Discounting as a double-edged sword: the values of both future goods and present economic growth decrease with the discount rate

ABSTRACT

How to compromise between economic growth and sustainable development is a major question. Particularly, climate policy affects capital and production levels (GDP), but it also affects the long-term economic growth, or the development of Total Factor Productivity (TFP) (e.g. technological developments), which enables more effective future production using a given capital. A slowdown in TFP development rate may result from either restrictions on production or climate damages. Such a slowdown results in a long-lasting decrease in GDP that persists long after the restrictions are no longer implied and/or long after the environment recovers from the damages. Therefore, effective climate policy entails analysis that incorporates present and future changes in both capital and TFP. Here, we derive an analytic formula for the economic values of TFP development. The values derived from the formula are consistent with those derived in detailed Integrated Assessment Models. The advantage of the formula is that it reveals the role of some key parameters in determining these values. Specifically, we show that higher discount rates imply lower values to TFP development. Therefore, considering higher discount rates is a double-edged sword, implying that future environmental damages are less costly but also that present economic growth is less valuable.

KEYWORDS:

• Climate policy
• dynamic optimization
• economic growth
• endogenous discount
• intergenerational discounting

JEL:

• H43
• Q58

Acknowledgment

I thank Kerry Smith, Charles Perrings, and the anonymous reviewers for their helpful comments on the manuscript. I thank Simon Dietz for helpful discussions.

Disclosure statement

No potential conflict of interest was reported by the author(s).