Discounting Choices

Continuing our discussion of the role that science should play in policy-making brings us to two recent economics papers published about the proper discount rate to use in climate change policy.  While some might argue about whether economics is a science, it undeniably has important contributions to make to policy decisions around what should be done about climate change.  It also faces the same problem that the physical sciences, whose progress is based on dissent, face when trying to contribute to policy discussions.  That is, there are aspects of economics that reasonable people can reasonably disagree about.  This is particularly true when it comes to the choice of a discount rate.

The discount rate, in its simplest incarnation, is simply a measure of how much one cares about future generations.  The higher the discount rate the less you care about the future relative to the present.  When taught in economics 101 it is often framed as a choice between $100 today or some larger amount a year in the future.  A high discount rate implies that the amount received a year from now would have to be large to induce one to accept that instead of $100 today.  If you could be convinced to forego the $100 today for $110 a year from now that would imply a 10% discount rate.  Requiring $120 in a year instead would imply a 20% discount rate and so on.

It should be clear then that everyone’s discount rate will be slightly different.  As Geoffery Heal points out, the choice of discount rate is “a primitive ethical judgment – it captures how much one cares about the welfare of future generations.  As such, it is a parameter that is unique to each person; much like the moral legitimacy of the death penalty or abortion rights.”  In other words, it is something that economics as a profession is not well-suited to determine on its own. Instead, it lies in the domain of politics, where the voices of an entire populace are represented, rather than the opinions of a few economic experts.

At least that was the case until two recently published papers.  The first of these papers, by Geoffery Heal and Antony Millner, argues that even if there are as many different legitimate discount rates as there are members of a population, these different rates can be combined into a representative rate using a social choice method.  This approach considers all of the different possible discount rates in a population and provides a formal mechanism to weight each of these rates and arrive at an efficient representative rate.  This rate declines over time and eventually equals the lowest rate in the population.

The second paper, by a virtual who’s who of environmental economists including one Nobel laureate, argues that there are significant advantages to using this type of declining discount rate in policy analysis.  While their result is driven by future uncertainty – rather than weighting a population’s choices of the discount rate – the end result is similar.  In both cases, the suggestion is that policy-makers utilize a declining discount rate.  This is very different, as the authors of the second paper point out, from the constant rate used by governments in the United States but similar to those used in the United Kingdom and France.

While this entire discussion may seem academic it does have important policy implications.  One need look no further than the differences between the recommendations made by the Stern Report and those made by William Nordhaus with regard to climate change mitigation to see why the choice of discount rates matter.  Nordhaus chooses a discount rate only 1.4% higher than Stern but, as a result, ends up with a social cost of carbon 10x less.  Thus, he suggests much less in the way of mitigation efforts.

While neither of these new papers has proposed the value to use for the discount rate in public policy analysis, they do provide formal mechanisms for arriving at a discount rate that is representative of the population.  In doing so they have taken a step towards removing one major obstacle in formulating climate change policy: choosing the right discount rate.  They’ve also provided an example of how non-political academic disciplines can help resolve questions which have no objectively correct answer. Hopefully there are similar solutions available for the other challenges we face that lack objective solutions.

 

Image Credit: WikiWitch via Wikimedia Commons

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