One textbook on cost-benefit analysis says that discounting is not controversial in cost-benefit analysis, but that the rate at which we should discount is. While there are still some fringe voices among cost-benefit researchers who argue for a 0% discount rate, the point is well-taken that most agree discounting is necessary. The point is also well-taken that researchers have not coalesced around a “right” rate to discount at.
Part of this is the nature of the discount rate. The purpose of discounting in cost-benefit analysis is to capture differences in time preference for income for society. If you were offered $100 today or $100 in a year, you’d probably take $100 today. You would need to be offered $103, $105, or maybe even $111 in a year for it to be worth it for you to hold out. Because of uncertainty about the future, a certain amount of income today is widely agreed to be preferable to income later, all else being equal.
A discount rate is ultimately supposed to be about adjusting for how much society prefers current income to future income. This is a hard thing to account for and depends on which society we’re talking about, how they think about income, and the quality of the income (the latter of which can vary significantly in cost-benefit analysis due to the range of outcomes that are monetized).
So if we are going to discount future costs and benefits in a cost-benefit analysis, how do we go about choosing the correct discount rate? Despite the controversy over which discount rate to choose, analysts have coalesced around a few specific recommendations.
3% Discount Rate - The “Consumption Rate”
If you put a gun to my head and asked me what the best discount rate was for any given cost-benefit analysis, I’d have to turn to the 3% discount rate. In a 2021 Resources for the Future issue brief, researchers Qingran Li and William A. Pizer refer to this discount rate as the “consumption rate.”
Li and Pizer say that the 3% discount rate comes from the after-tax earnings on investments. The logic here is that households (who they say are considered the “ultimate authority on ‘welfare value’”) will not favor government policies that yield lower returns than they could receive in the private market.
The 3% discount rate is the rate I have generally seen most and is favored by many because of its focus specifically on time preference and its adjustment downward from the 7% figure due to taxes being included. But don’t count 7% out yet.
7% Discount Rate - The “Investment Rate”
While 3% is the rate I tend to see, it only holds a slight edge over the 7% discount rate, which is based on the average long-term rate of return on a mix of corporate and noncorporate assets. This is the rate of return before taxes, but is still generally considered as a leading discount rate for conducting cost-benefit analysis.
The federal Circular A-94 guidance for discount rates for federal agencies endorses a 7 percent rate for the above reasons, though suggests that higher rates should be used in circumstances where purely business income will be at stake for example since costs will likely be higher due to business’s steeper time sensitivity.
11% - The Developing CountRy Rate
A 2015 technical note from the Inter-American Development Bank says that “In general, developed countries tend to apply lower rates (3-7%) than developing countries (8-15%), although in most cases these rates have been reduced in recent years.” Discount rates are just as controversial in developing countries as they are in developed countries, but traditionally have tended to land around 11%.
More recent reports have recommended lower discount rates in developing country contexts. These are often in light of evaluating the costs and benefits of interventions to mitigate climate change, which tend to front load costs in favor of generating long-term benefits. But there is another way to tackle this problem.
Variable Rate - Accounting for Future Generations
A common approach to dealing with the problem of costs and benefits incurred far in the future is to adopt a variable discount rate, or a discount rate that changes over time. An argument in favor of this approach is that applying a steady discount rate generations into the future privileges the time preference of people in the present over those in the future.
This approach is endorsed by the UK Green Book, the official guidance document from the United Kingdom’s Treasury on how to conduct cost-benefit analysis and other economic analysis. The Green Book recommends a 3.5% discount rate that then declines over the long term.
Sensitivity Analysis
Because of the range of different possible discount rates, my recommendation is to incorporate discounting into your sensitivity analysis. Conduct a partial sensitivity analysis of 3% and 7% discount rates to see how using alternate discount rates impact your results. If costs fall on business earnings, try higher rates to see what happens. Then vary sensitivity analysis in a Monte Carlo simulation to see what range of impacts are possible under different discount rates.
We may not have one discount rate in cost-benefit analysis, but we certainly know enough to try some out and see what they tell us about the policy we are analyzing.