ARCHIVED - User Charging in the Federal Government - A Background Document

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Appendix A - Guidelines for User Charging in the Public Sector

Introduction

This appendix sets out a decision-tree approach to establishing charges for goods and services in situations where government has a public policy goal. It is intended to assist public sector managers in deciding which goods and services to charge for, how best to charge, and which factors to take into account when establishing prices. Having clear and rational arguments based on economic theory will help managers facilitate dialogue with user groups and permit discussion to focus on issue resolution. This guide is not a substitute for consultations but should help managers consult with stakeholders.

Approach

The decision-tree approach, as illustrated is Figure 1, is intended to synthesize the material presented in this paper. It is an attempt to simplify a complex decision-making process; note that this relatively simple model does not provide a "one size fits all" charging formula. Each case requires careful consideration -- the decision tree helps to illustrate the process. The following text explains each point along the decision tree.

A. Is there a public policy goal?

The first question is whether government involvement is justified on grounds of public policy. A clear and relevant public policy goal is the foundation for any government intervention. A straightforward answer is particularly important in the current environment of fiscal restraint and government downsizing. If the answer is YES, it is appropriate to consider user charging. If the answer is NO, it may be appropriate to cease the activity in question or devolve it.

 

B. What is the nature of government involvement?

At this stage it is necessary to determine the nature of government involvement. This initial distinction is instrumental in the charging decision. There are three paths that can be considered:

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• Providing Goods and Services
  Directly
  Indirectly
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• Managing Externalities
• Granting Rights and Privileges

 The three separate paths may mask some overlap and intersection. The distinction, while artificial in part, helps to organize thoughts and keep the steps clear and transparent. This should simplify decision making.

Providing Goods and Services

C. What type of provision is appropriate?

Once the government has chosen to provide goods and services, it must decide the appropriate means doing so:

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• directly through government production of the good or service; or
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• indirectly through partnership with the private sector. (This should be considered where there is a compelling case to produce or procure the good or service in the private sector, e.g., private sector provision, public/private partnerships, etc.)

The government must then determine the publicness of the good or service. Publicness, as discussed in Section 2, refers to the extent to which a government activity is a purely public good or service. A purely public good or service can be described in two dimensions:

At the other end of the spectrum, purely private goods and services are rival in consumption and completely excludable. "Mixed" goods and services display different degrees of rivalness and excludability.

D. What is the extent of rivalness?

Goods and services that are candidates for user charging should be compared to other public sector activities to determine their innate rivalness. See Box 2 for examples of public sector activities ranked on the publicness scale. The rationale and implication of this exercise are that activities with a higher (or lower) degree of rivalness are more (or less) desirable candidates for charging on efficiency grounds as compared to activities that are more public in nature. With mixed goods and services, there is a case for partial user charging.

E. What is the extent of excludability?

The manager should identify the potential to exclude users who are not prepared to pay. Identifying the level/cost of excludability of the goods or services helps determine whether charging is possible. The more (or less) excludable the good or service the more (or less) likely it is the government can charge successfully for its use.

 

 

F. Is the government the sole provider of mandatory or regulatory service?

Government may play an important role in regulatory activities or in providing mandatory services. This situation presents a unique challenge to charging since it may not at first be evident why users of these services should be required to pay since significant public benefits are conferred. However, user charges can be justified if a direct economic benefit accrues to the user. These benefits include market stability, improved marketability, consumer confidence and reduced legal liability for users.

It will be important to ensure that users of mandatory services are consulted and charges established only following open dialogue between user groups and government. This "user pay, user say" approach to managing these programs could not exist if users were not charged for the service. Appropriate institutional controls will ensure due process.

 

G. Is there a large capital investment involved?

The nature of the production process can affect the government's ability to impose user charges for some goods and services. This is particularly true where production requires a large, up-front capital investment or other sunk costs. A high initial investment and a decreasing unit cost as the quantity of output increases normally imply a natural monopoly. Marginal cost pricing will not allow full cost recovery.

While these issues are complex and should be dealt with case by case, the general charging strategy should be based on recovering average variable costs (roughly equivalent to operations and maintenance costs) while defraying all or part of sunk costs through appropriations. (Refer to Section 2 of the main report for further discussion.)

H. Is market information available?

Once the characteristics and appropriateness of applying user charges are identified, the next step is for the manager to gather as much information, i.e., on costs and usage patterns, and develop a sound understanding of the data. The following set of issues draws from Section 3 of this report. The nature of the information available in part determines the appropriate technique.

