Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / How the Government's Discount Rate Shapes Trillion-Dollar Decisions
Transcript
- Lucas: The federal government is about to spend roughly six trillion dollars this year. But whether that money is well spent often comes down to a single number that most people have never heard of. It's called the discount rate. Luna: And this number actually decides which projects get funded, right? Like, if the discount rate is too high or too low, it can make or break a multi billion dollar investment. Lucas: Exactly. The discount rate is used in cost-benefit analysis to convert future costs and benefits into present value terms. Every major federal project—from building a highway to setting fuel economy standards—has to pass a test where its net present value has to be positive. Luna: So a lower discount rate makes future benefits worth more today, which makes long-term projects look better. A higher rate does the opposite. Lucas: Right. And that's why the recent update to OMB Circular A-94—the document that sets the government's recommended discount rates—is such a big deal. In 2025, the Office of Management and Budget lowered the real discount rate for most projects from 2.5 percent to 1.5 percent. Luna: That's a full percentage point drop. How did they justify that? Lucas: It's based on the real yield on long-term Treasury bonds, which has fallen over the past decade. The idea is that the government's cost of borrowing is a proxy for the opportunity cost of capital. So when Treasury yields go down, the discount rate follows. Luna: But critics argue that using a low discount rate systematically biases the government toward projects with long payoffs—like climate infrastructure or research—and away from short-term fixes. Lucas: They do. Let's take a concrete example. Consider a flood protection project that costs $100 million today but is expected to prevent $200 million in damages thirty years from now. At a 2.5 percent discount rate, the present value of those avoided damages is roughly $95 million. So the net present value is negative—the project wouldn't be funded. Luna: But at 1.5 percent, the present value jumps to about $128 million, making it a go. Same physical project, different number. Lucas: And that's just one project. Multiply this across thousands of federal decisions each year, and a one-point shift in the discount rate can redirect tens of billions of dollars. The Congressional Budget Office noted that the 2025 change could make investments in long-lived assets like dams, tunnels, and energy grids far more attractive. Luna: It's almost like the government is changing its time horizon. But what about projects where the benefits come decades later, like climate change mitigation? The discount rate becomes incredibly important there. Lucas: Absolutely. For climate policy, the choice of discount rate is intensely political. A low rate—say, 1 percent—would justify aggressive action today to avoid far-off damages. A higher rate, like 3 percent, often leads to a 'wait and see' approach. The recent OMB update pushes more projects into the 'do now' column. Luna: But some economists say we shouldn't use the same discount rate for intergenerational projects. They argue that because we're making decisions that affect people not yet born, we should use a much lower rate, or even a zero rate, to reflect ethical obligations. Lucas: That's the 'social discount rate' debate. William Nordhaus, the Nobel laureate, has argued for a rate around 4 percent based on market returns on capital. On the other side, Nicholas Stern used a near-zero rate for his famous climate review. That single assumption accounted for a huge chunk of the difference in how dire the report looked. Luna: So the discount rate isn't just a technical detail. It's a philosophical statement about how much we value the future. Lucas: Exactly. And the government's choice has real consequences. For instance, the 2025 update affected the evaluation of new energy efficiency standards for appliances. A lower discount rate made the long-term energy savings more valuable, which justified stricter standards that industry groups opposed. Luna: Did that lead to legal challenges? Lucas: It did. A coalition of manufacturers sued, arguing that the lower discount rate inflated the benefits and violated the Administrative Procedure Act. The case is still pending. So this isn't just a wonk fight—it lands in court. Luna: Right, because the discount rate directly affects the stringency of regulations. And then there's the impact on infrastructure projects. I read that the Army Corps of Engineers is now reconsidering several flood control projects that previously failed cost-benefit tests. Lucas: That's correct. The Corps uses a discount rate tied to OMB guidance, so projects in Louisiana and Texas that would have been rejected at 2.5 percent are now on the table. The expected cost is billions of dollars, but proponents argue it's cheaper to build now than pay for disaster relief later. Luna: But opponents would say that we're just trading one form of spending for another—and that the discount rate masks the true risk of cost overruns or changing conditions. Lucas: That's a fair critique. Discounting assumes that future benefits are certain, but many infrastructure projects face huge uncertainties. Some economists advocate for using a 'risk-adjusted' discount rate that accounts for the probability that the project will be delayed or canceled. Luna: So what's the bottom line? Is the 1.5 percent rate appropriate, or is it distorting government decision-making? Lucas: The honest answer is that it's a judgment call. The rate is based on current Treasury yields, but those are partly driven by artificial phenomena like quantitative easing and global demand for safe assets. Some argue the true social opportunity cost of capital is higher. The OMB's choice to follow the market rate is defensible, but so is the argument for a different rate. Luna: It almost feels like the discount rate itself should be a question for democratic debate, not just an OMB technical exercise. Lucas: And that gets to the heart of fiscal policy. How we value future generations is a reflection of our priorities. If you think that's an interesting and important question, this is exactly the kind of thing we explore on The Fiscal Policy Podcast. If you find value in these conversations, you can support the show at buy me a coffee dot com slash fexingo. Luna: Yeah, it keeps us independent and free of outside influence. And we really appreciate those who chip in. Lucas: So back to the discount rate: one key takeaway is that the next time you hear about a massive government project being approved or rejected, remember that the answer often depends on a single number—one that is not set in stone. And that number can change with a pen stroke inside the OMB. Luna: And that pen stroke can move billions of dollars. Makes you wonder: should there be more transparency around how that number is chosen? Lucas: Absolutely. Some policy experts have called for a formal review process where the discount rate is debated publicly, similar to how the Federal Reserve sets interest rates. But for now, it stays inside the executive branch. And that means it's a powerful lever for shaping long-term investment—one that most voters have no idea exists. Luna: Well, at least now we know. Thanks, Lucas. Lucas: Thanks, Luna.