Social discounting and the cost of public funds: problems with current global practice

Image: Алекс Арцибашев, Unsplash
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Since the early days of social discounting in the 1960s, three mutually inconsistent approaches have become embedded globally. All face significant analytical and/or practical problems. This paper reviews the issues, why divisions persist, and the contexts in which the inconsistencies may contribute significantly to misleading analysis. It concludes that there may never be any broad global consensus on best practice, but identifies aspects where limited progress may sometimes be feasible.
Key points for decision-makers
- Social discount rates (SDRs) are used to put a present value on costs and benefits that will occur at a later date. In the context of climate change policy this is very important for working out how much today’s society should invest in trying to limit the impacts of climate change in the future.
- One of the three approaches is the financial economists’ approach, which proposes that the social cost of tax-funding is revealed by the expected rate of return to private sector equity and debt financing of a similar activity. This is rarely applied.
- The other two approaches, usually described as Social Opportunity Cost (SOC) and Social Time Preference (STP), are both widely applied.
- The SOC approach derives the SDR as a weighted average of the cost of government foreign borrowing and the opportunity cost of private sector investment and consumption displaced by marginal general taxation.
- The STP approach sees taxation as fundamentally different from equity financing. For government, the discount rate is determined by society’s time preference for marginal consumption.
- The author’s analysis shows:
- The financial economists’ approach to social discounting does not recognise the profound differences between taxation and equity investment.
- The assumptions in the SOC approach lead SOC rates generally to be much too high for comparing alternative streams of public spending in cost effectiveness analysis.
- The STP approach is in principle rigorous but in practice lacks a well-established method for handling the social cost of marginal general taxation.
- Global support for all three approaches is now deeply entrenched, and likely to remain so indefinitely.
- The author’s recommendations include that general STP discount rates should not include any significant premium for income correlation in public service benefits; cost-benefit analysis (CBA) options should be initially ranked in STP discounting regimes by their value for money; SOC regimes should more widely recognise the distinction between CBA and cost effectiveness analysis; and students of public sector microeconomic appraisal techniques should be encouraged to see the continuing global inconsistences of practice in social discounting as an issue for concern.