The choice of the social discount rate and the opportunity cost of public funds

Abstract

The decades-old literature on the correct method for choosing and estimating a social discount rate (SDR) has resulted in two, largely opposing viewpoints. This note seeks to clarify the key sources of disagreement between these two camps. One view advocates that the choice should be based chiefly on the social opportunity cost of the return to foregone private capital investment (SOC), and suggests a SDR of around 7%. The other viewpoint, expressed by the authors, argues that the choice should be based on the social rate of time preference (STP), the rate at which society is willing to trade present for future consumption, suggesting a SDR of around 3.5%. Because of the fundamentally normative basis of the SDR choice, neither approach generates testable hypotheses that would allow falsification. For government project evaluation, the choice ultimately depends on the opportunity cost of public funds, which in turn depends on how fiscal policy actually operates. The STP approach contends that governments set targets for deficits and public debt, so that a marginal government project will be tax-financed, largely crowding out current consumption. The SOC belief is that governments set revenue targets, so that any government project will be deficit-financed on the margin, which will largely crowd out private investment. The authors also argue that a SDR based on the STP approach is appropriate for: benefit-cost analysis of government regulations, self-financing government projects, and government cost-effectiveness studies.