Discounting for Public Benefit-Cost Analysis

To determine the overall value of a policy to society, the US government calculates costs and benefits both now and over time. To compare costs and benefits that occur at different times, future impacts must be reduced in value, or discounted, since future costs and benefits are less significant than those same costs and benefits today. Higher discount rates mean that future effects are considered increasingly less significant; a low discount rate means that they are close to equally significant.For nearly 20 years, the Office of Management and Budget (OMB) has advised federal agencies to use two discount rates in policy analyses: 7 percent and 3 percent. The 7 percent rate captures the return paid by private capital, reflecting effects on investment and business, and the 3 percent rate the return received by consumers, with the difference due largely to taxes. When applied to government policies that have costs today but benefits extending far into the future, the two rates can have strikingly different outcomes. Recent estimates of social cost of carbon (SCC) The social cost of carbon refers to the monetized benefits (avoided climate damages) from reducing one ton of carbon dioxide. are six to nine times higher using 3 percent rather than 7 percent, and this discrepancy can have significant, cascading effects on the benefit-cost analysis of policies. The Obama administration adopted a range of SCC estimates centered on a 3 percent discount rate. Several years later, the EPA under the Trump administration adopted SCC estimates based on both 7 and 3 discount rates with equal emphasis.In contrast, economic theory suggests converting the dollar effects on investment and business to their consumption equivalents. That way, costs and benefits (measured entirely as effects on consumers) can be discounted at the consumption rate across the board. This idea has not caught on, however, because the “shadow price” to convert capital goods into consumption equivalents and the distribution of costs and benefits (across investment versus consumption) are not always certain.In this issue brief, we show that a shadow price is no more difficult to identify than discount rates of 7 or 3 percent. Nor is it difficult to establish bounds based on whether costs and benefits accrue to capital or consumption, valuing them differently and appropriately. This approach provides more consistency than the current use of alternative 3 and 7 percent discount rates, particularly for valuing benefits far into the future.