Multi-Sector Economic Modeling Results Must Be Interpreted With Caution

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CGE modeling may be the best forecasting technique for this issue, but it can produce results that are easily misinterpreted outside of the economics profession. Indeed, understanding some of the assumptions built into these models is important for how citizens and policymakers should evaluate their findings.

Let's start by looking at some of the key results, then analyze how they were generated. First, the models indicate that environmental regulatory costs taken in the aggregate do indeed reduce economic growth. The amounts vary depending on the model, but to the outside observer, not by very much. One model [19] that examined 35 industrial sectors, plus households and government activities, over the period 1974-85 (the period during which many U.S. regulations were phased in) concludes that GDP growth was reduced by about 0.2 percent annually as a result of the costs of environmental rules. (Keep in mind that this is a reduction in the rate of GDP growth, not a reduction in GDP. The economy still grows, but by slightly less per year.)

But CGE models have to predict reduced economic growth because of environmental compliance. After all, pollution control costs in these models are treated as extra expenditures necessary to produce the same level of valued output (just as they are in the conventional methodology for evaluating the short-run costs of individual regulations). The outcome is implicit in how the model is constructed. So this finding isn't necessarily a complete picture for what people and policymakers want to know about real world regulation, where a pollution control sector emerges as part of the economy, and helps to produce environmental protection, which is also an "output" with value.

Nevertheless, CGE models do reveal other consequences of environmental compliance costs that are not captured by conventional regulatory cost calculations. These concern the long run accumulation of indirect effects. One of these indirect linkages is critical to understand in order to correctly interpret the results CGE models produce. If environmental regulations impose costs that make outputs more expensive for consumers, then what economists call the "real wage" - the value in goods and services of the money people are paid for labor - declines. But because savings are linked to income, and investment is determined by savings, the lower real wage results in less capital formation. Over time this causes a further drop in real wages because the productivity of labor declines when it has less capital to work with. This may be an indirect effect, but to the American people, it would be an important one.

However, for simplicity, CGE models generally assume that household savings are the only available source of investment funds. This is what economists call a "closed economy," in which capital from outside the country cannot be tapped. Making the opposite assumption about access to international investment capital - an "open economy," like the world we live in - drastically alters the results of CGE models. In one, for instance, the total economic cost of environmental rules was 40 percent lower [20].

A second indirect consequence of environmental regulation predicted by CGE models is lower employment over time. But this is not unemployment in the way people understand the term - involuntary, regulation-induced layoffs. Because these models assume that people will work more for higher wages and vice versa, the reduced employment predicted by these models is the consequence of voluntary choices of individuals who elect to "consume" more leisure when the real wage falls, not the involuntary unemployment of concern to policymakers and the public.

One additional issue to consider in evaluating the conclusions reached by CGE models concerns the benefits of environmental policies. CGE modeling does not include benefits at all. It can't. The technique is designed to model the goods and services producing economy. It only estimates costs. The benefits of environmental regulations - improved human health and reduced environmental damage - don't fit into this framework.

Studies using CGE models take pains to remind readers that the entire benefits side of environmental regulation is not captured. But the omission of benefits has important implications. First, if this methodology is intended to measure costs and impacts of environmental rules beyond those estimated using conventional regulatory cost estimation methods designed to evaluate individual regulations, there is an obvious asymmetry with the benefits side. If indirect effects and linkages can amplify the costs of environmental protection requirements in the long run, as CGE models demonstrate, aren't there then long run benefit-related indirect consequences that should taken into account?

In fact, the benefits of environmental regulations do have long run economic implications. For example, healthier workers are more productive and miss fewer work days [21]. Enhanced labor productivity, however, is not reflected in CGE models. Healthier people also consume less medical care. If this raises their effective real income and their savings, according to the logic of CGE models this would raise the rate of private investment. A cleaner environment also enhances the productivity of some investments, and reduces the costs of others. None of these positive effects are incorporated into the long run predictions of these models. Finally, just as CGE models by definition treat all regulatory costs as non-productive, they don't define improved human health and other categories of benefits as valuable outputs. If these improvements were treated like other forms of consumption, then the costs of regulations would be seen also as producing valued outputs instead of just draining resources from other productive activities.

The upshot of all of this is that CGE models report more or less what we expected to hear - that environmental regulations do involve costs. But, as is the case with conventional measures of regulatory costs, if the benefits were incorporated, environmental protection might not reduce economic growth, properly defined, at all.

For answers to the other questions:
1. What Do We Spend on Environmental Protection?
2. Regardless of the Cost of Environmental Protection, Is It Still Money Well Spent?
3. Does Environmental Protection Cause Unemployment, Plant Closures, and Reduce International Competitiveness?
4. Does Environmental Protection Decrease U.S. Economic Growth?
6. What Conclusions Can We Draw?

Multi-Sector Economic Modeling Results Must Be Interpreted With Caution

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