Equity shmequity: How US government’s ‘discounting’ policy hurts the global poor

The Office of Management and Budget (OMB) recently finalized its Circular A-4 guidance on regulatory analysis, constituting the first update to the guidance in 20 years. These guidelines shape how cost-benefit analysis is conducted across the government, which in turn informs countless regulations. One of the core changes made to the guidance was to lower the “social discount rate” used. Previously, OMB recommended two rates for this purpose: 3 and 7 percent. Agencies will use a single 2 percent social discount rate going forward.

An individual’s “discount rate” expresses how that person values present consumption relative to future consumption. For example, a person might only be willing to give up one hamburger today in exchange for two hamburgers next Friday. This tendency to prefer present over future consumption is a universal human trait known as “time preference.”

OMB says “society’s” rate of discount is 2 percent per year, but the method it uses to calculate that number is arbitrary. OMB relies on the same method that was used in the prior version of the guidance, but that method itself had no economic foundation. Rather, the government merely assumed “society’s” discount rate was equivalent to the rate on long-term government bonds. Interest rates being relatively low in recent decades is how OMB now justifies its decision to use a lower rate than was used previously.

The new discounting guidance is problematic for several reasons. First of all, OMB’s decision to use a single social discount rate, rather than two or even more rates, conflicts with the recommendations of numerous commenters, including OMB’s own peer reviewers. Uncertainty about what rate to use, as well as heterogeneity across the population, would seem to imply that a multitude of rates should be considered.

The reality is that there is no single interest rate in the economy that reflects every individual’s discount rate simultaneously. The population exhibits a variety of different discount rates across individuals, and even the same individual might exhibit different discount rates in different contexts. Using a single rate for all individuals in all contexts, as OMB does, is going to naturally conflict with the vast majority of individuals’ preferences.

One group that is likely to be especially made worse off by the new guidelines are the poor, including the global poor. Low-income individuals often exhibit higher rates of time preference than high-income individuals. Differences in time preferences across income groups also hold across countries. Rates of time preference tend to be higher in low-income nations.

This is important because another change made in OMB’s update is to place more emphasis on benefits accruing to individuals living outside the United States. Thus, it is odd for OMB to, on the one hand, emphasize benefits to foreigners, while on the other hand, ignore that the US is relatively richer than most of the world, and many individuals in poorer countries have higher rates of time preference on average.

In explaining its decision, OMB discusses how it relies on market interest rates to estimate the social discount rate (a method known as the “descriptive” approach to discounting). Given OMB’s endorsement of this method, it is also reasonable to ask what interest rates the poor can borrow at.

Many poorer individuals are credit constrained, forced to borrow at relatively higher rates of interest. In many cases, the 20 percent or higher interest rates frequently found on credit cards will be their best option. Furthermore, the Consumer Financial Protection Bureau estimated in 2015 that 26 million Americans have no credit history. Some of those with no or poor credit history will not be able to borrow at any interest rate. This is also true in developing nations. For these individuals, their borrowing rate is essentially infinite.  

OMB’s selection of a lower social discount rate also appears inconsistent with the agency’s newfound support for “equity weighting,” whereby benefits and costs are given greater weight when they accrue to the poor. Following OMB’s logic, it is appropriate to use higher discount rates when regulations affect the poor or the developing world. Yet OMB recommends using even lower social discount rates than 2 percent when regulations have impacts on the distant future. This recommendation comes up most often in the context of climate change, where regulations also have some of the largest estimated global impacts.

There is nothing wrong with prioritizing future generations, but OMB should be more honest with the public that when it does so there is a conflict that arises between present and future interests. Future generations are likely to be relatively richer due to economic growth. The current, poorer generation often wants to consume resources that future generations would prefer be invested for their benefit. Prioritizing future generations usually means giving less priority to the present one, and vice versa.

In a sense, any social discount rate OMB opts to use is going to be in conflict with the preferences of most individuals. It would be better if OMB acknowledged this in a transparent manner. That way it would be clear to the public that cost-benefit analysis as presently conducted has nothing to do with advancing the values of the individuals who currently comprise society. It has everything to do with advancing a particular ideology found amongst analysts in the government.