Calculating the trade-off between short and long-term benefits in policy-making

Impact Area: Government Policy
Institution: York Management School, University of York
Leading Academic: Professor Mark Freeman

Background

There is significant expert disagreement on how the distant future should be valued relative to the present. In general, people have a strong preference to consume now rather than later due to impatience and the expectation that we will become richer over time. Governments also tend to prioritise spending on projects that bring relatively short-term benefits. Yet there are a number of pressing long-term issues in both the public and private sectors – including the threat of catastrophic climate change, the need for infrastructure investment, and addressing widespread deficits in defined benefit pensions plans – where there are strong demands for immediate action.

To determine the financial and economic case for undertaking long-term investment, the expected future benefits must be discounted at an appropriate discount rate. Because of the effects of compound interest over long periods of time, small differences in the actual rate chosen can lead to highly divergent recommendations, meaning that policy choices can be extremely sensitive to small differences in beliefs.

Given this, the appropriate policy response to the threat of climate change, for example, depends not only on our understanding of questions of natural science but also about what it means to be “fair” across generations. An appropriate discount rate is then chosen that reflects the policy maker’s values concerning intergenerational fairness. In particular, the policy maker must consider: (i) from an ethical perspective, should we place greater value on our children than our great-grandchildren? and (ii) if we expect future generations to be wealthier than our own, should we be saving on their behalf? Work undertaken at The York Management School has been widely used in practice by governmental and other organisations to inform policy on issues which involve a trade-off between short-term and long-term benefits.

Solution

The York Management School has carried out extensive research exploring the optimal approach to discounting the future benefits of very long-term projects. This work includes a major survey of experts’ opinions on what discount rate should be applied and explores the reasons for differences in opinion. They have also helped determine how these responses should be aggregated into a consensus view on the most appropriate discount rate that a government should use. A third area of work contributes to the literature that shows that governments should use lower discount rates for very long-term projects than for projects with shorter maturities; a finding that helps strengthen the financial and economic case for pursuing climate change mitigation policies.

Impact

The research of the York Management School has influenced the UK Treasury’s policy on discount rates, including the appropriate discount rate for evaluating big public spending projects such as transport infrastructure. They have also written two reports for the Office of National Statistics (ONS) on how to value long-term assets within the national accounts.

They have also provided advice to a range of international organisations – including the Bill & Melinda Gates Foundation, the Dutch Ministry of Finance and the OECD - and presented at policy-oriented conferences on the topic of valuation. The work they have published on this topic has also been cited within a National Academies of Sciences, Engineering, and Medicine report and a White House Briefing Paper.

The York Management School is currently working with Leeds University Business School on a pensions accounting project with the Institute of Chartered Accountants of Scotland (ICAS) and the European Financial Reporting Advisory Group (EFRAG) on discounting pensions liabilities. The broad ideas presented by the research can be extended to a range of important social issues, particularly infrastructure investment, pensions policy and long-term healthcare initiatives.