Social discount rate

The social discount rate (SDR) is a crucial concept within public finance and cost-benefit analysis, primarily used by governments and public agencies to evaluate the long-term societal value of projects and policies. It represents the rate at which society values present benefits and costs relative to future benefits and costs⁷³. Unlike a private discount rate used by individuals or corporations, the social discount rate accounts for broader societal considerations, including intergenerational equity and the collective well-being of a population over extended periods⁷².

History and Origin

The conceptual foundations of the social discount rate emerged from early economic theories on intertemporal choice and resource allocation. Pioneers like Arthur Pigou in the early 20th century highlighted the distinction between private and social valuations of the future, recognizing that individuals might be "myopic" compared to society's longer-term interests. A pivotal contribution came from Frank Ramsey, who in 1928, formulated a rule for optimal savings that implicitly included elements now central to the social discount rate⁷⁰, ⁷¹. His work laid theoretical groundwork for understanding how a society might balance present consumption against future economic growth and well-being⁶⁹.

Over time, the application of social discounting became formalized in government policy analysis. For instance, in the United States, the Office of Management and Budget (OMB) provides guidance, such as Circular A-4, on how federal agencies should conduct cost-benefit analysis and determine appropriate discount rates for public projects⁶⁷, ⁶⁸. These guidelines have evolved to reflect ongoing academic debate and changing economic realities⁶⁴, ⁶⁵, ⁶⁶.

Key Takeaways

• The social discount rate (SDR) is a measure used in cost-benefit analysis for public projects to evaluate the present value of future costs and benefits from a societal perspective⁶³.
• It accounts for factors such as society's pure time preference and the diminishing marginal utility of consumption as society becomes wealthier over time⁶¹, ⁶².
• A higher SDR places less weight on future outcomes, potentially favoring short-term projects, while a lower SDR gives more weight to the long-term, which can be crucial for projects with delayed benefits like environmental protection⁵⁹, ⁶⁰.
• The choice of social discount rate is highly influential in determining whether a public project or policy is deemed economically viable, particularly for initiatives with very long time horizons, such as climate change mitigation⁵⁶, ⁵⁷, ⁵⁸.
• Debates often arise over the ethical implications of the social discount rate, especially concerning intergenerational equity and how much the welfare of future generations should be discounted⁵⁴, ⁵⁵.

Formula and Calculation

The most common theoretical framework for calculating the social discount rate is derived from the Ramsey rule, often expressed as:

Where:

• ( s ) = the social discount rate
• ( \rho ) (rho) = the pure rate of time preference, representing society's impatience or the ethical judgment about discounting future utility simply because it is in the future. A ( \rho ) of zero implies equal weight on current and future well-being, all else being equal⁵¹, ⁵², ⁵³.
• ( \mu ) (mu) = the elasticity of marginal utility of consumption, which reflects how much the welfare derived from an additional unit of consumption decreases as overall consumption increases (i.e., diminishing marginal utility)⁴⁹, ⁵⁰.
• ( g ) = the expected rate of economic growth per capita. As societies are generally expected to become wealthier over time, a dollar received in the future might provide less additional utility than a dollar received today when society is relatively poorer⁴⁷, ⁴⁸.

This formula suggests that the social discount rate is composed of two main elements: the pure rate of time preference (an ethical choice) and a component reflecting expected future wealth and the diminishing value of additional wealth.

Interpreting the Social Discount Rate

Interpreting the social discount rate involves understanding its implications for societal decision-making over time. A positive social discount rate means that a unit of benefit (or cost) received in the future is valued less than the same unit received today when converted to its present value⁴⁶.

A higher social discount rate implies a greater preference for immediate benefits and a diminished valuation of long-term outcomes. This can make projects with upfront costs and distant benefits, such as environmental protection or long-term infrastructure, appear less appealing in a net present value analysis⁴⁴, ⁴⁵. Conversely, a lower social discount rate assigns greater weight to future consequences, promoting investments that yield benefits far into the future⁴², ⁴³.

The selection of the rate often reflects societal values concerning future generations, sustainable development, and the extent to which current generations should make sacrifices for future well-being⁴¹.

Hypothetical Example

Consider a government deciding whether to invest in a major renewable energy project that costs $10 billion today but is projected to yield environmental and economic benefits equivalent to $15 billion in real terms 50 years from now.

If the government uses a social discount rate of 5%, the future benefits would be discounted significantly:

In this scenario, the project's net present value would be ( $1.299 \text{ billion} - $10 \text{ billion} = -$8.701 \text{ billion} ), making it appear financially unviable from a present-value perspective, despite larger nominal future benefits.

However, if a lower social discount rate of 2% is applied, reflecting a stronger societal commitment to long-term environmental outcomes:

Here, the project's net present value would be ( $5.595 \text{ billion} - $10 \text{ billion} = -$4.405 \text{ billion} ). While still negative in this simplified example, the significantly higher present value of benefits would suggest it is closer to viability and might be considered acceptable if non-monetized benefits are substantial or if the society prioritizes long-term gains over short-term financial returns.

