My interest in how discount rates are applied to investment decisions comes from my corporate background building and evaluating many business cases for large, long term projects where parameters, including the discount rate, are prone too often to gaming behaviour. Particularly for government and semi-government organisations which don’t have the advantage of a straight forward Weighted Average Cost of Capital (WACC) calculation.
The recent paper by Gowdy et al. (2013) ‘The evolution of hyperbolic discounting: Implications for truly social valuation of the future’ made me think more about the vexed question of how the social discount rate should be calculated. With exponential discounting, which is typically used in corporate finance, the present value of returns in future years approach zero fairly quickly. This is problematic for social issues such as climate change, as indicated in ‘The economics of climate change’ (Stern 2007), the motivation for incurring remediation costs now is the expected positive social returns far out into the future.
Gowdy et al.’s view is that hyperbolic discounting should be used because it at least leaves a positive residual present value for long dated social returns in the future. A hyperbolic discount rate approaches a value over time which is materially greater than zero compared to the conventional exponential discount rate that approaches zero. However, hyperbolic discounting is a behavioural heuristic which varies greatly across sections of the community. Research conducted by Harrison et al. (2002) ‘Estimating individual discount rates in Denmark: A field experiment’ indicated that hyperbolic discount rate between socio-economic groups can differ by around 10%, 32.9% for the poor verse 22.5% for the rich.
My view was why not just have a zero discount rate?
Interestingly in the paper ‘Are we consuming too much’, (Arrow et al 2004) the authors noted that Ramsey (1928) and Solow (1974) were of the view the social discount rate should be zero. A zero discount rate was rejected because it implies a savings rate of around 67% which economists including Arrow thought was not realistic. However, if you assume the cost of bringing up kids forms part of the investment/savings requirement, this would account for 50% outright of the 67% (leaving 17%) savings expected when the discount rate is zero. ‘Cost of raising a child in Australia’ summary data : 50% of income ~ 3 kids, middle income, after tax of 30%.
Treating the cost of raising children as ‘savings’ then makes applying a zero social discount rate to long term, inter-generational, decisions reasonable. The difference between an optimal social consumption discount rate and zero being the ‘positive externality (outside the marketplace) from the welfare of future generations’ (Arrow et al. 2004).
Arrow K, et al. 2004 ‘Are we consuming too much?’ The Journal of Economic Perspectives, 18(3), 147-172.
Gowdy, J., Rosser, J. B., & Roy, L. (2012). The evolution of hyperbolic discounting: Implications for truly social valuation of the future. Journal of Economic Behavior & Organization.
Harrison, G. W., Lau, M. I., & Williams, M. B. (2002). Estimating individual discount rates in Denmark: A field experiment. The American Economic Review, 92(5), 1606-1617.
Ramsey FP, 1928 ‘A mathematical theory of saving’, The Economic Journal, 38(152), 543-559.
Solow RM 1974 ‘The economics of resources or the resources of economics’, The American Economic Review, 64(2), 1-14.
Stern, N. (2008). The economics of climate change. The American Economic Review, 98(2), 1-37.