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1 Introduction

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 to value the future costs and benefits of public projects and to estimate the cost of investing in public assets (the capital charge calculation).[1] As a result, the discount rate plays an essential role in guiding public spending and investment decisions.

The public sector discount rate can be interpreted as the minimum rate of return that the government expects from its investments. As a result, it represents the benchmark against which the returns from public sector investments should be assessed. Too high or too low a discount rate could cause the government to make the ‘wrong' investments. In particular, setting the discount rate too high could lead to the rejection of public spending initiatives that would otherwise be regarded as valuable.

Furthermore, a high discount rate, by lowering the weight that is attached to future outcomes, tilts decisions towards projects that deliver net benefits in the near term. Conversely, a low discount rate tilts decisions towards projects which deliver net benefits over the longer term.

The recommended discount rate is, not surprisingly, highly controversial. Its choice involves both technical issues and a range of value judgements. This paper provides a comparison of alternative approaches. The aim is to clarify alternative viewpoints and so provide the basis for a balanced debate about advice regarding public sector discount rates. There are likely to be many competing opinions, many of which may ultimately boil down to value judgements which cannot be reconciled objectively. The paper aims to distinguish where objective considerations can be used to make recommendations and where value judgements are involved.

Emphasis is given to the two main approaches to the public sector discount rate. These are the social rate of time preference approach and the social opportunity cost of capital approach. It also covers some other key considerations relevant to how public projects might be discounted, such as whether discount rates should be constant or whether they should gradually fall over the length of life of a project.

It is of course recognised that the question of the public sector discount rate and the total amount of government expenditure are in principle intimately related. For example, a lower discount rate may be expected to be associated with higher planned levels of current expenditure. In practice however, current and planned spending levels are determined by a complex political process which involves many considerations other than the discount rate. These broader considerations are covered by New Zealand's Fiscal Management Approach and are therefore not discussed here; see Lomax, McLoughlin and Udy (2016). The focus here is purely on the approaches taken to thinking about a public sector discount rate in the context of comparing cost-benefit profiles for the appraisal and ranking of public sector projects.

Similarly the need to attach a monetary value to costs and benefits in each period during the life of a public project, where market prices are not available to provide a guide or markets are subject to distortions, presents a huge challenge that has also given rise to an extensive literature. The measurement of costs and benefits and the choice of public sector discount rate are often conflated, in particular in dealing with risk and uncertainty. Furthermore, it is often suggested that the ‘excess burden' of taxation needed to finance the project should be taken into account. Sometimes the problems of measuring future benefits are simply assumed away when discussing discounting. Again, while recognising these issues, given the aims of this paper, focus is largely on the discount rate alone, although the questions of risk and opportunity costs are necessarily discussed.

Finally, it is important to stress that the purpose of this paper is to clarify issues and provide a framework for discussion. It is not intended to propose any particular recommendations, or even reach unambiguous conclusions. As mentioned earlier, rational policy analysis requires clarification of the separate roles of value judgements and economic technicalities.

Section 2 provides a brief introduction to the need for discounting, along with the basic mechanics of discounting and computing present values. Section 3 outlines the basic intuition behind approaches to discounting. Sections 4 and 5 go on to outline the two main approaches to thinking about public sector discount rates. These are, as mentioned above, the social opportunity cost of capital, and the social rate of time preference approaches. Section 6 compares these two approaches and so 'sets the scene' for debate. Section 7 introduces the issue of time-varying discount rates. Section 8 concludes.

The public sector discount rate has been the subject of an extensive and often highly technical and controversial literature over a very long period.[2] This paper makes no pretence to be comprehensive or to provide a review of the vast literature: references to this literature are therefore highly selective. As mentioned earlier, its aim is to set out the issues in a way that can stimulate rational debate. While it is not possible to avoid some technicalities, every attempt has been made to make the discussion clear and widely accessible.

Notes

  • [1]In New Zealand, other discount rates are used across government, most notably, the risk-free rate for accounting valuations: see http://www.treasury.govt.nz/publications/guidance/reporting/accounting/discountrates. These are used as the basis for valuing a number of public sector assets and liabilities; for example, insurance liabilities (particularly ACC's insurance claims liability), employee benefits (such as pensions), and the student loan book. These discount rates are outside the scope of this project.
  • [2]A flavour of the controversy can be obtained from the debate following the Stern Report (2006) on climate change: see for example, Carter et al. (2006), Dasgupta (2006), Nordhaus (2006) and Varian (2006). For broader literature reviews, see Harrison (2010) and OECD (2015).
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