On the Formulation of the Alternative Scenario in Cost-Benefit Analysis

In this note we discuss how a cost–benefit analysis could be formulated in a second-best world where lump-sum taxation is not available. The question is how the government’s budget is balanced. Different options are available. A value added tax or an income tax or a profit tax could be adjusted so as to balance the budget. Alternatively, expenditures on public or private goods are displaced. A variation occurs if the government has a policy target. For example, a certain number of hectares of valuable forest areas should be preserved. Then, the central part of a cost–benefit analysis is to compare the costeffectiveness of different policy instruments that can be used to achieve the target. However, there are also deadweight losses provided there are distortionary taxes. Such considerations also opens up for a broader formulation of the valuation question in willingness-to-pay experiments than one based on lump-sum taxation.