 

Calculating Costs

The costs of determining optimal pricing strategies are economic costs and not simple accounting costs. While accounting costs are defined as those direct and indirect costs relating to a particular activity, economic costs are defined as the accounting costs plus those costs associated with the opportunities that are forgone by not putting resources to their highest-valued use. Ideally, the manager should account for both. These costs should be determined for varying levels of service.

While it is very important to account for all related economic costs, it is also imperative that any deviations from outright accounting costs be justified. Transparency and a clear outline of all procedural rules preserve the integrity of all costing exercises.

Calculation of economic costs, particularly the opportunity cost element, can be high. A pragmatic approach might be to identify the likely divergence between economic and accounting costs. Then, if in the manager's judgement the difference is small or the impact on user charging minimal, accounting costs may be an appropriate proxy. If the difference or the cost impact is large, economic costs should be estimated.

Average and marginal costs can be estimated from the above cost data. Average cost is the total cost associated with a given level of output divided by the number of units supplied -- sometimes called unit costs. Marginal cost is the change in costs for a unit change in output. These costs should be determined for different levels of production.

Understanding the Nature of Demand

It is also important for managers to understand and identify the usage patterns of the service in question. Usage patterns refer to changes in demand for a service over a short period of time, such as a day or a season. Identifying usage patterns will help managers assess whether user charges should include discriminatory or congestion-related pricing. (Referto Section 3, Approximations to Efficiency.)

After considering the above factors, the best pricing strategy will be based on equating estimated demand and short-run marginal costs, thus yielding a market price. If estimating demand and costs is not possible or if usage patterns are an issue, reasonable approximations are appropriate. These might include average incremental cost pricing, multi-part tariffs, Ramsey pricing, etc. (Refer to Section 3, Approximations to Efficiency, for further detail on alternative pricing methods and their application.)

Managing Externalities

Government may manage externalities. Externalities are impacts of an economic transaction that affect individuals not participating in the transaction itself. They are in addition to the "private" costs and benefits of the transaction and are not captured in market prices.

I. What type of externalities exist?

There are two types of externalities. Activities that generate external benefits are deemed positive externalities (e.g., health education, vaccination, drug testing, etc.), and those that lead to external costs are deemed negative externalities (e.g., congestion, cigarette smoke, pollution, etc.).

- Positive Externalities

An important argument for public sector involvement in the management of externalities is to support the creation of positive externalities. For example, government may create positive externalities by providing subsidies to producers. A classic example is government funding for research and development by universities and industry. The government provides these funds so that society at large benefits from the knowledge generated by these activities.

- Negative Externalities

The public sector often plays a role in managing negative externalities by applying charges or some other compliance mechanism. These controls can modify behaviour as well as recover appropriate funds for reversing or diminishing the impact of negative externalities. For example, in some jurisdictions, tradable pollution permits are sold to control the level of pollution. In this case, optimal pricing of the externality should "internalize" its social cost for producers. They take responsibility for these costs in addition to their private costs of production. (Refer to Section 3, Pricing Externalities, for further detail on specific pricing methods and their applications.)

Granting Rights and Privileges

In certain cases, the government has the authority to grant a right or privilege to a private beneficiary. There are two important aspects to user charging: the cost of administering access and economic rents. The starting point for determining the charge for limited rights and privileges (e.g., permits, licences, etc.) is the cost to government of making that right or privilege available. These costs may include inspection, management and administrative expenses.

Economic rents should be taken into account in setting user charges. This will promote efficient use of the resource by the purchaser since the charge reflects the value of the economic rents. Furthermore, by better managing access to rights and privileges, the government can claim a fair share of the economic rents for the benefit of the public. Market mechanisms such as auctions will help establish the value of economic rents and thus, appropriate user charges. (Refer to Section 3, Pricing "Rents" -- A Market-value Approach, for further detail on specific pricing methods and their applications.)

Conclusion

There are administrative costs associated with user charging. Managers and program designers must judge the extent to which these costs can be absorbed. Administrative costs may limit the extent or design of user charges, and at times this may require a pragmatic trade-off between economic and administrative efficiency.

Private sector charging is a dynamic process that reflects fluid market conditions. Efficient user charging in the public sector should also be a dynamic process and charges will have to adjust to change. The guidelines outlined above permit user charges to evolve in changing market conditions.

