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Executive Summary

The public sector discount rate reflects how the government values outcomes that occur in the future relative to those that occur in the present. It is used across central and local government to 'weight' future costs and benefits when agencies carry out cost-benefit analysis (CBA), and to estimate the cost to the Crown of investing in public assets (the capital charge calculation). Despite many years of debate, there is no consensus on this topic, either in academic research or in policy guidance. This paper sets out the alternative approaches to discounting and explains the assumptions involved.

The discount rate can be interpreted as the minimum rate of return that the government expects from its investments. This gives two ways of thinking about the discount rate.

The social opportunity cost of capital approach (SOC) defines the discount rate as the rate of return that a decision-maker could earn on a hypothetical ‘next best alternative' to a public investment

The social rate of time preference approach (SRTP) defines the discount rate as the rate of return that a decision-maker requires in order to divert resources from use in the present, to a public investment.

In theory, in an ‘ideal' market, these two rates are brought into alignment in equilibrium. Rational decision-makers continue to invest as long as the rate of return that can be earned on public investments exceeds the rate demanded. However, as there are no markets for public investments, there are no market signals to equate preferences for investing in such projects with rates of return. This leaves the two alternative ways of approaching public sector discount rates introduced above.

SOC is typically measured by reference to the rate of return on private-sector investments with similar risk characteristics to the public project under consideration. Under this approach, the discount rate is composed of a risk-free rate of return plus a risk-based premium which varies according to the riskiness of the project. This the basis for the NZ Treasury's current advice.

SRTP is a direct statement of the decision-maker's preferences for valuing the future. Loosely speaking, it states that the discount rate depends on any intrinsic preference for trading-off the future relative to the present (so-called 'pure time preference'), and the extent to which decision-makers may wish to prioritise the present, if there is an expectation that living standards are expected to grow in the future.

There is no completely objective way of determining public sector discount rates. Essentially the discount rate reflects how the government values the future when making decisions on behalf of society. It is therefore natural to expect that value judgements and assumptions are necessary. First, a market-based SOC assumes that political decision-makers should trade-off the future for public investments in the same way that individuals and businesses do when making decisions about their own personal consumption and investment. However, it is possible that many individuals in their political roles as citizens might be more concerned about future social outcomes than is reflected in their decisions about their own personal consumption and investment.

Second, a market-based SOC assumes that the government cares about the same types of risk, and demands the same risk-premiums, as private investors. Risk-premiums in financial markets are determined by the volatility of individual asset returns, and how those returns are expected to vary relative to the investor's overall portfolio. This approach to measuring and pricing risk may not be meaningful in a public sector context. Furthermore, governments' ability to manage risk is likely to be different to that of private sector firms. These considerations mean that the risk-premium component of public sector discount rates could, depending on how the government evaluates and prices risk, be different from those implied by private sector rates of return.

Elements of both approaches may be relevant to many policy and operational decisions that require discounting, in which case a hybrid approach might be appropriate. Different approaches may be relevant for different contexts.

The standard model of discounting involves discounting future amounts at a constant proportional rate, however long the time horizon under consideration. This is known as constant exponential discounting. One concern that has been raised with this approach is that, even with a low discount rate, the weights that a decision-maker attaches to future time periods eventually converge toward zero. An alternative approach is to apply a progressively lower rate to net benefits in more distant time periods. This is known as hyperbolic discounting, and has the effect of scaling-up the weight attached to the more distant future relative to exponential discounting.

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