Adrian Katz on public sector discounting

This week, my ECONS102 class has been covering the economics of education. One of the key aspects of the topic is the introduction of discounting. This is important in the private education decision (about how much education to invest in), because the benefits of education come in the future, while the costs (including opportunity costs) happen now. In order to make an effective decision, we need to discount the future benefits so that they can be compared with the present costs.

Discounting is also important in public sector decision-making, such as decisions on funding healthcare (and my ECONS102 class will turn its attention to health economics next week), transport and other infrastructure, environmental policy, and many other decisions where there are long-term benefits (and/or long-term costs).

So, I was interested to read this post on the Asymmetric Information substack yesterday by Adrian Katz (senior economist at NZIER), who gives a quick run-down on public sector discounting:

The public-sector discount rate plays a central role in determining which government interventions get the green light, and which stay on red...

The Treasury currently recommends a discount rate of 5.0% for most projects. The Treasury’s CBAx guidance also suggests an alternative rate of 2.0% but does not explain how this should be used.

Some government agencies use different discount rates. For example, NZTA uses a rate of 4.0%, and Pharmac uses 3.5%. Having different discount rates for different government organisations is at odds with the Treasury’s current approach and makes it harder to compare different types of government spending.

Katz then briefly outlines the debate over how the discount rate should be set. It is worth reading that debate if you want to understand more about how the discount rate is set currently. Katz then concludes that:

Arguments about the discount rate are often motivated by political views about the role of government in society or ethical views about what we owe to future generations. Policy advisors face difficulties in making these judgements on behalf of society without clear evidence of New Zealanders’ views on these complex issues.

The choice of discount rate can make a big difference to evaluating the present value of future costs and benefits. The Treasury recommendation of a 5 percent discount rate would discount an amount in 20 years' time by 62.3 percent (=1-[1/(1+0.05)^20]), and an amount in 50 years' time by 91.3 percent (=1-[1/(1+0.05)^50]). In contrast, using the Pharmac rate of 3.5 percent would discount those amounts by 49.7 percent (=1-[1/(1+0.035)^20]) and 82.1 percent (=1-[1/(1+0.035)^50]) respectively. So, $1000 in 20 years' time would have a present value of $377 using the Treasury rate, but $503 using the Pharmac rate. And $1000 in 50 years' time would have a present value of $87 using the Treasury rate, but $179 using the Pharmac rate.

With a lower discount rate (like Pharmac) more alternatives with long-term benefits and near-term costs would have benefits that are greater than costs (that is, a benefit-cost ratio greater than one). As a result, the government would have evidence in favour of investing in more infrastructure, more climate change mitigation, more education and more healthcare. Discount rates matter.