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Appendix B - A Special Note on Earmarking

Experience around the world suggests that widespread earmarking has seldom been beneficial. This is due to the cost and difficulty of controlling many separate funds and to the inappropriateness of many of the political linkages established between particular revenues and expenditures. Moreover, it is more difficult to run a coherent fiscal policy if it is not possible to determine in advance the level of some major expenditures and revenues. For these reasons, earmarking and formal linking of revenues to expenditures have traditionally been avoided in Canada.

Nonetheless, an important aspect of the efficiency argument for user charges - and the political acceptability of such charges -- is the extent to which the prices charged finance the services for which they are levied. Recently, interest in earmarking has revived somewhat in Canada. For example, the Royal Commission on National Passenger Transportation, the Government and Competitiveness Project, and the Ontario Fair Tax Commission have all recently produced survey papers on this subject. Some see it as a way to reduce taxpayer resistance to higher taxes. Others see it as a way to achieve greater accountability with respect to how tax dollars are spent. Charging for publicly provided services is important. To the extent that the benefits of such services are attributable to individuals, businesses, or small groups, the appropriate policy is to charge the marginal cost price and to earmark the revenues to the service that generated them. This is the only way the correct amounts and types of service will be provided to the people willing to pay for them.

For this reason, whenever there is a strong "benefit" linkage between the tax (or charge) levied and the expenditure financed, revenues should flow into a special fund and be the primary source of funding for that expenditure. A larger amount in the special fund will generate a larger level of expenditure in the earmarked area, more or less on a dollar-for-dollar basis. With this system, as noted earlier, the marginal expenditure decision is in the hands of the taxpayer-voter. Provided there is a logical connection between the source of the funds and the services purchased with them -- and no overriding reason to sever this connection -- strong earmarking offers a desirable method of financing. In budgetary terms, establishing special "quasi-private," self-financing operating agencies is one way to implement this logic. As noted earlier, if such devices work well they may turn out to be way stations on the road to full outsourcing or commercialization.

The key feature of benefit-related earmarking is that it reveals social preferences for public services and sends a clear signal to public sector managers. Under these conditions, earmarking assists in providing an efficient level of public goods to households. The supply of public goods will automatically adjust to the demand for them. To the extent earmarking implements the benefit principle of taxation, it solves the two most important problems in public finance: deciding how much of a public good to supply and who should pay for it. Little more can be asked of any fiscal institution.

Of course, for earmarking to be fair and consistent with public policy purposes, it must be restricted to where it works best. Both earmarking and user charges are appropriate only when three conditions are met:

When these conditions hold, it is fair and efficient to charge each taxpayer in accordance with the marginal cost of providing the service in question. Even when transaction costs make assessing user charges impractical, earmarked benefit taxes may provide a useful approximation. In the case of the earmarked gas excise tax, for example, road users as a group are made to pay for some of the road services they consume. Such arguments are even stronger when the link between pricing and investment is considered. If no user charge were assessed, consumers would presumably demand more of a service and politicians would face strong political pressures to supply the amount demanded.

Earmarking, like user charge financing, can be applied well or poorly. Neither has much economic rationale when the benefit link between tax and expenditure is completely severed. When a revenue source is earmarked and the expenditure function totally unrelated, spending is not based on demand for the service but on an arbitrary and irrational funding procedure. Under such conditions there is certain to be either "too much" or "too little" of the public service. In the absence of a clear benefit link between user charges and the service provided, earmarking may well result in an efficiency loss rather than an efficiency gain compared to general fund financing.

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Selected Annotated References

Introductory Note

The following brief list of references provides more information on the arguments for applying prices to a wide range of public sector activities. It also covers the limitations of pricing and the political and administrative difficulties of introducing charges for services previously supplied "free." Some items also contain extensive discussions of the principles of designing public prices and user charges as well as examples of applications of these principles.

One of the lessons to be derived from this literature is that, while general principles help determine what should be priced and what general form the prices should take, specific problems require specific solutions. Those seeking guidance in designing and implementing pricing policy for particular activities must refer to specialized literature. It is impractical to review such literature here, but many of the items listed contain extensive references to relevant material.

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Selected References

Arnott, R. et al., eds. Public Economics: Selected Papers by William. Cambridge: Cambridge University Press, 1994. Fundamental papers on theory and practice of public pricing by one of pioneers in field: well worth reading for combination of analytical power and close attention to practical detail.

