Now, later, or never: applying asymmetric discount rates in nuisance remedies and federal regulations.

AuthorWang, Yang

TABLE OF CONTENTS INTRODUCTION I. DISCOUNTING BENEFITS AT DIFFERENT RATES A. Descriptive Approach B. Prescriptive Approach II. MODELING NET PRESENT VALUE OVER TIME A. A First Model with Asymmetric Discount Rates B. Ask "When," Not "If": A Marginal Net Present Value Approach C. Achilles and the Tortoise: The Paradox of Infinite Postponement III. THE M-NPV MODEL AND NUISANCE REMEDIES: A CASE STUDY A. The Cathedral Revisited: Entitlement and Rules of Protection B. Time Dividing Rules and Entitlement: The Boomer Case C. M-NPV Step 1: Who Gets the Entitlement, and at What Time? D. M-NPV Step 2: Protecting the Time-Divided Entitlements IV. THE M-NPV MODEL APPLIED TO THE COST-BENEFIT ANALYSIS OF FEDERAL REGULATIONS A. The Debate over Cost-Benefit Analysis and Asymmetric Discounting B. The M-NPV Model Applied to Federal Environmental Regulations C. An Economic Justification for Progressively More Stringent Regulations CONCLUSION APPENDIX INTRODUCTION

Discounting, "[t]he procedure for determining the present value of a future dollar," (1) has long been recognized as a crucial element in the calculation of tort damages. Following decades of application by state courts in the late nineteenth and early twentieth centuries, (2) the notion that future economic losses must be discounted to present-day value first received express endorsement from the U.S. Supreme Court in 1916. (3) In the ninety years that followed, the use of discount rates in computing tort damages became firmly established in American jurisprudence and widely practiced by courts. (4) More recently, discounting has also become indispensable to the executive branch of the federal government in the economic analysis of its regulations. (5) Since 1981, when President Reagan's Executive Order 12291 first mandated cost-benefit analysis for all major federal regulations, (6) federal agencies such as the Environmental Protection Agency, the Food and Drug Administration, and the Department of Housing and Urban Development have routinely discounted and compared future costs and benefits to study the impact and desirability of proposed regulations. (7)

Discounting has intuitive appeal. As Judge Posner writes, "To most people, a dollar today is worth a great deal more than a dollar ten years from now." (8) There are two reasons this is the case: opportunity cost, because a dollar today can be invested, and pure time preference, because individuals are generally impatient. (9) By converting a future dollar into its present-day equivalent, discounting enables us to aggregate and compare values across different time periods. (10) In the classic model of discounting, the formula for making such a conversion from the future to the present is:

[u.sub.t] [v.sub.t]/[(l + r).sup.t],

where [v.sub.t] is the future value in year t, r is the discount rate, and [u.sub.t] is the present value of [v.sub.t]. (11) Cost-benefit analysis applies this formula to compute the present value of future costs and benefits of a proposed project or regulation. (12) Under the Net Present Value ("NPV") test, an activity is worthwhile if and only if it has a positive net present value, defined as the difference between the present value of benefits and the present value of costs. (13) A negative net present value indicates that the activity costs more than its benefits and therefore fails the cost-benefit analysis. (14)

Despite its intuitive appeal and simple mathematical formulation, the use of discounting in cost-benefit analysis remains a subject of heated academic debate, (15) at the center of which is the difficulty of determining the appropriate discount rate. (16) The classic model of discounting predicts a constant discount rate equal to the real market interest rate, (17) but scholars have since identified a number of other factors affecting the discount rate, such as risk premium, social preference, and ethical implications. (18) From a theoretical perspective, even though scholars generally agree that the discount rate depends on more than the interest rate alone, they disagree on the extent to which these other factors influence the discount rate. (19) Some contend that one should not discount nonmonetary "future enjoyments" such as human lives and environmental benefits, (20) essentially advocating a discount rate of zero for such assets. (21) Empirical analysis has not fared much better in producing a consensus. Various experimental studies observed a range of behavioral discount rates too wide to provide any practical guidance, (22) further confirming the challenge in obtaining an appropriate discount rate for use with cost-benefit analysis. In practice, federal agencies vary in selecting discount rates, and even within one agency discount rates may vary from regulation to regulation "for no apparent reason." (23) Because of the theoretical controversy and the practical difficulty in ascertaining the appropriate discount rate, as well as the "extremely erratic" government approach to choosing a discount rate, (24) some scholars have questioned the feasibility and credibility of cost-benefit analysis, (25) noting that even a minute discrepancy in the estimated discount rate can result in a substantial change in the present value of costs and benefits from the distant future. (26)

