Professor John Quiggin has argued for years that a high private discount rate, or an individual’s preference for present over future benefits, does not imply that society as a whole should apply such discounting to evaluate long term projects.
The good professor has been kind enough to formalise this principle to demonstrate its internal consistency. He concludes
Unless society is willing to discriminate in favour of earlier born individuals against their later born contemporaries, the pure rate of social time preference must be zero, regardless of whether or not individuals display pure time preference with respect to their own lifetime consumption.
Before I consider how one logically reaches this conclusion, I will start by quickly highlighting the importance of this principle. Professor Quiggin highlights the issue in the context of action to mitigate climate change. Because costs of mitigation occur in the ‘present’ (roughly speaking), and benefits occur in the future, a positive discount suggests forgoing present costs and enduring whatever future costs arise from climate change.
For me, a zero rate of social time preference (meaning a total discount rate in the order of the real rate on government bonds, or around 2 per cent), has implications for role of public spending and investment more generally – infrastructure, social programs, or any government spending directed towards long term benefits. It suggest that ‘gold plating’ of infrastructure may not be such a terrible thing (provided it reduces future maintenance costs or improves the lifespan of infrastructure). Also, it suggests that preventative measures are usually socially justifiable – whether they be ‘soft’ social investments such as support programs for struggling youths, or physical investment in flood protection infrastructure.
To follow the logic, it is best to start by considering why time preferences exist? The short answer is opportunity cost. An individual has a finite life, and needs to allocate their time in a way that provides them appropriate benefits. They may not maximise in the strict economic sense, but they do trade-off various options. Forgoing some kind of pleasurable activity now requires a chance at something even better in the future, since you never really know if the expected future benefits will arrive, or if you will be around to enjoy them.
But society does not have a finite life in any tangible sense.
So here’s the professor’s basic idea. If society values current benefits to each individual equally, at whatever age they happen to be, then it must also value these benefits equally when the current younger generation are older.
For simplicity imagine a two person society – one child age 10 and one ‘verge-of-retirement’ boomer at age 60. The government is evaluation a project, say a rail line, that is likely to provide community benefits in the form of reduced travel time, freight costs and so forth, in the order of $10million per year. There are valid reasons why a private firm won’t invest in this line, and the rail line is expected to last 50 years.
Traditionally, one would conduct a cost-benefit analysis with the cost in the current period, and the benefits spread over future periods, and discounted back to the present at some rate, say 5% for simplicity.
If we discount an expected 50 year future stream of $10million benefits each year we find that the project is worth about $183million. If it costs more than that, the costs outweigh the benefits, and it is apparently not socially optimal to invest.
But now let’s think about intergenerational fairness. We valued $1 of benefit this year for both the 10 year old and 60 year old at $1. But we value the benefit to the 10 year old in fifty years time, when they are 60, at a mere 9 cents. Sure, we discount future costs as well, such as maintenance, but we can’t ignore the conundrum that benefits to individuals alive today, when they are the same age, are valued differently.
If we think at a macro level and consider costs in resources terms – labour, materials, capital, land and so on – then we say that diverting these resources from other productive uses in the future, is less costly than in the present. Better to divert society’s resources to maintenance in ten years time, than to building a more durable piece of infrastructure in the first place. But what this simply means is that the people who won’t be alive in ten years time incur none of those future costs, while younger people who are still around, incur them all.
From the perspective of society as a whole, our opportunity cost is all other production being undertaken at any point in time. Divert 300 workers to fix a rail line, reduce output in other areas by whatever those 300 worker would have contributed (yes, assuming stable unemployment).
So what does this mean? Does it mean we should spend $500million building that rail line instead, which is the value of the un-discounted expected benefits for 50 years?
What it really means is that cost-benefit analysis should use a zero rate of time preference, and the resulting very low total discount rate. But more importantly, cost benefit analysis with a near zero discount rate should be used as a tool for ranking potential public infrastructure or social investment to see which candidate projects are likely to deliver the best returns. This ranking will be different to the ranking when using a larger positive discount rate that would be suitable for evaluating private projects.
This principle also suggests that the ‘gold-plating’ of public infrastructure can often be socially beneficial if it reduces future costs significantly. Meaning that in the long term, maintenance costs (including closures etc) are significantly reduced.
It means that public spending should look uneconomic when evaluated by measures suitable to private enterprise. But ideally should facilitate private markets where private markets can produce better social outcomes.
A zero social discount rate raises plenty of new questions about selling State owned assets to pay off debts, even beyond the fundamental economic irrationality. Exactly how much were these assets worth from a social perspective? New Queensland Premier Campbell Newman intends to sell a number of government office buildings in Brisbane, meaning future governments will have to lease space from private building owners – a cost that shouldn’t be substantially discounted.
Economists are typically terrible at aggregating from micro principles to the macro economy. But the principle of a zero rate of social time preference, in a society that values each year of each persons life equally, is one of those cases where aggregation from the individual to the society has not merely been assumed away.