Socio-economic analyses in practice

Jens Stissing Jensen

What is a socio-economic analysis?
Socio-economic analysis is a tool that is often used in connection with establishing political priorities for major societal investments. This could be, for example, investments in new roads, sewers or district heating systems. In addition, socio-economic analyses are also used to assess the impact of, for example, new taxes and levies or new energy-saving campaigns. The philosophy behind socioeconomic analysis is to weigh up the pros and cons of new investments and new types of regulation for society as a whole.

For example, a socioeconomic analysis can be used to assess the advantages and disadvantages of a new motorway. For some individuals, a new motorway will have positive effects because they will be able to get to work quicker. However, others who live close to the new road will experience negative effects in the form of increased noise and pollution. The mechanism behind a socioeconomic analysis of the new motorway would identify and weigh up all the experienced effects (also called use effects) for all the affected individuals relative to a situation in which the investment is not implemented. A key challenge in socioeconomic analysis is how to compare the different utility effects. How do we compare the negative use effects for individuals who experience increased noise, for example, against the positive use effects for the individuals who will be able to get to work quicker? In order to be able to compare such effects, they must each be assigned a price in DKK. For example, the negative use effect of increased noise can be priced by examining how much the market price of property exposed to noise falls. Another method is to ask the affected individuals how much they would be willing to pay to avoid the noise. A price for the positive use effects for individuals who will be able to get to work quicker can be estimated by calculating a price for their time (for example, 85 DKK/hour). By adding the time saved for all users of the new road together and multiplying the total by 85 DKK, the total use effect can now be calculated. Once all the positive and negative effects of the investment have been identified and converted into DKK, the overall social effect can be calculated by subtracting the negative effects from the positive.

An advantage of socio-economic calculations is that they make it possible to investigate where society gets most value for money. For example, socioeconomic calculations can be used to calculate whether the societal benefit of a new motorway on Zealand is greater or less than the societal benefit of investing in a new light railway in Aarhus. Socioeconomic analyses can also be used to identify the most effective method of solving specific problems. For example, socioeconomic analyses have been used to assess which methods are most effective at reducing Denmark’s greenhouse gas emissions.

It is important to note that socio-economic analyses are fundamentally different from, for example, government budget analyses or business analyses. Such analyses calculate the effects of new investments for a single actor and only include the effects to which can be attributed economic value on a market. In contrast, socioeconomic analyses look at the effects for society as a whole, including both the effects that can be attributed economic value on markets and those that can not, e.g. noise and air pollution.

From good relationships to good analyses
The widespread use of socioeconomic analyses in Denmark only really began to gain momentum in the mid-1990s, when its use was promoted, in particular, by the Ministry of Finance, which at that time had developed into a strong and dominant ministry. While in the 1980s, the Ministry of Finance was primarily busy making sure that public consumption was more or less in balance with government revenue, in the 1990s, the ministry began to formulate a more active agenda for its work. The Ministry of Finance no longer wanted to simply ensure that budgets were met, but also that resources were used and distributed optimally. From the perspective of the Ministry of Finance, one of the key problems was that the allocation of resources largely depended on personal relationships. For example, if a ministry had a charismatic minister or a minister with good connections with the Prime Minister, there was a high probability that the ministry would be successful in securing funding for its initiatives. From the perspective of the Ministry of Finance, there was a high risk that this allocation mechanism did not lead to the most optimal use of state resources. Therefore, the Ministry of Finance began to argue that the allocation of resources should be based on the ‘best analyses’ rather than the best personal relationships. However, analyses were not much use if their results were not comparable within an individual policy area as well as across different policy areas. Therefore, the Ministry of Finance began to promote socio-economic analyses as a common analytical ‘language’ across the entire state administration. The ministry also began to develop standardised methods to ensure the comparability of analyses across different policy areas.

Thus, the capacity of the various ministries to attract resources for their initiatives became less dependent on charismatic ministers with good connections to the Prime Minister and more dependent on their ability to demonstrate socio-economic value creation through socio-economic analyses.

