million acres of scenic areas, farmland, and wildlife habitat--more
land than is held in State parks and recreation areas in the entire
United States. Land trusts are established by national organizations
such as the Nature Conservancy, the Conservation Fund, and the National
Audubon Society as well as by groups at the local, State, and regional
levels. Land is preserved through outright purchase, purchase of
development easements, leases, and land management agreements.
Land acquired by land trusts is often purchased later by Federal
resource management agencies. This acquisition sequence has several
advantages. Local organizations may have better information about the
environmental characteristics of particular tracts of land and more
flexibility in conducting timely transactions with private landowners.
Resale of land to the Federal Government, in turn, provides trusts with
revenue to continue their preservation activities. Federal tax policy
also affects land preservation activities. Land trusts try to acquire
land through donations or below-market-value purchases, relying on
incentives provided by the income, property, and estate tax codes to
obtain properties or land use rights.
Federal interaction with land trusts raises two policy questions.
First, do Federal agencies pay fair market value for land purchased from
trusts? A recent report by the General Accounting Office suggests that
they do. Second, should incentives for land preservation be altered
directly through targeted programs such as the WRP, or more indirectly
through changes in tax codes? Direct land retirement programs have some
advantages over increases in broad-based tax incentives in their ability
to target properties and set priorities for land preservation. For
example, the WRP ranks easement bids according to cost, significance of
ecological functions, and geographic location, among other criteria. In
contrast, income or property tax credits or estate tax deferrals are
available to all owners of eligible lands. Eligibility can be
conditioned on providing environmental benefits, but the lands eligible
for the tax incentive may not be the most ecologically desirable or
cost-effective locations for such efforts. On the other hand, the
greater budgetary visibility of direct programs may make them more
difficult to sustain.
dred million to several billion dollars per year from expanded water
pollution trading. EPA is developing a framework for expanded use of
effluent trading. Expanded use of trading programs to protect wetlands
and species habitats, provided they are ecologically sound, can also
achieve regulatory goals while providing cost-reducing flexibility in
the timing and location of protection efforts.

AIR POLLUTION TRADING

Precursors of today's air pollution emissions trading programs were
established in the 1970s. An example is the ``offset'' program, which
allows new pollution sources in areas with poor air quality, provided
they reduce other emissions sources in the area by more than their own
emissions. Another example is the ``bubble'' program. This program
subjects a group of individual sources in close proximity to a single
common limit on total emissions, and allows the sources to trade
emissions rather than comply with individual limits. Even though subject
to numerous restrictions, these programs have delivered emission
reductions at lower cost.
A more comprehensive approach to emissions trading was implemented
in the national program that allows power plants to trade sulfur dioxide
emissions (a precursor to acid rain) under the 1990 amendments to the
Clean Air Act. This program, whose initial phase began in 1995, allows
firms to save money by complying with performance standards rather than
strict emissions controls requiring the use of specific technologies.
The shift to performance standards makes possible a broader range of
cost-effective compliance strategies, such as blending coals with
different sulfur contents. This flexibility has also created competition
among compliance options, lowering the costs of both fuel switching and
removal of sulfur from stack exhausts. These benefits have been achieved
even though the initial phase of the program has so far resulted in
limited trading of allowances among firms. This phase requires only a
limited number of plants to participate and sets sulfur dioxide
standards that are less restrictive than standards in the second phase
will be. Under these circumstances, electricity producers have been able
to achieve the benefits of more flexible regulation without extensive
reliance on allowance trading with other producers. In the second phase
of the program, beginning in 2000, performance standards will be tighter
and more plants will be involved. Consequently, emissions trading among
firms seems likely to become more important.
Local and regional efforts along these lines are emerging as well.
In 1994 Southern California implemented a regional emissions trading
market for nitrogen oxides, which also cause acid rain and contribute to
haze and ground-level ozone pollution. Known as the Regional Clean Air
Incentives Market, or RECLAIM, the Southern California program is
broadly similar to the national market for sulfur dioxide emissions
discussed above, but with some distinctive features. For example, the
program sets limitations on the location of emissions that are traded,
to help prevent ``hot spots.'' The RECLAIM program for nitrogen oxides
is part of a larger compliance strategy that seeks to lower total
emissions in the region toward levels needed to achieve mandated air
quality standards. Under such an approach, regulators can simultaneously
improve the environment, enhance cost-effectiveness, and provide
flexibility for economic growth in the region. Other areas (notably the
Northeast) are in the process of developing their own nitrogen oxide
trading programs.
Programs like the national sulfur dioxide allowance market and
RECLAIM, which establish an aggregate emissions limit for a whole class
of emitters, entail setup costs to establish allowable aggregate
emissions limits, initial allocations of allowances, and trading rules.
EPA has proposed an ``open markets'' system for trading of allowances
for both nitrogen oxides and volatile hydrocarbon emissions in the
absence of these elements. Under this approach, various types of
emitters can participate in a variety of cost-reducing trades. For
example, a paint shop switching to a lower volatility paint for 6 months
could sell the short-term emissions reductions to a refinery with a
temporary need to cover surplus emissions. A similar approach to
bilateral trading could be an important complement to international
efforts aimed at protecting the stratospheric ozone layer (Box 5-3).
Regulators face an important challenge in using the open market
approach: how will Federal and State air quality regulators obtain
adequate assurance that proposed emissions reductions are credible?
EPA's proposal reflects several approaches. The agency's preferred
approach is a ``buyer beware'' plan whereby the user of an open markets
emission reduction credit ultimately is responsible for the quality and
integrity of the credit. This approach provides maximum environmental
security by giving buyers strong incentives to check the legitimacy of
credits, but it could also deter buyers from participating in the
market, since they would incur a liability if sellers fail to live up to
their obligations. EPA has identified alternative liability
arrangements, such as placing more liability on sellers (with a system
of spot checks to detect inadequate performance) and using third-party
verification through brokers, who would be able to absorb legal
liability for the quality of credits and provide warranties to buyers.

