Category: Energy Policy

Does economic analysis shortchange the future?

Decisions made today usually have impacts both now and in the future. In the environmental realm, many of the future impacts are benefits, and such future benefits — as well as costs — are typically discounted by economists in their analyses.  Why do economists do this, and does it give insufficient weight to future benefits and thus to the well-being of future generations?

This is a question my colleague, Lawrence Goulder, a professor of economics at Stanford University, and I addressed in an article in Nature.  We noted that as economists, we often encounter skepticism about discounting, especially from non-economists. Some of the skepticism seems quite valid, yet some reflects misconceptions about the nature and purposes of discounting.  In this post, I hope to clarify the concept and the practice.

It helps to begin with the use of discounting in private investments, where the rationale stems from the fact that capital is productive ­– money earns interest.  Consider a company trying to decide whether to invest $1 million in the purchase of a copper mine, and suppose that the most profitable strategy involves extracting the available copper 3 years from now, yielding revenues (net of extraction costs) of $1,150,000. Would investing in this mine make sense?  Assume the company has the alternative of putting the $1 million in the bank at 5 per cent annual interest. Then, on a purely financial basis, the company would do better by putting the money in the bank, as it will have $1,000,000 x (1.05)3, or $1,157,625, that is, $7,625 more than it would earn from the copper mine investment.

I compared the alternatives by compounding to the future the up-front cost of the project. It is mathematically equivalent to compare the options by discounting to the present the future revenues or benefits from the copper mine. The discounted revenue is $1,150,000 divided by (1.05)3, or $993,413, which is less than the cost of the investment ($1 million).  So the project would not earn as much as the alternative of putting the money in the bank.

Discounting translates future dollars into equivalent current dollars; it undoes the effects of compound interest. It is not aimed at accounting for inflation, as even if there were no inflation, it would still be necessary to discount future revenues to account for the fact that a dollar today translates (via compound interest) into more dollars in the future.

Can this same kind of thinking be applied to investments made by the public sector?  Since my purpose is to clarify a few key issues in the starkest terms, I will use a highly stylized example that abstracts from many of the subtleties.  Suppose that a policy, if introduced today and maintained, would avoid significant damage to the environment and human welfare 100 years from now. The ‘return on investment’ is avoided future damages to the environment and people’s well-being. Suppose that this policy costs $4 billion to implement, and that this cost is completely borne today.  It is anticipated that the benefits – avoided damages to the environment – will be worth $800 billion to people alive 100 years from now.  Should the policy be implemented?

If we adopt the economic efficiency criterion I have described in previous posts, the question becomes whether the future benefits are large enough so that the winners could potentially compensate the losers and still be no worse off?  Here discounting is helpful. If, over the next 100 years, the average rate of interest on ordinary investments is 5 per cent, the gains of $800 billion to people 100 years from now are equivalent to $6.08 billion today.  Equivalently, $6.08 billion today, compounded at an annual interest rate of 5 per cent, will become $800 billion in 100 years. The project satisfies the principle of efficiency if it costs current generations less than $6.08 billion, otherwise not.

Since the $4 billion of up-front costs are less than $6.08 billion, the benefits to future generations are more than enough to offset the costs to current generations. Discounting serves the purpose of converting costs and benefits from various periods into equivalent dollars of some given period.  Applying a discount rate is not giving less weight to future generations’ welfare.  Rather, it is simply converting the (full) impacts that occur at different points of time into common units.

Much skepticism about discounting and, more broadly, the use of benefit-cost analysis, is connected to uncertainties in estimating future impacts. Consider the difficulties of ascertaining, for example, the benefits that future generations would enjoy from a regulation that protects certain endangered species. Some of the gain to future generations might come in the form of pharmaceutical products derived from the protected species. Such benefits are impossible to predict. Benefits also depend on the values future generations would attach to the protected species – the enjoyment of observing them in the wild or just knowing of their existence. But how can we predict future generations’ values?  Economists and other social scientists try to infer them through surveys and by inferring preferences from individuals’ behavior.  But these approaches are far from perfect, and at best they indicate only the values or tastes of people alive today.

The uncertainties are substantial and unavoidable, but they do not invalidate the use of discounting (or benefit-cost analysis).  They do oblige analysts, however, to assess and acknowledge those uncertainties in their policy assessments, a topic I discussed in my last post (“What Baseball Can Teach Policymakers”), and a topic to which I will return in the future.