Socio-economic analysis as a political battleground
In principle, socioeconomic analyses should produce a clear calculation of the effects of a particular investment or new type of regulation. In practice, however, socioeconomic analyzes always involve a large number of assumptions about the effects that are to be included and how they should be priced. These methodological assumptions have evolved into a central political battleground because they have a major influence on the outcome of the analyses.

One of the decisive methodical assumptions is the so-called discount rate. The discount rate is used to address the phenomenon of future effects being estimated to have a lower value than effects that occur here and now. Therefore, it is necessary to discount future utility effects so that they reflect their so-called present value. For this purpose, a certain discount rate is applied. For example, a discount rate of 4 per cent means that a utility effect with a value of 104 DKK, which occurs in a year, has a present value of 100 DKK. In practice, the discount rate is of decisive importance when calculating the socio-economic value of long-term investments. A high discount rate means that future utility effects will have a very low present value, while a low discount rate means that any future utility effects will have a higher present value. In Denmark, the Ministry of Finance decides the discount rate and it has often been accused of using a very high discount rate. In recent years, the Ministry has repeatedly reduced the discount rate. This means that long-term investments are calculated to have higher socio-economic value.

Another methodical battleground concerns how concrete effects should be valued. For example, in relation to valuing air pollution, one of the key discussions has been about the value of lost years of life. As individuals who are exposed to air pollution statistically die earlier than otherwise, a higher value of lost lives leads to higher socio-economic costs of air pollution, and thus higher socio-economic valuation of initiatives that reduce air pollution.

Finally, defining which effects should be included in socio-economic analyses plays a crucial role. Such delimitations are necessary as it is impossible in practice to identify and calculate all the effects of new investments or regulations.

Socioeconomic analyses of investments in cycling infrastructure are an example of how the definition of the effects can be crucial. Traditionally, socio-economic analysis in the field of transport has only focused on adverse health effects related to accidents and air pollution. When the municipality of Copenhagen developed a analytical method for cycling some years ago, they also decided to incorporate the positive health effects of physically active forms of transport. The municipality succeeded in persuading the Ministry of Transport to include these effects in their methodological manuals. Health production has since become the decisive socio-economic argument for bicycle investments as the health production derived from a single kilometre amounts to no less than 7 DKK.

Another example of how defining the effects can play a crucial role is illustrated by discussions about the inclusion of so-called broader socio-economic effects, which refer to effects that have no immediate connection to the actual investment or regulation being investigated, but which can nevertheless be classified as indirect effects. An example of broader effects is so-called tax distortion effects, which were introduced by the Ministry of Finance as a mandatory element in socioeconomic analyses in 1999. Tax distortion effects refer to the assertion that investments that are financed through taxes may have specific negative effects. This is because, for example, taxes are assumed to have negative effects on motivation to work. Therefore, higher taxes are assumed to encourage workers to reduce working hours and increase leisure time because the gain from work is reduced. Therefore, tax-funded investments are assumed to lead to lower labour supply. Based on this reasoning, the Ministry of Finance has introduced a tax distortion loss, which means that each tax-funded crown which is used for a given investment must be calculated to have a socio-economic cost of 1.2 DKK.

In response to the Ministry of Finance’s introduction of the tax distortion loss, the Ministry of Transport has, for example, attempted to introduce positive broader effects of transport investments. The Ministry argues that transport time and transport costs constitute a distortion effect on the labour market. According to the Ministry, investments that reduce transport time will thus increase labour supply as the gain from working will increase. Similarly, the Ministry argues that markets for goods and services are optimised when transport costs are reduced through investments in new infrastructure.

What the above discussion illustrates is that socio-economic analysis is not an objective tool, which merely produces neutral assessments of the effects of new investments or regulations. Socio-economic analysis is rather a complex method of calculation, where many elements need to be set and adjusted. Thus, socio-economic analysis is also a political tool because the way in which the method is set up will always suit specific interests and agendas better than others.

Next: Alternatives to cost-benefit analysis – an example