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Introduction

There is a wide-ranging academic literature on the setting of a public sector discount rate. Broadly speaking there are two approaches plus a couple of variants:

  1. One is based on the view that the discount rate should reflect government policy preferences[2]. This is one version of the so-called “social rate of time preference”. The main exponent is probably Martin Feldstein, but others include O Eckstein and S A Marglin. A more recent exponent is Sir Nicholas Stern’s review of the economics of climate change. However, most exponents of this view recognise that the opportunity cost of capital (see below) should be recognised where the alternative is for the funds to be invested in the private sector.
  2. The financial economics literature takes the view that the discount rate should reflect the socialopportunity cost of capital, which in turn depends on the level of non-diversifiable risk in a project. It is in effect the pre-tax rate of return that can be expected from private sector investments that have similar risk characteristics. The main tool used to calculate this discount rate is the capital asset pricing model (CAPM). The main Australasian academic exponents are Bob Officer from Monash University and the University of Melbourne and Martin Lally from Victoria University of Wellington. It has been adopted internationally by the main multilateral organisations and a number of countries including France and Canada (see below). It is the approach that underpinned the existing Treasury discount rate since at least 1971 and is also the logic followed by the capital charge calculation.
  3. Another is a hybrid of the “social rate of time preference” and the “social opportunity cost of capital”. The discount rate equals the sum of the after-tax Government bond rate (or some other measure of the rate at which individuals save in secure investments) and the expected growth rate in per capita consumption times the negative elasticity of marginal utility with respect to consumption. The main academic exponent is probably A C Lind and the approach has been adopted by the UK Treasury in its Green Book on project appraisals.
  4. Finally, some commentators draw attention to the “equity premium puzzle”, i.e. the fact that the difference between empirical values of the risk-free interest rate and the return on equity is much larger than predicted by theory, and conclude that the government’s opportunity cost of capital is much lower than indicated by the CAPM. This approach appears to be followed by Germany and the U.S., who set their discount rates equal to their pre-tax government borrowing rates.

Some of these views may not be as irreconcilable as they seem. For example, the principal advocates of the social rate of time preference approach acknowledge that the opportunity cost of capital must be taken into account as a shadow price. The practical effect of doing so is arguably not that different from taking the social opportunity cost of capital approach, at least where cash flow profiles are similar.

The opportunity cost of capital is the return foregone by investing in one project rather than in an alternative project. I.e., the cost of a project is the value of the next best alternative foregone. One alternative outside the public sector is investment in the share market. The share market is likely to be a good indicator of the next best alternative because the companies who make up the market are incentivised to search out the best investments in the economy, both locally and overseas, and because the government does in fact invest in the share market through the NZ Superannuation Fund and could choose to vary the amount invested.

Basing the discount rate on the opportunity cost of capital is sometimes criticised on the grounds that it assumes that markets are perfect. Two important and pervasive market imperfections are externalities and taxation:

  • Externalities: There are two ways of taking account of externalities. One is to adjust the discount rate; the other is to take them into account explicitly in the individual cash flows. The latter is considered to be the better approach.
  • Taxation: A tax on capital income reduces the amount of investment compared with a situation where there is no such tax. The volume of investment could therefore be considered to be sub-optimal. Using a post-tax rate of return as the public sector discount rate could therefore be regarded as correcting for, or avoiding, the market imperfection created by tax. We note, however, that using a pre-tax rate of return is equivalent to taxing public sector investments. The tax rate required to meet a given government revenue required is therefore lower than if only private sector investments were taxed. It is generally accepted that the deadweight cost of taxation increases exponentially with the rate of tax. A lower tax spread over a wider set of investments is therefore less distortionary than a narrower tax limited to private investments only.

We conclude that market imperfections do not provide sufficient reason to modify the discount rate.

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