New discount rate pub

05/12/2011 § 6 Comments

On Friday, NZIER (where I work) published an Insight about discount rates. Chris Parker has collected some thoughts and questions about discount rates and policy. Specifically, he is interested in whether Treasury’s 8% is the right number. The work has come out of our preparations for the visit of Prof Martin Weitzman, who is in Wellington this week.

Discount rates are one of those pointy-head policy details that are actually really important. I remember working on business loss valuations many years ago, and discovering just how much difference the assumed rate made to the value of losses.

They are prominent in the climate change area. The results in the Stern report were heavily influenced by the 1.4% discount rate used. The report came in for a lot of criticism for using such a low rate. So, just as an example, take $1,000 in damages that will occur in 25 years. At the Stern rate, the present value is about $700; at the Treasury rate, the present value is around $150. That makes a big difference to a benefit-cost ratio.

I’m glad to see Chris working on raising the issue. Because it is so central to evaluating long-term investments, it’s worth thinking about and getting right.

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§ 6 Responses to New discount rate pub

  • Michael Reddell says:

    I struggle to see the basis for using discount rates that are not materially influenced by the actual cost of capital available to the NZ government and its citizens. Parker or Weitzman may, in principle, be right that the interests of future generations should be rated more highly than they are under an 8% real discount rate, but……..NZ already does a high level of public investment (% of GDP) by OECD standards, and the real cost of borrowing (and probably of equity) is high by advanced country standards. Since the limits of (public and private) leverage have proved more binding in the last few years than had generally been anticipated, decisions to undertake materially more public investment (a consequence of using a lower discount rate) would have real and material consequences for the level of consumption undertaken in the near-term. In some respects that looks like the financial repression adopted in China – where state entities get access to very cheap capital, at the cost of the household sector.

    Incidentally, I was surprised not to see any mention of real options analysis in Parker (or in the Weitzman presentation). One can think of a higher discount rate (as, for example, used in the private sector) as a crude way of incorporating the value of real options in respect of irreversible investments.

    • Chris Parker says:

      Thanks Michael for commenting on the Insight article. I’ve got a couple of comments, but I’ll paraphrase Michael’s argument (to show whether I got it or not):

      1: only the cost of capital seems to have any proper basis to be a social discount rate
      2: there’s enough public investment already, and the current economic climate means that any more will come with a sting
      3: So using anything lower will lead to more public investment, which is bad, particularly at the present time.

      I’d say first and foremost the issue is about valuing future costs and benefits appropriately. If we’re not doing that now, and improving things causes other inconveniences and costs, then tough. Just like we shouldn’t use a low discount rate to mask poor valuation of environmental issues, we shouldn’t use a high one to mask (a possible risk of) poor fiscal policy.

      Second, CBA isn’t as influential as us economists would like. What proportion of government spending is governed by CBAs? It’d be minuscule. Transport’s a major user of CBA, but even then it’s not used to determine the size of the National Land Transport Fund. The flood gates won’t open on government spending if we were to use a rate like the UK, simply because it’s not the social discount rate that decides how much we borrow and spend. If it was, there wouldn’t be the billions of dollars worth of viable (BCR>1) transport projects currently unfunded.

      Third, we might spend more, but I’d like to think that with more projects found to be viable that NZ would become more open minded about how to fund them, including user pays, charging for externalities, and public/private co-funding. As a nation we can do so much better on these fronts.

      Fourth, the social rate of time preference is very much a proper basis for the social discount rate. I think the SRTP is at most 4% real (average historic real government bond rate). If true that means a certain $105 (real) next year is preferred to a certain $100 now to society overall, regardless of whether the private sector returns 8% or 18%. If the latter’s a viable option, then we should make an effort and subject it to the rigours of standard CBA by stating (certainty equivalent) annual consumption impacts over the appraisal period, and then use the SRTP. If it’s better, then that’ll come out in the wash.

      Finally, re real option analysis: we can no doubt do better with CBA. But again, the discount rate is too important to fiddle with to account for other things we’re not so good at.

  • Michael Reddell says:

    Thanks Chris. On your points:

    I agree (of course) that we should use “appropriate” discount rates. But the real challenge is to know what the appropriate rates are, and soemtimes argument by corollary can shed some light on that. My bigger concern though is about identifying a sound justification for systematically using discount rates that differ materially from those used in the private sector given that (a) government is essentially an agent for citizens and (b) ever dollar spent (whether from taxes or borrowing) by the Crown constrains (probably not one for one in the short run) what citizens can spend (from current income or borrowing).

