The article in the url below engages in a fascinating discussion about the appropriate discount rate that governments should use to determine the costs of implementing a project today that will bear costs and benefits into the future. In other words, discount rates are important because they allow us to understand the value of those future costs (and benefits), and price them accordingly:
"Within the federal government, future costs and benefits are now 'discounted' at an annual rate of 3%—a figure used under the presidencies of both Barack Obama and Donald Trump."
This is not simply a minor bureaucratic issue because a different discount rate produces a different price and, thus, has a big influence on current policy decisions:
"Every year, the federal government makes hundreds of decisions that impose costs on the private sector in exchange for expected benefits. … For example, the Occupational Safety and Health Administration regulates guardrails in workplaces. The installation of guardrails requires upfront costs and ongoing maintenance costs, which may become significantly higher over the years. In exchange, the regulation is meant to reduce fatality rates over many years. The discount rate provides a way to turn the many years of expenses, and greater safety, into a measure of the costs and benefits that can be compared."
Of course, such tradeoffs between immediate costs and potential (largely uncertain) long-term benefits are particularly relevant for addressing issues such as climate change. Not only is this a practical policy issue, however, but a moral issue in that the pollution we emit today will have costs that are largely borne by those in the future:
"But what's the right discount rate? Ever since 2003, an obscure document known as Office of Management and Budget Circular A-4 has served as a kind of constitution for assessing the costs and benefits of regulations. It calls for a 3% rate when trading off social costs, a figure meant to reflect the long-term risk-neutral rate of interest."
As the article explains, however, this figure of 3% is not some number derived from immutable natural or economic laws, but was arbitrarily constructed in 2003 using the 'three-decade average yield on 10-year Treasury securities, after accounting for inflation.' Of course, interest rates change, which suggests the federal government's discount rate should also change:
"Repeating Circular A-4's calculation today yields a discount rate of 2%. Calculations using other interest rates confirm a comparably large decline. Measuring the long-term real rate of interest is difficult, but the evidence is clear that some value less than 3%, likely 2% or less, is warranted."
How much of an impact would moving from a discount rate of 3% to one of 2% mean?
"A discount rate of 2% instead of 3% might seem minor, but it would profoundly affect regulatory choices—sometimes leading to more aggressive measures, sometimes telling regulators to back off. With a 3% discount rate, for example, the benefits of cutting a ton of carbon emissions are $50 (according to a standard number used by the Obama administration). But with a 2% rate, the number jumps to $125. And with that $125 figure, the argument for more ambitious regulation of greenhouse gas regulations from cars, trucks, and power plants suddenly becomes more compelling."
There seems to be some indication that the current administration understands the value of updating the discount rate. The authors of the article clearly think it is a change that should have been made some time ago:
"There is an overwhelming case for using a lower discount rate to evaluate policies that provide costs and benefits over many years, even over many decades. This shift will produce less regulation in some areas and more in others. But the numbers don't lie. To protect the interests of the American people, we should listen to what bond markets are saying loud and clear."
Take care
David
David Chandler
© Sage Publications, 2020
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The Right Number
By Michael Greenstone and James H. Stock
March 6-7, 2021
The Wall Street Journal
Late Edition – Final
C5
