In the complex world of regulatory cost-benefit analysis, the President’s Council of Economic Advisers (CEA) is struggling with the basic principle of discounting. Discounting is crucial in converting future benefits and costs into present values for comparisons across time. This process involves using different rates such as consumption rate for future consumption and a higher investment rate for investment flows. The application of these rates depends on the benefits and costs being analyzed, with regulations often involving both consumption and investment elements, making the analysis complex.
Federal regulatory agencies have a history of misapplying these rates, such as discounting consumption streams at investment rates which doesn’t make sense for health, safety, and environmental regulations. The Biden administration eliminated the use of a 7 percent investment rate for social regulations, but the CEA is now discounting investment flows at a consumption rate which is a new mistake. This error was evident in the analysis of the Medicaid program focusing only on federal government finances, where using a consumption rate of interest was inappropriate.
The appropriate discount rate should be an investment rate or a weighted rate accounting for consumed versus invested cash flows. However, the CEA is using a 2 percent consumption discount rate, which is a clear misapplication of economic principles. The error is likely to be replicated in the accounting statements accompanying most regulations, crucial for regulatory oversight. Adhering to this guidance would be inappropriate for rules with financial costs and benefits, leading to misallocation of resources on a massive scale.
The choice of discount rate can dramatically alter the perceived value of long-term policies and investments. Misapplication of discount rates undermines the credibility of government economic analysis and casts doubt on the reliability of recommendations to policymakers. To rectify the situation, federal economists need to return to first principles, recognize the distinction between consumption and investment flows, and apply appropriate discount rates to each.
Accurate economic analysis is crucial for addressing long-term challenges like climate change, healthcare reform, and infrastructure investment. It is essential for federal economists to ensure that their analyses reflect the best economic thinking in practice, by using investment rates or carefully weighted combinations of investment and consumption rates. This would prevent undervaluing the opportunity cost of government spending, leading to support for programs that may not deliver real-world value commensurate with their costs.