This Note does not attempt to resolve the controversy surrounding the choice of discount rates or the use of cost-benefit analysis. Instead, it builds on a substantial body of literature that advocates asymmetric discounting--the use of a lower discount rate when computing the net present value of benefits than when computing the net present value of the corresponding costs--and argues that a proper application of asymmetric discount rates will change the inquiry of cost-benefit analysis from "whether to adopt a proposed activity" to "when to adopt." Part I of this Note reviews recent literature on the need for asymmetric discount rates in cost-benefit analysis. It observes that even though scholars disagree on the precise value of the appropriate discount rate, many agree that future costs and benefits must be discounted at different rates. Part II then constructs a simple model, consisting of two activities competing for the same resource, and analyzes the consequences of asymmetric discounting under this model. This Part proposes that, to maximize the joint social utility, the resource should be time divided between the competing activities rather than permanently allocated to one or the other. Part III applies this model to nuisance suits between polluters and victims of pollution. This Part argues that, when choosing how to allocate an entitlement to valuable resources between competing parties, courts should consider time dividing the remedy instead of permanently awarding entitlement to one side or the other, as courts traditionally have done. Likewise, the two categories of rules designed to protect entitlements, property rules and liability rules, may also be alternated over time to maximize social utility. Part IV extends the model to augment the traditional economic analysis of federal environmental regulations. It identifies two perhaps unintended consequences of applying asymmetric discount rates in the cost-benefit analysis of federal regulations. First, from a pure utility-maximizing point of view, many federal regulations to which asymmetric discounting is applicable should be adopted neither now nor never, but rather at some point in the future. Second, agencies should adopt progressively more stringent regulations over time in order to maintain a maximum level of social utility.

  1. DISCOUNTING BENEFITS AT DIFFERENT RATES

    In determining the appropriate discount rate to use with a cost-benefit analysis, the real interest rate approach serves as a starting point. Introductory economics and finance textbooks often illustrate the theory of discounting by using the real interest rate as the discount rate, (27) because under perfect market conditions, rational consumers will "equate their marginal rates of time preference to the rate of interest." (28) "Based on this justification, and perhaps partially due to the relative ease in calculating the real interest rate from the return on long-term government bonds, many courts in this country and other common law jurisdictions have adopted the real interest rate approach to discounting future cash flows. (29) This Part provides a brief survey of the large volume of literature that suggests the real interest rate may not be the appropriate discount rate.

    1. Descriptive Approach

      The real interest rate approach described above is a simplified version of what is commonly referred to as the descriptive approach. "The descriptive approach," as defined by Professor Arrow in his influential 1996 article, "looks at investments in the real world, and sets the discount rate accordingly." (30) Advocates of the descriptive approach "begin[] with evidence from decisions that people and governments actually make" and infer the discount rate from such evidence. (31)

      Under the descriptive approach, risky future payoffs must be discounted at a higher rate than risk-free ones. The basic financial principle that "[a] safe dollar is worth more than a risky one" (32) implies that, to be acceptable, risky projects must be able to earn a higher return than safe projects. Under this approach, a risk-adjusted discount rate, consisting of the risk-free discount rate plus a risk premium, is appropriate for evaluating uncertain future benefits. (33) The risk premium component of the risk-adjusted discount rate is further divided into specific risk, the risk associated with the unique characteristics of the future cash flow, and systematic risk, the risk associated with the market as a whole. (34) Because specific risk "stems from the fact that many of the perils that surround an individual company are peculiar to that company," (35) the discount rate used in...

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