Social discounting and the cost of public funding in practice

This paper is a contribution to the understanding and development of social discounting regimes. It first addresses three, often overlooked, implications of how public funding differs from private financing by debt and equity.

One implication is that the cost of systematic (income-correlated) risk in public service benefits does not fall as a rate of return, but as an absolute reduction in the value of the benefits. Another is that, while ‘social opportunity cost’ discounting can for some governments be the best practicable option for most cost-benefit analysis, it is unsuitable for other applications, which require lower rates. This can be handled by a hybrid regime.  Third, with ‘social time preference’ discounting, it is usually assumed that the cost of public funding should be handled by an explicit shadow price for public spending. However, a value-for-money approach, optimising spending from given, constrained budgets, is in important ways superior.

The paper then examines US Federal and United Kingdom central government conventions, illustrating hybrid and value-for-money regimes, and also illustrating the difficulties of establishing and maintaining analytically rigorous social discounting procedures in practice.

Key points for decision-makers

  • Social discount rates are used to put a present value on future costs and benefits. The rate is especially important in the context of global climate change policy analysis.
  • The social opportunity cost (SOC) discounting convention frames the cost of public funding as if it were very similar to the financing of a commercial enterprise by debt and equity. This method has great strengths of simplicity, political appeal and ease of application but has many anomalous implications.
  • The social time preference (STP) convention frames the issues by separately specifying a social time preference rate for consumption and a cost of public funding from taxation.
  • The SOC approach is long-established in Federal Canada, and in Federal and State governments in Australia and in New Zealand. The European Commission and several European countries apply STP rates, often with an explicit shadow price for public spending. US Federal government applies a hybrid approach, with SOC for most cost-benefit analysis and lower rates for other applications.
  • The SOC convention can be a reasonable approximation for many cost-benefit analyses, comparing public spending with consumption benefits over the medium term. It is, however, not suitable for such analysis over more than a few decades, nor for cost effectiveness analysis, comparing public spending with future expenditure saving, nor for comparing streams of consumption over time.
  • The STP convention is analytically preferable, as long recognised in US Federal government, but no robust methodology has emerged for fully valuing public spending relative to consumption and this cost is often overlooked. This can, however, be handled by prioritising public spending options from spending agency budgets by cost-effectiveness, as in UK central government.