Date created: 15/5/07
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John Quiggin

No discount on equality

John Quiggin Australian Financial Review

12 April 2007

How much should we care about the state of the economy, and the environment, in 2050? Questions like this are usually pushed to the back of the queue in political debate.

But the release of the 2007 Intergenerational Report especially as the latest report comes at a time when we are debating policy responses to climate change, also focused on 2050 and beyond.

In economic discussions of issues like this, the crucial variable is the discount rate that is applied to costs and benefits accruing in the future. A high real discount rate, say 10 per cent, means that we can effectively ignore what happens in the future. At such a rate, it would make sense to use up assets today, even if they would be worth 100 times their current value in 50 years time.

But arguments about discounting are generally arcane, with Greek letters like delta and theta being thrown about freely. And regrettably, even respected economists often get things wrong when they try to simplify the story, as was shown by a number of the published criticisms of the recent Stern review of climate change.

Still it is possible to understand the basic issues, and reach a sensible conclusion. To begin with the obvious, some of us will still be around in 2050, and some will not. On current mortality statistics, I have a fair chance, if not quite even-money. So, the price of a lifetime annuity or health insurance policy I can buy today incorporates an implicit judgement about investment returns and other economic variables in that year.

The crucial implication here is that expectations about events decades from now have economic implications today, at least for members of the generations that can expect to … This in turn means that the intergenerational perspective adopted in the … report is the correct one. The way to think about these problems is not in terms of striking a balance between the present and the future, but in terms of equity between generations.

The only reasonable basis for equity between generations is that all should be treated equally. Baby boomers should count the same as Gen X-ers and both should count the same as members of the generations about to born. No inherent discount factor should be applied to future benefits simply because they accrue to later-born generations.

If all generations count equally, the only reason for discounting benefits received in the future is that later-born generations will, on average, have higher lifetime incomes. This means that a given dollar increase in their incomes will yield less additional welfare than the same increase for an earlier-born and (on average) poorer generation.

For a number of reasons, an appealing way of taking this fact into account is to assume, for the purposes of public policy, that a given percentage change in income is of equal social value no matter whether it is received now or in the future, by a wealthy person or a poor person.

With this rule the appropriate social rate of discount is equal to the rate of growth of real income. Happily, it turns out that the average long run real rate of interest on government bonds, the corresponding market price, is fairly close to the rate of growth of income. So this rule is broadly consistent with observed outcomes (there are some tricky complications to do with returns to equity investment, but I’ll leave them for another day).

Although the Intergenerational Report does not use an explicit discount rate, the equal-sacrifice rule is implicit in the idea that, with a stable balance between the public and private sectors, governments should aim to hold constant the ratio of tax revenue to national income. If inherent discounting were applied to future generations, the implied policy would be to run deficits now, and shift the tax burden to the future.

The Stern Review, although approaching the issue from a different starting point, reached essentially the same conclusion. Stern allowed for a small inherent discount factor, to take account of the bleak possibility that no-one might be around in the future because of nuclear war, meteor strikes and so on, but otherwise followed the approach I’ve described.

It’s a hopeful sign then, if Treasury is, as Secretary Ken Henry recently stated, returning to a central place in the debate on climate change. A consistent approach to intergenerational equity is long overdue.

John Quiggin is an Australian Research Council Federation Fellow in Economics and Political Science at the University of Queensland.

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