TRADEABLE FISHING QUOTAS

Overfishing--the consequence of unrestricted access to ocean fish
stocks--has put heavy pressure on many of the world's fisheries.

Box 5-3.--Protecting the Stratospheric Ozone Layer: An Incentives-Based
Approach

Methyl bromide is a pesticide that is damaging to the
stratospheric ozone layer which shields the earth from harmful
ultraviolet radiation. Recent adjustments to the Montreal Protocol, the
international treaty governing ozone layer protection, place the first
global limits on methyl bromide. Industrial countries must phase out
methyl bromide production and use by 2010, except for certain essential
uses such as treatment of imports and exports (currently less than 10
percent of global use). Use by developing countries (currently about 20
percent of the world total) will be frozen in 2002, with additional
controls to be negotiated in the next 2 years.
Interim reductions by industrial countries en route to a phaseout
will also be required. By limiting the total quantity of methyl bromide
available, rising methyl bromide prices will automatically and cost-
effectively allocate the remaining supply to more highly valued uses.
The signatories to the Montreal Protocol will review the expanded use of
market-based measures for controlling methyl bromide. One option, an
international trading system, could allow some countries to reduce their
methyl bromide use more slowly, by purchasing allowances from countries
that have reduced use ahead of schedule.
Current U.S. law requires more stringent control on methyl bromide
use than do the adjustments to the Montreal Protocol. The Clean Air Act
bans, without exemption, all U.S. methyl bromide production and use by
2001. U.S. agricultural producers have expressed concern that they will
be placed at a competitive disadvantage if other countries are allowed
to continue methyl bromide use. The Administration supports legislative
changes necessary to allow for continued methyl bromide use beyond 2001,
in cases where alternatives do not exist, to safeguard U.S. agricultural
competitiveness.
Without limits on access, anyone with the necessary skills and financing
can enter the industry. The exercise of individual self-interest in this
case leads to serious economic waste from excess entry and damage to the
resource, since individual boat operators do not take into account the
long-term consequences of depletion in their own harvesting decisions.
Any unilateral exercise of forbearance simply expands the catch
available to others.
Traditionally, fisheries management has attempted to cope with this
problem through such measures as limited fishing seasons and
restrictions on allowable gear. These efforts slow depletion of stocks
in a costly manner by requiring the use of less efficient technology and
creating market gluts during the abbreviated fishing seasons. And in any
event these efforts often are overwhelmed by technical advances in
harvesting methods.
A promising alternative is the use of individually transferable
quotas (ITQs). In a manner analogous to air pollution trading programs,
ITQs operate by setting a limit on the total allowable harvest and
creating tradeable rights to a share of the harvest. With trade in ITQs,
the harvest is undertaken by the most efficient operators, and since the
quota rights can be used at any time during the year, the harvest rate
does not glut the market. The sale of ITQs also provides a temporary
financial buffer for less efficient operators, who are induced to leave
the industry as overcapitalization declines.
Several challenges must be addressed in establishing an ITQ program.
These include determining the initial size of the quota, allocating the
quotas, and addressing the effects of an ITQ for one fish species on
others; setting up a monitoring program; and dealing with the plight of
fishing communities whose residents might not remain competitive in the
ITQ market.
ITQs are currently being used by two East Coast regional fishery
management councils, on a larger scale in an Alaskan fishery, and in
other countries. The effects of harvest limits and pressures to increase
harvest efficiency are shown in the decline of excess capital applied in
the East Coast fisheries: the number of vessels has decreased by more
than 50 percent. Similarly, in one application in British Columbia the
decreased economic waste is indicated by an increase in the net overall
economic return to the fishery of 65 percent.

