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I am interested in understanding the rationale behind discounting in the context of government policy appraisal.

As far as I understand it, there are three main components to the discount values normally used:

  1. Estimate of catastrophic risk.

  2. GDP growth.

  3. Time preference value of money.

Adjustment of future costs/revenues to the first two of these make sense to me, but the third seems to include a "normative judgement" that I want to check I understand.

By adjusting for the time preference value of money in policy appraisal we are explicitly saying that we value the utility of present people more than the utility of future people? Not just because an event may lead to the destruction of society (1), or because the economy will grow and hence costs/benefits will be smaller in the future (2), but because future benefits mean less to current people now.

Any confirmation or challenge to my understanding would be appreciated.

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    $\begingroup$ I’m not familiar with this area, but are you saying that these three components are used to determine the discoount rate? If so, the time preference for money might be related to the debt finance interest costs associated with a project. Since interest costs will compound, current expenses imply compunding future costs versus the future benefits. So if we want to bring back to present value, we discount future benefits to compare to current expenses. $\endgroup$ – Brian Romanchuk Sep 24 '18 at 12:11
  • $\begingroup$ @BrianRomanchuk Surprisingly the junction between discounting and cost of capital (opportunity cost, risk premium, ...) is anything but direct for theoretical economists. Yet, it is the only real-life usage, be that for public projects evaluation or whatever. $\endgroup$ – keepAlive Oct 7 '18 at 20:58
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As Kitsune rightly points out the usual reason for the inclusion of the time preferences for money into the discount formula (or Ramsey fomula) is that we observe this kind of behaviour in people. Given that many economists take a positive approach towards the study of economics, that is a logical stance.

That being said the last word is not spoken on this, and discounting and its use in benefit cost analyses for especially long-term policies is an active area of research. The Stern review on the economics of climate change sparked intense debate on whether we should include a pure rate of time preference and if so, what its size should be. On the one had you had economists like Stern who argued for a very small rate (0.01 % if memory serves), only to account for catastrophic risk, on the other hand there were economists like Nordhaus who argued for a rate close to 3%, based on observed choices by people in real life and the interest rates. Wikepedia covers the debate here

Martin Weitzman did a study among 2160 economists what the real discount rate should be for climate change (that is pure rate of time preference plus discounting because of GDP growth) called Gamma discounting and published in the AER. He found a range from -3 to 27%, which may give you an idea of the disagreement among economists on the issue of discounting.

Drupp, Freeman, Groom and Nesje did a more detailed follow-up in 2015, called discounting disentangled. Their range for the full discount rate is lower, from 0 to 10%, and they also asked explicitly what the pure rate of time preference should be. The mean recommended value for the latter by their 200 surveyed experts was 1.10%, but even that rate had a range from 0 to 8%.

Interestingly, the person who first came up with the Ramsey formula, Frank Ramsey, in a mathematical theory of saving, argued for a rate of time preference for societies of 0, calling a positive rate "ethically indefensible", although he does use a positive rate later on in the paper.

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  • $\begingroup$ "the usual reason for the inclusion of the time preferences for money into the discount formula (or Ramsey fomula) is that we observe this kind of behaviour in people" There is overwhelming evidence that people do not time discount exponentially, so how can appealing to common individual behaviour/preferences justify exponential time discounting? $\endgroup$ – afreelunch Apr 2 at 14:05
  • $\begingroup$ I never justified exponential discounting. I agree that especially in personal decisions people may discount hyperbolically. I pointed out where some economists usually get their number from when it comes to pure rate of time preference. Whether discounting exponential, gamma or hyperbolic is a different discussion all together. $\endgroup$ – Maarten Punt Apr 2 at 14:55
  • $\begingroup$ It's not a different discussion. As you mentioned, economists often justify exponential discounting based on individual preferences/behaviour. The 'discounting formula' and 'Ramsey formula' that you mention are formulae for exponential discounting. $\endgroup$ – afreelunch Apr 2 at 15:26
  • $\begingroup$ The OP asked about why the time preference of money is included in discounting. I agree that most of my answer refers to its inclusion in exponential discounting, which is, whether we like it or not, the dominant way in which discounting is applied in cost-benefit analysis, and was, given the other factors mentioned, the framework the OP referred to. Within that framework as well as within the other frameworks, mentioned in much of the linked literature, there is a component to capture that people are impatient. Whether that impatience should be applied exponentially is different. $\endgroup$ – Maarten Punt Apr 3 at 8:04
  • $\begingroup$ If it's not applied exponentially, then welfare judgements will be time inconsistent! This would be a rather bizarre approach to take $\endgroup$ – afreelunch Apr 3 at 10:16
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It's not so much that we as policy makers value present welfare more than future welfare intrinsically.

The time preference for money is just stating that people would rather have a dollar today than a dollar tomorrow. The premise behind banking is that people will lend money today for money plus extra tomorrow. So that is generally the context behind that third justification for the discount factor you list.

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