Practical Applications

The social discount rate is a fundamental tool in various areas of public policy and economic planning:

• Public Policy Evaluation: Governments use the social discount rate in cost-benefit analysis to evaluate a wide range of proposed regulations, infrastructure projects (like highways or public transit), and social programs⁴⁰. This ensures that decisions consider long-term societal impacts.
• Environmental and Climate Change Policy: It is particularly critical for assessing policies aimed at mitigating climate change or preserving natural resources. Since the benefits of such policies (e.g., reduced future disaster costs, cleaner air) often accrue over many decades or centuries, the chosen social discount rate profoundly impacts how worthwhile these investments appear today³⁸, ³⁹. For example, the OECD has published extensive analysis on why social discount rates matter for climate policy decisions OECD report on climate policy.
• Health and Safety Regulations: Agencies evaluating public health interventions or safety standards apply the social discount rate to quantify the present value of future lives saved or illnesses avoided³⁷.
• Long-term Planning: The social discount rate informs decisions on large-scale, generational projects that extend beyond typical investment horizons, influencing resource allocation for future generations³⁵, ³⁶. The U.S. Office of Management and Budget (OMB) Circular A-4 provides specific guidelines for federal agencies on the use of discount rates in regulatory analysis, emphasizing their role in comparing costs and benefits over time OMB Circular A-4.

Limitations and Criticisms

Despite its widespread use, the social discount rate is subject to significant debate and criticism:

• Ethical Considerations: A primary critique revolves around the ethical implications of discounting future well-being. Some argue that a positive pure rate of time preference is "ethically indefensible" because it implies that the welfare of future generations is inherently less valuable simply because they are born later³³, ³⁴. This can lead to policies that appear to neglect long-term societal costs or benefits. Nicholas Kristof, in a New York Times opinion piece, posed the question "Should We Discount the Future?", highlighting the moral dimensions of this economic tool New York Times opinion piece.
• Uncertainty and Declining Rates: The choice of a constant social discount rate over very long periods, especially for projects like climate change, is questioned due to inherent uncertainties about future economic growth, technological advancements, and catastrophic risks³⁰, ³¹, ³². Some economists advocate for declining social discount rates over time, which would give more weight to the distant future²⁷, ²⁸, ²⁹.
• Measurement Challenges: Empirically determining the appropriate values for parameters like the pure rate of time preference and the elasticity of marginal utility of consumption can be difficult and subjective²⁵, ²⁶. Different methodologies and expert opinions can lead to vastly different recommended rates, impacting policy outcomes dramatically²², ²³, ²⁴.
• Opportunity Cost vs. Time Preference: There is ongoing debate about whether the social discount rate should primarily reflect society's opportunity cost of capital (i.e., the returns that could be earned in the private sector) or society's time preference for consumption¹⁹, ²⁰, ²¹. Using a higher rate based on the opportunity cost of capital might undervalue public goods with non-market benefits¹⁸.
• Risk Premium: While private discount rates often include a risk premium, the inclusion of a risk premium in the social discount rate is debated, especially for projects where risks are aggregate or not diversifiable in the same way as private investments¹⁵, ¹⁶, ¹⁷.

Social Discount Rate vs. Private Discount Rate

The distinction between the social discount rate and a private discount rate is fundamental in finance and economics. While both are used to calculate the present value of future cash flows, their perspectives, components, and applications differ significantly.

The main point of confusion often arises because both rates involve discounting future values. However, the private discount rate primarily reflects the financial opportunity cost of capital and individual impatience or risk, while the social discount rate incorporates broader ethical and welfare considerations for society as a whole¹³, ¹⁴. A private discount rate might be higher due to specific project risks or market conditions, whereas the social rate aims to reflect how society collectively values future well-being, often leading to lower rates for long-term projects¹¹, ¹².

FAQs

Why is the social discount rate important?

The social discount rate is important because it dictates how much weight is given to future costs and benefits when evaluating public projects and policies. A small change in this rate can significantly alter the perceived economic viability of long-term investments, such as those related to climate change or public health, which have effects far into the future value⁸, ⁹, ¹⁰. It helps policymakers make informed decisions that balance current needs with the well-being of future generations.

What is "pure time preference" in the context of social discounting?

Pure time preference refers to the idea that society, or individuals within it, might inherently prefer benefits sooner rather than later, even if there's no change in wealth or risk⁵, ⁶, ⁷. In social discounting, it represents an ethical choice about whether to value the well-being of people alive today more than the well-being of people in the future, simply due to their temporal distance⁴. This is one of the most debated components of the social discount rate.

How does economic growth affect the social discount rate?

Economic growth typically leads to a higher social discount rate. The reasoning is that future generations are expected to be wealthier than the current generation³. Due to the principle of diminishing marginal utility—meaning that an additional unit of consumption provides less satisfaction when one is already rich—a dollar in the future for a richer society might be considered less valuable than a dollar today for a relatively poorer society. Th¹, ²erefore, the prospect of future wealth justifies discounting future benefits, as those benefits will accrue to a wealthier population.