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The choice of the social discount rate and the opportunity cost of public funds

  • Mark A. Moore EMAIL logo , Anthony E. Boardman and Aidan R. Vining

Abstract

The decades-old literature on the correct method for choosing and estimating a social discount rate (SDR) has resulted in two, largely opposing viewpoints. This note seeks to clarify the key sources of disagreement between these two camps. One view advocates that the choice should be based chiefly on the social opportunity cost of the return to foregone private capital investment (SOC), and suggests a SDR of around 7%. The other viewpoint, expressed by the authors, argues that the choice should be based on the social rate of time preference (STP), the rate at which society is willing to trade present for future consumption, suggesting a SDR of around 3.5%. Because of the fundamentally normative basis of the SDR choice, neither approach generates testable hypotheses that would allow falsification. For government project evaluation, the choice ultimately depends on the opportunity cost of public funds, which in turn depends on how fiscal policy actually operates. The STP approach contends that governments set targets for deficits and public debt, so that a marginal government project will be tax-financed, largely crowding out current consumption. The SOC belief is that governments set revenue targets, so that any government project will be deficit-financed on the margin, which will largely crowd out private investment. The authors also argue that a SDR based on the STP approach is appropriate for: benefit-cost analysis of government regulations, self-financing government projects, and government cost-effectiveness studies.


Corresponding author: Mark A. Moore, Simon Fraser University, Beedie School of Business, 500 Granville Street, Vancouver, British Columbia V6C 1W6, Canada, Tel.: +778-782-7715, e-mail:

  1. 1

    However, in MBV (2013, p. 12) we argue that, using recent US data, a superior approach to estimate the SOC would result in a rate of approximately 5%. There is no reason to repeat that analysis here.

  2. 2

    For simplicity, we maintain the benefit-cost tradition of assuming full employment, although we think it unlikely that there is much crowding out of anything during periods of less-than-full employment. We also ignore the possibility that the public investment will simply crowd out net exports (as in Lind, 1990).

  3. 3

    Standard BCA recommends choosing projects that pass the Kaldor-Hicks test of potential Pareto improvement. This implies both that the initial distribution of endowments is legitimate and that a policy that produces winners and losers is normatively acceptable, as long as the winners could more than compensate the losers and the losers could not bribe the winners to forgo the project.

  4. 4

    The OMB concurs that BCA of regulations that largely affect consumption should use a SDR based on the STP and recommends an estimate that is based on the real, pre-tax return to long-term government bonds of around 3% (OMB, 2003, Section E). The OMB also advises the use of this rate for BCA studies of cost-effectiveness, lease purchases, asset sales and internal government investments (OMB, 1992). Its default rate recommendation when private investment is primarily displaced is to use 7%, based on the real average ROI in the US, which is a variant of the SOC approach.

  5. 5

    The increase in the interest rate will also increase saving somewhat, reducing current consumption, and it will appreciate the exchange rate and lower net exports, increasing foreign borrowing. In advocating a SDR of approximately 7%, Burgess and Zerbe (2011) assume that 54% of the project’s borrowing is at the expense of private investment, 10% reduces consumption and 36% increases foreign borrowing.

  6. 6

    Of course, this statement relies on the normative judgments implicit in the Kaldor-Hicks criterion (see footnote 3, supra).

  7. 7

    Since actual (as opposed to lump-sum) taxes generally impose deadweight welfare losses, one can simply treat these losses as an extra social cost, in addition to the revenues needed to fund the project, when calculating net benefits.

  8. 8

    Of course, both alternatives are stylized reifications of the actual (chaotic) government budget decision-making processes. Especially in the US, with its separation of powers, there is no single entity that functions as “the government.”

  9. 9

    Formally incorporating uncertainty about the future growth rate into the Ramsey formula would lower the SDR due to a precautionary motive (Cropper, 2012).

  10. 10

    See Cropper (2012) and the references therein as to the rationale for discounting the far future with a schedule of declining discount rates.

  11. 11

    We take the Arrow and Lind (1970) view that, due to missing insurance markets, the government has an advantage over the private sector in risk diversification, and this is reflected in the lower rates that the government pays on its debt, compared to private rates. See also Arrow (1995).

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Published Online: 2013-08-29
Published in Print: 2013-12-01

©2013 by Walter de Gruyter Berlin Boston

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