Valuing the Future: the social discount rate in cost-benefit analysis
Visiting researcher paper
This paper by Mark Harrison was released on 22 April 2010.
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- Key points
- The discount rate is a critical parameter in cost-benefit analysis whenever costs and benefits differ in their distribution over time, especially when they occur over a long time period.
- Approaches to selecting real discount rates fall into two broad groups, both of which have given rise to a wide range of recommended rates:
- a 'descriptive' approach based on the opportunity cost of drawing funds from the private sector; and
- a 'prescriptive' approach that derives from ethical views about intergenerational equity.
- The arguments here support the descriptive approach and provide a starting point for the discount rate — the marginal return to private capital in Australia over the past four decades, which has averaged almost 9 per cent real.
- Market rates reflect the opportunity cost of investing in public projects, and there is no case for allocating resources to low return investments when higher returns are available. Using an artificially low discount rate for project evaluation can make future generations worse off. Ethical arguments for a low discount rate are more a reason to increase savings and investment.
- Government projects for which cost-benefit analysis can assist decision making cover a huge range: regulatory changes; infrastructure investments with significant gestation periods and long benefit streams, whose magnitudes are positively related to general economic conditions; and climate change policies with cost and benefit streams extending over centuries, but with high uncertainty.
- No single discount rate could meet the precise financing and risk characteristics of each project in this wide range of applications.
- Taxes make a big difference between the before-tax 'investment rate' that investments earn and the after-tax 'consumption rate' that lenders receive, and a project's discount rate choice should ideally reflect the extent to which its financing reduces investment and consumption.
- Government projects are not in general free of risk; some have expected net benefits inversely related to aggregate consumption, but many have expected net benefits positively correlated with aggregate consumption. Discount rates should embody an appropriate compensation for risk. The rate should be equal to the rate of return on private projects with similar levels of risk. The market price of risk is what people have to be paid to bear risk and reveals attitudes to risk even where markets are imperfect.
- The appropriate adjustments for taxes and risk cannot be precisely estimated — one reason why sensitivity testing is important. A base rate of 8 per cent, and testing over a range of 3 to 10 per cent is proposed.
Leonora Nicol (Media, Publications and Web) 02 6240 3239 / 0417 665 443>
Cover, Copyright, Contents and Preface
- Overview - including key points
- Chapter 1 The concept of discounting in cost-benefit analysis
1.2 The discount rate in cost-benefit analysis
1.3 Why discount?
1.4 Real and nominal discount rates
1.5 The discount rate’s impact on project viability
- Chapter 2 Approaches to discounting
2.1 Different views on the social discount rate in practice
2.2 Cost-benefit analysis and the efficiency criterion
2.3 Defining the social discount rate
2.4 The prescriptive approach
2.5 Inter-generational issues
2.6 Why the efficiency standard is relevant for inter-generational project evaluation
- Chapter 3 The discount rate and market benchmarks
3.1 The discount rate in an undistorted capital market
3.2 The effects of capital taxes
3.3 The Ramsey formula
3.4 The marginal return to capital
3.6 Discounting the distant future
- Chapter 4 Setting the social discount rate
4.1 Adjusting for taxation and foreign capital flows
4.2 Adjusting for risk
- Appendix A Accounting for Inflation
- Appendix B How project finance affects present and future consumption
- Appendix C Inter-generational comparisons: the social welfare function approach
- Appendix D The shadow price of capital and the weighted average discount rate
- Appendix E Foreign Capital
- Appendix F Deriving the Ramsey equation
- Appendix G Rates of return in Australia
- Appendix H Asset pricing
- Appendix I Discounting the distant future