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