TECHNOLOGY DIFFUSION FOR POLLUTION CONTROL IN AGRICULTURE

Government can play a role in improving environmental quality not
only by internalizing externalities, but also by correcting market
failures in the provision of information. Improved production techniques
and management practices can improve efficiency and cut waste and
pollution, in effect substituting one clean input--information--for
other, polluting inputs. However, information has certain aspects of a
public good--it is difficult for individual suppliers to restrict its
use to those who have paid for it. As a result, private markets may
undersupply information about environmentally beneficial technologies.
Information problems can also constrain the adoption of new technologies
by farmers. In such cases, the government may be able to improve
efficiency by collecting and providing information about resource-
conserving practices.
U.S. agricultural policy has a long tradition of emphasizing
education, technical assistance, and subsidies to achieve economic and
environmental goals. Technology transfer programs dating back to the
1930s have encouraged farmers to adopt soil conservation practices to
maintain soil productivity through erosion control. The traditional
extension and technology transfer system has increasingly emphasized
technologies aimed at off-site environmental damages. Integrated pest
management and conservation tillage are examples of the environmentally
beneficial practices that have been promoted.
More recent programs have aimed at curbing water pollution from
agriculture through provision of public information and financial
incentives for farmers. Demonstration programs have been set up to
encourage the adoption of best management practices (BMPs). An
assumption underlying such voluntary environmental programs is that
technological options can reduce both production costs and pollution. In
theory, if these practices do reduce costs through more efficient use of
water, fertilizer, and pesticides, demonstration programs will encourage
their long-term adoption. Programs frequently include short-term
subsidies to encourage initial adoption.
The adoption of BMPs has yielded some impressive results. For
example, one study found that depending on field conditions, corn
farmers in Nebraska who adopted soil nitrogen testing could reduce their
use of fertilizer up to 25 percent with no loss in yields. In this case,
the soil testing procedure substitutes information for chemical
fertilizer applications. Moreover, farmers who participated in the
Department of Agriculture's educational programs appeared to have made
more effective use of nitrogen testing results than did nonparticipants.
Although the history of government programs to promote BMPs is still
somewhat limited, useful lessons have already emerged. First,
familiarity with new management practices has been found to encourage
adoption, especially for BMPs that represent minor changes in current
operations. Second, although profitability is a prime consideration in
BMP adoption, it is not the only one. The belief that a BMP improves
water quality has been found to be an important incentive for adoption,
particularly in areas where agriculture has impaired ground water used
for drinking. Third, significant regional differences exist in the
perceived profitability and adoption rates of BMPs. Thus, no single set
of practices may be widely adopted, and a decentralized approach may be
needed to promote environmental technologies in agriculture. There may
also be a role at the State level for research that tailors BMPs to
local environmental conditions.

CONCLUSION

Without regulation to protect health, safety, and the environment,
the quality of life Americans enjoy would be significantly lower than it
is today. At the same time, regulation and the regulatory process must
keep pace with changes in knowledge, technology, the economy, and social
priorities. Reinventing regulation to work more cost-effectively and to
address the greatest needs is a crucial step down this path. The efforts
made thus far to enhance the performance of environmental regulation
illustrate how broad are the opportunities for improvement.