Wednesday, December 15, 2010

I Prefer OMB's Current Approach to Discounting

Under current rules, the President's Office of Management and Budget (OMB) requires federal agencies to discount streams of future costs and benefits of regulations at alternative 7% and 3% discount rates. The reason for this is made clear in Circular A-4 (see here):
As a default position, OMB Circular A-94 states that a real discount rate of 7 percent should be used as a base-case for regulatory analysis. The 7 percent rate is an estimate of the average before-tax rate of return to private capital in the U.S. economy. It is a broad measure that reflects the returns to real estate and small business capital as well as corporate capital. It approximates the opportunity cost of capital, and it is the appropriate discount rate whenever the main effect of a regulation is to displace or alter the use of capital in the private sector. OMB revised Circular A-94 in 1992 after extensive internal review and public comment. In a recent analysis, OMB found that the average rate of return to capital remains near the 7 percent rate estimated in 1992. Circular A-94 also recommends using other discount rates to show the sensitivity of the estimates to the discount rate assumption.

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The effects of regulation do not always fall exclusively or primarily on the allocation of capital. When regulation primarily and directly affects private consumption (e.g., through higher consumer prices for goods and services), a lower discount rate is appropriate. The alternative most often used is sometimes called the "social rate of time preference." This simply means the rate at which "society" discounts future consumption flows to their present value. If we take the rate that the average saver uses to discount future consumption as our measure of the social rate of time preference, then the real rate of return on long-term government debt may provide a fair approximation. Over the last thirty years, this rate has averaged around 3 percent in real terms on a pre-tax basis. For example, the yield on 10-year Treasury notes has averaged 8.1 percent since 1973 while the average annual rate of change in the CPI over this period has been 5.0 percent, implying a real 10-year rate of 3.1 percent.

For regulatory analysis, you should provide estimates of net benefits using both 3 percent and 7 percent.
New recommendations (here) from the Benefit-Cost Analysis Center at the University of Washington, sponsored by the MacArthur Foundation and authored by Professor Richard Zerbe, make the requirements of Circular A-4  seem almost liberal (something OMB critics could hardly imagine). Professor Zerbe validates  OMB's 7% base discount rate; as noted in a previous blog post (here), he recommends a range of discount rates from 6% to 9% (coming close to OMB's old baseline discount rate of 10%). However, Professor Zerbe recommends using only a single discount rate in any BCA, without the flexibility currently provided in Circular A-4 for alternative calculations using 3% discount rates in cases where the opportunity-cost of capital is less of an issue than present-versus-future rates of consumption.

In Professor Zerbe's view, the opportunity-cost-of-capital approach to discounting is the only correct approach, despite recent work by many other economists supporting consumption-based discounting (which generally implies lower social discount rates).

We can only hope that the MacArthur/Benefit-Cost Analysis Center recommendations on discounting do not influence OMB policy (or policies of similar state-level agencies). Otherwise, the consequences for socially beneficial environmental, health and safety regulations could be severe.

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