Enduring Principles of Sound Regulatory Analysis

White House through the gates
By Mark Febrizio
November 27, 2018

Originially posted in The Regulatory Review, a publication of the Penn Program on Regulation.

This fall marks the twenty-fifth anniversary of Executive Order 12,866. The order, issued by President William Clinton and retained by every subsequent president, establishes how agencies should analyze their new regulations and have them reviewed in advance by the White House Office of Information and Regulatory Affairs (OIRA).

A recent event hosted by The George Washington University Regulatory Studies Centercommemorated the executive order. Speakers attributed the order’s longevity to the process used to draft the order and to the regulatory analysis principles it espoused. It is important today to understand these principles and why they offer a valuable guide to sound regulatory decision-making.

The section of the order entitled “Principles of Regulation” reinforce key economic insights embodied in earlier orders from Presidents Jimmy Carter and Ronald Reagan. These principles call for problem identification, assessment of alternatives, and benefit-cost analysis. They reflect sound economic thinking and ultimately underpin the rest of the regulatory review framework contained in Executive Order 12,866.

Identifying the problem that a regulation is intended to address should be the first step in crafting a rule. The regulatory philosophy expressed in section 1(a) of the order restricts agencies to issuing regulations that “are required by law, are necessary to interpret the law, or are made necessary by compelling public need.” Relatedly, section 1(b)(1) directs agencies, when identifying the problem, to articulate “the failures of private markets or public institutions that warrant new agency action” and “assess the significance of that problem.”

Absent a compelling need, regulators should be careful to avoid disrupting the market signals and incentives for innovation critical to the production of socially beneficial outcomes. The order recognizes, however, that when market forces are inadequate to produce efficient outcomes, regulation may be warranted.

A definitive guidance document on regulatory analysis from the Office of Management and Budget(OMB)—known as Circular A-4—divides market failures that could justify regulation into three main categories:

  • externalities, including public goods and common-pool resources, where the actions of one party have uncompensated effects on those not involved in the relevant market transaction;
  • market power, such as monopolies; and
  • inadequate or asymmetric information.

Although the presence of a market failure is not always a sufficient condition for government intervention, identifying a compelling public need for regulation is a necessary step in evaluating the goals and efficacy of an agency rulemaking.

After identifying the existence of a problem, section 1(a) of Executive Order 12,866 requires agencies to decide “whether and how to regulate” based on an assessment of “all costs and benefits of available regulatory alternatives, including the alternative of not regulating.” Section 1(b) spells out that these options include “alternatives to direct regulation” and “alternative forms of regulation.” Flexibility in the use of regulatory tools can “encourage innovation and growth as well as competition among regulated entities.”

Examining a wide range of feasible regulatory alternatives can function as a proxy for competition. Rather than an agency simply considering one option, the assessment of multiple alternatives helps ensure that the chosen regulatory approach better addresses the compelling public need identified. This is similar to the process by which firms compete by creating products that better serve the wants and needs of consumers. To mimic competition further, the order prioritizes “market-oriented approaches” or performance standards that offer flexibility to regulated entities and may be more adaptable to technological changes.

Relatedly, explicitly considering tradeoffs—often in terms of costs and benefits—when comparing different options is crucial to identifying the consequences of and choosing among regulatory alternatives. Comparing alternatives to a baseline—typically “the alternative of not regulating”—helps isolate the effect of the regulation. By providing a plausible counterfactual of what would occur absent government regulation, an analysis of a proposed rule demonstrates what the preferred approach would accomplish relative to feasible alternatives.

In this way, benefit-cost analysis acknowledges the reality of constraints in regulatory decision-making. Taking steps to achieve one objective always presents an opportunity cost, since it will divert resources or time away from seeking to achieve another goal. Benefit-cost analysis assists with comparing the relative values of proposals, recognizes the importance of considering what potential unintended consequences could result from an action by including indirect benefits and costs in the analysis, and shows appreciation for intertemporal differences in value by recommending usage of discount rates for comparing between different time periods.

Incremental analysis of a regulation compared to a baseline is akin to marginal analysis in economics. Calculating “incremental effects”—the “differences between successively more stringent alternatives”—permits analysts to assess the components of a regulation responsible for certain costs and benefits and aids decision-makers in evaluating the merits of individual requirements or subcomponents of a rule. As alternatives become more stringent, they might exhibit diminishing marginal returns as marginal benefits decline and marginal costs increase.

Section 1(b)(6) of Executive Order 12,866 instructs regulators about what criteria to focus on when evaluating the benefits and costs of different alternatives, which can sometimes be “difficult to quantify.” Revising the language of an earlier executive order about regulatory review, President Clinton modified one criterion that called for benefits to “outweigh” costs, to one where benefits must merely “justify” the costs of regulation. Nevertheless, Executive Order 12,866 still directs each agency to “select those approaches that maximize net benefits” and to “design its regulations in the most cost-effective manner to achieve the regulatory objective.”

Of course, practice often departs from theory. When used properly, analyses should both compare alternatives and clearly present the tradeoffs among them by using “a simple presentation of costs and benefits of alternatives that differ at the relevant margins.” But as the authors of a recent article on regulatory analysis have suggested, benefit-cost analyses are too often used as rationalizations for an agency’s preferred alternative rather than as a way to “meaningfully assess alternative policy options.”

Moreover, despite the longevity and impact of Executive Order 12,866, its provisions for retrospective review—most notably those in section 5—largely have not been successful because they do not include the incentives and institutions needed to make ex post analysis of existing regulations a regular and effective practice. Research suggests that agencies do not effectively incorporate the findings from retrospective review into proposed rulemakings. Agency noncompliance with presidential directives remains a significant barrier to effective retrospective review.

Another limitation of Executive Order 12,866 is that section 3(b) exempts independent regulatory commissions from the requirements of the order—an omission that can only be described as political in nature. There exists no inherent reason why centralized review and economic analysis cannot be implemented by independent agencies.

Still, Executive Order 12,866 has had success. And much of that success can be attributed to the economic concepts underlying its principles. Its provisions for centralized review provide an institutional setting where the core components of those principles have been consistently upheld and followed. OIRA review has proven key to inculcating an approach that has integrated economic thinking into the rulemaking process, prompting agency efforts to identify significant problems, evaluate alternatives, and assess the costs and benefits of alternative regulatory policies.