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A Tale of Two Taxes

Whether they are called “revenue enhancements” or “user charges,” fear of the political consequences of taxes restricts debate on energy and environmental policy options in Washington. In a March 7th post on “Green Jobs,” in which I argued that it is not always best to try to address two challenges with a single policy instrument, I also noted that in some cases such dual-purpose policy instruments can be a good idea, and I gave gasoline taxes as an example.

Although a serious recession is clearly not the time to expect political receptivity to such a proposal, the time will come — we all hope very soon — when the economy turns around, employment rises, and a sustained period of economic growth ensues. When that happens, serious consideration should be given to increases in the Federal tax on gasoline.

A gas tax increase — coupled with an offsetting reduction in other taxes, such as the Social Security tax on wages — could make most American households better off, while reducing oil imports, local pollution, urban congestion, road accidents, and global climate change. This revenue-neutral tax reform would exemplify the market-based approaches to environmental protection and resource management I examined in previous posts.

Such a change need not constitute a new tax, but a reform of existing ones. It is well known ­– both from economic theory and numerous empirical studies ­– that taxes tend to reduce the extent to which people undertake the taxed activity. In the United States, most tax revenues are raised by levies on labor and investment; the resulting reduction in these fundamentally desirable activities is viewed as an unfortunate but unavoidable side-effect of the need to raise revenue for government operations. Would it not make more sense to raise the revenue we need by taxing undesirable activities, instead of desirable ones?

Combustion of gasoline in motor vehicles produces local air pollution as well as carbon dioxide that contributes to global climate change, increases imports of oil, and exacerbates urban highway congestion. Can anyone really claim that — given a choice between discouraging work and discouraging gasoline consumption — it is better to discourage work?

According to the U.S. Department of Energy, a 50 cent gas tax increase could eventually reduce gasoline consumption by 10 to 15%, reduce oil imports by perhaps 500 thousand barrels per day, and generate about $40 billion per year in revenue.

Furthermore, this approach would be far more effective than on-going proposals to increase the Corporate Average Fuel Economy (CAFE) standards, which affect only new vehicles and lead to serious safety problems by encouraging auto makers to produce lighter vehicles. Also, remember that a major effect of CAFE standards has been to accelerate the shift from cars to SUVs and light trucks (so that overall fuel efficiency of new vehicles sold is no better than it was a decade ago, despite the great strides that have taken place in fuel efficiency technologies). As my Harvard colleague Martin Feldstein pointed out in The Wall Street Journal in 2006, the conventional approach “does nothing to encourage individuals to drive less, to use their cars more efficiently, or to shift sooner to new and more fuel efficient [and cleaner] vehicles.” A more enlightened approach ­— a market-based approach — would reward consumers who economize on gasoline use. And that is what a revenue-neutral gas tax is all about.

The revenue from the gas tax could be transferred to the Social Security Trust Fund and credited to current workers. If $40 billion per year from new gas tax revenues were transferred to Social Security, the payroll tax — the employee contribution to Social Security — could be cut by perhaps a third: a worker with annual wages of $30,000 would take home an additional $750 per year! The extra income would more than offset the cost of the gas tax, unless the worker drove over 35,000 miles per year in a car getting 25 miles or less per gallon. Rebating the gas tax in this way addresses the greatest concern about higher gas taxes — that they can hit hardest those workers who drive to their jobs. Further, a tax of this magnitude could be phased in gradually, perhaps no more than 10 cents per year over 5 years, allowing individuals and firms to adjust their consuming and producing behavior.

Proposals for gasoline tax increases in recent sessions of Congress would have dedicated the revenue to public spending (for transportation and other programs). A key difference is that the proposal I have outlined here is for a revenue-neutral change in which the gas tax revenue would be returned to Americans through reduced payroll taxes. To adopt some of the language I developed in my previous posts, such a change can be both efficient and equitable, and — for those reasons — perhaps even politically feasible.

Of course, such a scheme is not a panacea for U.S. energy and environmental problems. But it would make a significant contribution if enacted. On the other hand, political fear of the T-word in Washington may mean that it is never discussed seriously in public, let alone adopted. Most fear of taxes is due to politicians’ anxieties about asking their constituents to pay more. But an increase in the Federal gas tax, rebated through reduced payroll taxes would not cost most Americans any more and would have significant long-term benefits for the country. Still, fear of the T-word looms large; maybe it should be called an “All-American Ecologically Sound, Fully Recyclable, Anti-Terror, Energy-Independence Assessment.”

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