The Social Discount Rate

When calculating the value of an investment, or determining whether to undertake a certain project or action, future costs and benefits are reduced (or "discounted") into an equivalent value today. The reason for discounting is that a dollar received in a year's time is worth less than a dollar received today: over the course of the year inflation will degrade the purchasing power of that dollar, delayed consumption intrinsically has less value to us than consumption now, and a dollar received today could also be invested and earn a return over that year.

Discounting and the Importance of the Right Discount Rate

The discount rate is the percentage rate that is used to convert future values to present values. A discount rate of 4% (0.04) means that one dollar received in one year is worth $1/1.04 = 96 cents today. A discount rate of 10% (0.10) means that one dollar received in one year is worth $1/1.10 = 91 cents per day. Due to the geometric nature of discounting, the difference in present values becomes increasingly significant the further into the future that the dollar is received. For example, one dollar received in 15 years' time is worth $1/1.04¹⁵ = 56 cents with a discount rate of 4%, but only $1/1.10¹⁵ = 24 cents with a discount rate of 10%. The choice of discount rate clearly makes a very significant difference to the present value of future costs and benefits.