Are We Overstating the Economic Costs of Environmental Protection?

Reported expenditures for environmental protection in the U.S. are estimated to exceed $150 billion annually or about 2% of GDP. This estimate is often used as an assessment of the burden of current regulatory efforts and a standard against which the associated benefits are measured. This makes it a key statistic in the debate surrounding both current and future environmental regulation. Little is known, however, about how well reported expenditures relate to true economic cost. True economic cost depends on whether reported environmental expenditures generate incidental savings, involve uncounted burdens, or accurately reflect the total cost of environmental protection. This paper explores the relationship between reported expenditures and economic cost in a number of major manufacturing industries. Previous research has suggested that an incremental $1 of reported environmental expenditures increases total production costs by anywhere from $1 to $12, i.e., increases in reported costs probably understate the actual increase in economic cost. Surprisingly, our results suggest the reverse, that increases in reported costs may overstate the actual increase in economic cost. Our results are based a large plant-level data set for eleven four-digit SIC industries. We employ a cost-function modeling approach that involves three basic steps. First, we treat real environmental expenditures as a second output of the plant, reflecting perceived environmental abatement efforts. Second, we model the joint production of conventional output and environmental effort as a cost-minimization problem. Third, we calculate the effect of an incremental dollar of reported environmental expenditures at the plant, industry, and manufacturing sector levels. Our approach differs from previous work with similar data by considering a large number of industries, using a cost-function modeling approach, and paying particular attention to plant-specific effects. Our preferred, fixed-effects model obtains an aggregate estimate of thirteen cents in increased costs for every dollar of reported incremental pollution control expenditures, with a standard error of sixty-one cents. This single estimate, however, conceals the wide range of values observed at the industry and plant level. We also find that estimates using an alternative, random-effects model are uniformly higher. Although the higher, random-effects estimates are more consistent with previous work, we believe they are biased by omitted variables characterizing differences among plants. While further research is needed, our results suggest that previous estimates of the economic cost associated with environmental expenditures have been biased upward and that the possibility of overstatement is quite real. Key words: environmental costs, fixed-effects, translog cost model