Social Discount Rate

The discount rate adjusts future benefits and future opportunity costs for accurate comparison with present values. Other entries for “Discounting the Future” and “Net Present Value” explain the mathematics of discounting to net present value. The social discount rate is the discount rate that should be applied to costbenefit analysis of government investment projects generating benefits and costs over time. In economic theory, such government projects should provide public goods demanded by consumers who will not voluntarily reveal their true preferences in terms of paying for those goods. A prominent example is water resource projects for irrigation and electricity.

A simple illustration demonstrates the role and importance of the social discount rate. Suppose that a specific water resource project yields annually a 7% net benefit above opportunity cost. (In nominal dollars, $100 of cost incurred annually produces $107 of benefit.) Each year out into the future, the net present value of this 7% net benefit declines. The social discount rate determines the rate of that decline in net present value. If the social discount rate for a government project is set at 10%, then the project should not be undertaken because the net benefit of 7% annually is less than the social discount rate for the optimal allocation of the resources to be consumed as opportunity costs. If the social discount rate for a government project is set at 4%, then the project should be undertaken because the net benefit of 7% annually is greater than the social discount rate for the optimal allocation of the resources to be consumed as opportunity costs. Whether to undertake the project or not depends on the proper social discount rate.

In economic theory, the discount rate should equilibrate demand for savings by investors and supply of savings from savers. A saver does not spend his or her full income on current consumption. How much to save involves a comparison of the value of current consumption in relationship to future consumption. The discount rate is effectively a rate of compensation for deferring current consumption to future time periods.

The social discount rate selected for a government cost-benefit analysis is an important decision. It should reflect the true social opportunity cost of public investment. In economic theory, cost-benefit analysis should result in a mix of government and private market investments that maximizes overall social welfare. Government investment choices may displace private investment, reducing the future supply of private goods.

There are two schools of thought concerning selection of a social discount rate. One school argues that the private market rate of interest should be used to evaluate government projects. The argument is that, since government investment may reduce private investment, government projects should show at least the same rate of return as private projects. Otherwise government investment funds should remain in private hands. This argument assumes relatively strong capital market efficiency. In technical language, the market interest rate should equilibrate the marginal rate of time preference by savers with the marginal rate of return on private investment, and the market interest rate should be the same as the marginal rate of social time preference. The other school of thought argues that private citizens are shortsighted in evaluating present consumption of private goods relative to investment in future consumption of public goods. The marginal rate of social time preference is in effect too high. The argument is that government should exhibit greater patience than private citizens to promote the long-term welfare of society. Long-term welfare involves intergenerational equity.

...