Discounting in Cost-Benefit Analysis

This series of blog posts are about my first cost-benefit analysis with Scioto Analysis. As I am going through this process, I am writing about the challenges I come across and how I have been thinking about them. This week, I wanted to write about discounting, why it is important, and when it should be used.

Discounting is the process we use to estimate the difference in benefits policies create in the present from benefits they create in the future. Discounting is a cornerstone practice of good cost-benefit analysis.

Which would you rather have, $100 today or $100 in 10 years? It is pretty easy to understand why $100 in 10 years is the worse of these options. If you get hit by a bus tomorrow, that $100 later will be pretty useless. You could also invest your $100 today and end up with $200 in ten years. Having money now is better than having money later. 

When conducting cost-benefit analysis, discounting is extremely important because many impacts calculated incur short-term costs and long-term benefits. Appropriate discounting of future benefits is an essential step in determining the true value of a proposal from a social perspective.

In the context of my current cost-benefit analysis, I have spent a lot of time thinking about whether or not I should include future values. For context, the program I am analyzing is essentially government subsidies to encourage farmers to use less phosphorus fertilizer which in turn leads to less phosphorus runoff into Ohio’s waters.

The justification for including future impacts is that improved water quality is valuable year after year. However, there are two major assumptions that we must consider. First, the subsidy is a one-time investment meaning that all of our costs are accounted for in the present. Second, because the reduction in phosphorus is the result of using less fertilizer, we assume that going forward there are no new reductions in phosphorus. 

Whether or not discounting future benefits is appropriate depends on how we choose to monetize benefits. In this case, we model the benefits of this program as people’s willingness to pay for cleaner water. This means that the marginal decrease in phosphorus is valuable. We could discount the marginal increase in recreational use, but we should expect that benefit to be captured in the current willingness to pay for a marginal increase in water quality today. 

Choosing not to include future benefits in this analysis makes the most sense in this context, but as a policy analyst it is important to fully understand the implications of that decision. In this case, it leads to a more conservative estimate of the benefits of the program, which can be a useful direction to err.

This blog post is part of a series of posts on conducting cost-benefit analysis for newcomers by Scioto Analysis Policy Analyst Michael Hartnett.