As Congress acts to reform business accounting in the wake of recent corporate scandals, the same vigorous review needs to be applied to how the government accounts for regulation.

When a federal agency promulgates a major regulation, it normally must publish a cost-benefit analysis. In essence, this report on the costs and benefits is an accounting of the expected effects of the regulation, similar to a business’s accounting of the net present value of a project. Agency reporting, like business reporting, enables interested parties to monitor and evaluate the performance of the agency.  However, even with its many shortcomings and gray areas, business accounting remains far more comprehensive and sophisticated than regulatory accounting.

For example, after a business evaluates a project and decides to implement it, the project leaves traces in the firm’s balance sheet: loans financing the project appear as liabilities; cash used for financing is deducted from assets; goods purchased appear as assets; and so forth. As the project progresses, the accounts are updated with additional information, giving investors a true picture of the company’s financial health. 

By contrast, consider the case of an agency implementing an environmental regulation. Unlike a business, the regulation’s effects do not appear on the agency’s balance sheet.  There is a good reason for this: the benefits and costs are not assets and liabilities in the traditional sense; they are external to the finances of the agency.  An improvement in air quality does not increase the value of the agency’s assets, while the cost of compliance incurred by factories does not decrease the agency’s assets.  The agency’s accounting statements list its finances, the property it owns, and its appropriation, but they fail to reflect the effects of the regulations.  Since the effects of an agency’s regulations are often more important than its finances, shouldn’t they be subject to an accounting as well?

A Truer Picture

One way to do this is to give each agency a “Net Benefit Account” (NBA) that would treat the benefits and costs of regulations as items on the balance sheet.  Under this system, an agency’s regulations would be treated more like how a business treats projects. The agency’s cost-benefit analysis would provide the initial accounting of a regulation’s net benefit, and the net benefits of all regulations would be aggregated in the agency’s NBA.  Like business projects, the benefits and costs would change with additional information.  Over time, an agency’s NBA would determine the monetized net benefits of the agency’s regulations (putting aside the agency’s operating expenses). And provide a snapshot of the agency’s contribution to society.

The NBA could be used as a measure of each agency’s regulatory performance, in much the same way as transparent business accounting gives investors a yardstick to value a company. Congress and the President could use this information to punish or reward agencies.  Agencies with large NBA surpluses might, as a matter of law or politics, be subject to less exacting scrutiny or rewarded with greater resources.  Agencies with a depleted NBA would lose the ability to pursue marginal projects that might be dear to the agency’s sense of mission but inconsistent with a narrow cost-benefit analysis.  In this way, agencies could be treated more like businesses, whose investors do not usually monitor every single project but only demand that the projects in the aggregate produce an adequate return.  Agencies with large NBAs would have more freedom to pursue aggressive projects whose net benefits are initially uncertain, or whose benefits cannot be easily monetized, than would agencies with small NBAs.

The NBA system is similar to the regulatory budget proposal of the late 1970s and early 1980s.  However, that proposal included the costs but not the benefits: under the proposal agencies would be given a ceiling on the aggregate cost of their regulations.  As an agency issues regulations, the costs imposed on regulated entities would be subtracted from the surplus in the agency’s budget until nothing remained.  The purpose was to discipline agencies by limiting the amount of costs they could impose on society, forcing them to focus on more efficient regulations.

Yet the regulatory budget proposal had two flaws.  First, it depended on an initial determination of the budget’s size, but no guidance was provided for how this would be done.  Second, it did not so much encourage agencies to choose efficient regulations as regulations that imposed low costs.  But the proper goal is not minimizing costs, which can be best accomplished with no regulation, but maximizing net benefits. 

The NBA system is superior on both counts: the initial budget would be zero, or some small amount, to give the agency flexibility, and the agency could build up an NBA surplus only by issuing efficient regulations. 

Making Government Work

In sum, the NBA system would have two major benefits.  First, it would allow commentators and politicians to evaluate the performance of different agencies.  Second, it would provide a reward system to agencies, encourage innovation, and result in a better use of scarce resources.  The well-run agency could build up a surplus in its NBA, allowing it to take risks with regulatory projects that might initially fail a cost-benefit analysis but, in the end, produce a net benefit for society. This is similar to how businesses are rewarded when their projects generate profits, not when their projects are expected to generate profits.

The NBA system is not a panacea.  To maintain NBA accounts, agencies would need to gather and report a great deal of information.  Also, the system requires Congressional and presidential discipline to avoid rescuing agencies that deplete their budgets or interfering with agencies that have earned the right to flexibility because of their bulging NBA’s.  But none of this is new: cost-benefit analyses already performed by agencies generate most of the information needed for the NBA, and governmental accounting in other areas, while not perfect, has proven to be a valuable tool for disciplining and focusing government behavior.

Fixing our corporate accounting system is necessary to restore investor confidence. Likewise, changing our regulatory accounting methods would go a long way to instilling confidence in a responsive, effective government.

Eric Posner is a Professor of Law at the University of Chicago Law School.