Bailey, A.R. and D.G. Hull. The Way Out: A More Revenue Dependent Public Sector and How it Might Revitalize the Process of Governing. Montreal: Institute for Research on Public Policy, 1980. Review of Canadian federal policy on user charges in the 1970s; recommends much wider use of full-cost pricing and "revenue-dependency" for public services. Some of the points in this survey are still relevant.

Bennathan, E. and A.A. Walters. Port Pricing and Investment Policy for Developing Countries. New York: Oxford University Press, 1979. Excellent example of application of marginal cost pricing approach to an important area of federal transportation policy. For a somewhat different approach, see Haritos and Hildebrand.

Bird, R.M. Charging for Public Services: A New Look at an Old Idea. Toronto: Canadian Tax Foundation, 1976. Broad-ranging overview of scope for, design of, and limitations on the use of charges, public pricing, and earmarking in most areas of Canadian public finance.

Bos, D. "Public Sector Pricing," in A.J. Auerbach and M. Feldstein, eds., Handbook of Public Economics, Vol. I. Amsterdam: North-Holland, 1985. Comprehensive and rigorous survey of theoretical literature on public pricing.

Congressional Budget Office. The Growth of Federal User Charges. Washington, 1993. Recent survey of US practice. Useful background for anyone referring to extensive US-based literature on pricing of particular public sector activities.

Haritos, Z. and D. Hildebrand. Civil Marine Infrastructure: Annual Costs and Revenues, 1955-1969. Ottawa: Canadian Transport Commission, 1973. One of a series of CTC studies in the early 1970s -- others covered air, rail, and road transport -- which analyse transport infrastructure costs in detail While out of date, this attempt to provide the basis for applying the AIC (average incremental cost) pricing policy (set out in detail in Z. Haritos, Rational Road Pricing Policies in Canada. Ottawa: Canadian Transport Commission, 1973) remains of interest.

Johansson, P.O. An Introduction to Modern Welfare Economics. Cambridge: Cambridge University Press, 1991. A useful brief introduction, covering a variety of relevant topics. See in particular Chapter 8 for various practical approaches to preference revelation regarding externalities and public goods e.g., by the use of carefully designed surveys and such indirect measures as travel costs.

McAfee, R.P. and J. McMillan. "Analysing the Airwaves Auction," Journal of Economic Perspectives, Winter 1996. An account of important recent experience in applying advanced theoretical ideas to auctioning part of electromagnetic spectrum; helpful brief introduction to uses and limitations of auction approach. References to underlying (and often difficult) theoretical literature.

Meier, G.M., ed. Public Pricing for Development Management. Baltimore: Published for the Economic Development Institute of the World Bank by Johns Hopkins University Press, 1983. A useful collection of readings on the subject of public pricing aimed at managers in developing countries but relevant more generally.

Mushkin, S. ed. Public Prices for Public Products. Washington: The Urban Institute, 1972. Useful review of theory of public pricing and applications in a variety of areas in the US. A bit dated but still unmatched in scope in American context. Similar in this respect to Seldon (on UK) and Bird (on Canada).

Portney, P. "The Contingent Valuation Debate: Why Economists Should Care," Journal of Economic Perspectives, Fall 1994. A good introduction to the subject. See also the accompanying papers by Hanemann and Diamond and Hausman, particularly the sceptical view taken in the latter.

Seldon, A. Charge. London: Temple Smith, 1977. A somewhat polemic but still useful review of the arguments for charging prices in context of many public sector activities in the UK

Sproule-Jones, M. "User Fees," in A. M. Maslove, ed., Taxes as Instruments of Public Policy. Toronto: University of Toronto Press, 1994. A brief recent review of scope for user charges in Canada, with emphasis on provincial-local public sector activities.

Thirsk, W.R. and R.M. Bird. "Earmarked Taxes in Ontario: Solution or Problem?", in A.M. Maslove, ed., Taxing and Spending: Issues of Process. Toronto: University of Toronto Press, 1994. Comprehensive review of case for earmarking user charges and "user-charge-like" taxes, with emphasis on provincial-local public sector activities.

Wagner, R.E., ed. Charging for Government: User Charges and Earmarked Taxes in Principle and Practice. London and New York: Routledge, 1991. Useful collection of mostly theoretical papers on user charges and earmarked taxes; special emphasis on "public choice" approach.

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Endnote

¹ For distributional reasons, public utilities sometimes introduce "lifeline" block pricing systems, under which an initial small block of service (e.g. so many kilowatts of power) is priced much below cost. But this approach seems unlikely to be relevant in the federal public sector.

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