Carleton, Tamma and Greenstone, Michael, Updating the United States Government’s Social Cost of Carbon (January 14, 2021). University of Chicago, Becker Friedman Institute for Economics Working Paper No. 2021-04, Available at SSRN: https://ssrn.com/abstract=3764255
The Right Discount Rate for Regulatory Costs and Benefits
Suppose that regulation of greenhouse gas emissions from power plants would produce large benefits in 30 years—but only modest benefits today. Suppose at the same time that these same regulations require businesses to make a series of increasingly costly changes to their operations over the next several decades.
Since 1981, both Republican and Democratic presidents have required government agencies to calculate the cost and benefits of proposed regulations and to proceed only if the benefits justify the costs. To the surprise of many observers, President Joe Biden recently embraced those requirements, which means that cost-benefit analysis is likely to play a central role in his presidency.
When costs and benefits unfold over many years, as they often do, regulators have to choose an all-important number: the discount rate. That number determines the value today of regulatory costs and regulatory benefits that arrive in the future. The intuition is that benefits enjoyed today are worth more than those that occur in 2030, while we would rather incur costs in 2030 than today. Within the federal government, future costs and benefits are now “discounted” at an annual rate of 3%—a figure used under the presidencies of both Barack Obama and Donald Trump.
But that number has become exceptionally hard to defend. In some cases, the 3% figure will support indefensibly costly regulations. In other cases, it will support indefensibly weak ones.
Profound changes in international capital markets over the last several decades mean that the Biden administration should conduct a transparent and inclusive review of discounting, which we expect would lead to reducing the discount rate to 2% or possibly less. Doing so would produce immediate, substantial changes in the projected costs and benefits of countless regulations.
The reason for this change has nothing to do with politics. It is required by widely accepted economic principles and federal precedent. And though it may sound like a narrow technical issue, it has an enormous impact. Every year, the federal government makes hundreds of decisions that impose costs on the private sector in exchange for expected benefits. Sometimes both costs and benefits will occur in the near future. But sometimes the major costs will be faced in the coming decades, and sometimes the benefits will be delayed.
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