Economics - General

Should policymakers use a social discount rate?

Discount rates are commonly used in the world of finance. Would you rather have $1 today or $1 in 5 years? Most people would prefer $1 today. For instance, if you had $1 today and put it in a bank account, it would be worth more than $1 in 5 years. Thus, when making financial decisions, firms and many individuals consider funds received today to be more valuable than those in the future.

An important question is, should we use a social discount rate? For instance, consider the impact of global warming. Averting global warming will have immediate costs but the benefits would accrue to future generations. Should we use a social discount rate to “discount” the benefits received by future generations in any cost-benefit analysis?

According to a paper by Cowan and Parfit (1992) argue that a social discount rate should not be used when making policy decisions. Their logic is as follows:

  • Argument from democracy. What if the majority of voters prefer put more weight on current cost and benefits and downweight future cost and benefits? Cowen and Parfit argue that this is not an ethical argument because the individuals adversely affected by a social discount factor–i.e., future generations–are not able to vote on the policy.
  • Argument from probability. Events that may happen in the future are less certain. Thus, one may argue that we should discount future costs and benefits because we are less certain about them. This argument, however, is more about the precisions of the cost-benefit analysis than the fact that future costs and benefits should be down-weighted. A more persuasive argument, however, may be that in the future new technologies may make it less expensive to address any costs that occur in the future. If this were the case, however, the true impact of technology on costs could be modelled explicitly rather than addressed in a more ad hoc way through the social discount rate. This is particularly true since uncertainty/impact of technology is unlikely to proceed at a steady, linear pace as would be applied using a social discount rate.
  • Argument that our successors will be better off. If the economy continues to improve over the long-run, future generations will be better off than the current. If we care about equality of outcomes, we may want to discount the benefits that accrue to future generations. However, a more practical approach for implementing this goal would be to use a Rawlsian approach with an explicit aim that benefits should be shared across generations. This could be implemented using a distributional cost effectiveness analysis (DCEA) across generations rather than using an ad hoc social discount rate.
  • Argument on excessive sacrifice. Some may claim that without a discount rate, people may be forced to sacrifice now if the return on investment for future generations is high. While that is a concern, another concern is the following. Should individuals make a small sacrifice now to average a minor catastrophe in the near future or make the same (identical) small sacrifice to avert a major catastrophe in the distant future. With a social discount rate, sacrificing now for the minor, nearer-term catastrophe may be preferred, even though most individuals would say the major catastrophe is the preferred option.
  • Argument on special relations. So far we have discussed policy issues, but individuals also make decisions about the future affecting future generations and many do so, without discounting future outcomes. In fact, many parents would seem to have a negative social discount rate if they prefer their children (and grandchildren) to have better outcomes than themselves.

Perhaps the best argument is just to implement the math.

According to a social discount rate of 5 percent, one statistical death next year counts for more than a billion deaths in four hundred years.

The paper continues with economic arguments against a social discount rate (e.g., opportunity cost, marginal productivity of capital, positive time preferences) as well as some challenges in using altruism or bequests to justify a social discount rate.

Do read the whole article.

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