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The treatment of taxation in the cost-benefit appraisal of transport appraisal

Executive summary

Cost-benefit analysis (CBA) is a general method for appraising projects which aims to take account of all the ways in which a project affects people, and not merely those effects that are registered in conventional financial accounts. The Department of the Environment, Transport and the Regions (DETR) uses CBA to inform its investment decisions. Trunk road schemes are routinely appraised by a specific cost-benefit procedure, designed by the Department, known as COBA. The COBA methodology includes an 'indirect tax correction factor' which is used to scale down households' valuations of non-working time. Some commentators have regarded this scaling-down as arbitrary.

This report considers how indirect taxation should be treated in CBA, and reappraises the validity of the cost-benefit methods currently used by DETR. The principal conclusion is that good CBA practice requires the use of an indirect tax correction factor. In CBA, values can be expressed in either of two units of account - at factor cost, or at market prices. The indirect tax correction factor, which represents the economy-wide average rate of indirect tax, is the means of translating from one unit of account to the other. One implication of the proper use of the indirect tax correction factor is that, if a CBA uses the factor-cost unit of account, all valuations which are measured by household's willingness to pay must be deflated. The treatment of indirect taxation in COBA is shown to represent good CBA practice, with one minor exception (the failure to deflate the component of accident costs that is valued by willingness to pay).

In addition, this report considers whether the treatment of indirect taxation in COBA is consistent with appraisal methods used in the privatized transport sector. It shows that under certain strong general assumptions (essentially, that all the benefits of private-sector projects can be captured by the firms that undertake them and that the rate of indirect tax is uniform), the use of market criteria by private firms is equivalent to the use of CBA. When indirect taxes are not uniform, whether there is consistency across sectors depends on how the differences in tax rates are interpreted. This issue is particularly significant in the case of fuel tax. If the high rate of tax on fuel is interpreted as a charge for the use of the road system, there is no inconsistency between COBA and the criteria used in the privatized sector. If this tax rate is interpreted as a historical accident, the COBA methodology is still good CBA practice, but there is an inevitable inconsistency with the criteria used in the privatized sector. If it is interpreted as a pollution tax, then the COBA methodology is valid only given the understanding that the environmental impacts of projects are considered outside the COBA framework.

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