    On your second point, of course I totally agree that CBA is not used as much as it should be, and also that a lower discount rate would not automatically lead to more public investment. But…….if it didn’t lead to more public investment (or to things that are fairly economically equivalent, like more PPPs) a change in the discount rate wouldn’t be a debate worth having, except perhaps as a matter of intellectual principle.

    And on your fourth point, I don’t know that I agree. Private and social rates of time preference are analytically interesting, but if they are not what citizens use to make their own risky investment choices (as distinct from pure consumption today vs consumption tomorrow choices) why should they be the basis for govt investment (or regulatory mandates), acting as agents of citizens? As we know, the literature struggles to explain the size of equity risk premia (or, similarly, discount rates private businesses use in evaluating projects), but as officials and advisers to officials we should be pretty hesitant about assuming that our knowledge and understanding is superior to that implicit in private sector choices. This is doubly so as we know that conventional CBA does not do a good job of explicitly allowing for investment irreversibility and real options: rules of thumb (such as apparentyl very high required discount rates?) often capture some wisdom that isn’t obvious on the surface.

  • Chris Parker says:

    Hi Michael

    I like where you’re going in your first para by considering how projects are ultimately resourced. That’s a major debate we should be having. Having a social discount rate based solely on private returns implies (under a shadow price framework) that policy makers think a project 100% displaces private investment. That’s a prescriptive view of the world dressed up as though it’s descriptive. It confuses ‘could’ with ‘would’, and isn’t how the concept of opportunity cost works.

    I agree that more investment would occur. For what it’s worth, I don’t expect public expenditure to ramp up massively. I’d hope a discount rate reduction would rejig relative priorities, and actually help the public to be more supportive of other financing arrangements. I imagine it’s an easier story to convince rate payers etc to contribute more if it was going to a project that had a BCR well north of 1 rather than one well south of 1, and the discount rate can have the biggest effect on such a BCR for long-lasting projects.

    Re last point, I agree discount rate policy has got to match up with what happens in the real world. I’d also add it’s got to pass the sniff test of competent decision makers with their hearts in the right places, because they are free to ignore CBA. There’s an incentive compatibility issue here. If decision makers perceive discount rate policy to be broadly wrong, then ironically worse outcomes may result as CBA is replaced by inferior decision making frameworks. So it could be a false economy to seek more project discipline by using a high discount rate.

    Also, in terms of real world values, let’s not forget that risk-free post tax long-term bonds have historically earned 1%-1.5%. Arguably this is the most relevant ‘market rate’ to apply to the majority proportion of costs resourced from consumption. So market rates don’t imply high discount rates; it could equally imply low discount rates (with shadow pricing). But such low rates don’t pass most people’s sniff tests. Using a Ramsey equation to estimate the social rate of time preference that is materially higher than such low rates may smack of paternalism, but if that’s what informed decision makers accountable to taxpayers think is right, then so be it. Our job as economists is to try and make sense of it all, but not to decide.

    Cheers

  • Michael Reddell says:

    Chris

    Not to prolong this unduly, but you note:

    “Having a social discount rate based solely on private returns implies (under a shadow price framework) that policy makers think a project 100% displaces private investment. That’s a prescriptive view of the world dressed up as though it’s descriptive. It confuses ‘could’ with ‘would’, and isn’t how the concept of opportunity cost works.”

    I think that is a slightly caricatured interpretation of what I said. I’m not saying govt decisions should be made “solely” using private required returns, but that we need a good case to depart from something approximating those returns (especially as we are using private citizen’s money), As for full displacement, I noted that this probably doesn’t hold one for one in the short-term (common estimates are around 50% offset) but it also isn’t really a prescriptive view of the world; more a reflection of inter-temporal budget constraints (overlaid with the leverage constraints that hold in the real world). Assuming an economy runing roughly at capacity, resources can be used only once (an approximation for sure, since intensity can alter a bit) and the ability of govt investment (or regulatory mandates) to sustainably lift lifetime consumption possibilities is, at very least, a matter of empirical dispute (especially over the relevant ranges of debate),

    Regards

    Michael

    • Chris Parker says:

      Thanks Michael, you raise some good issues to ponder about what might be displaced and why. I like your suggestion that we can/should think more about the opportunity cost of displaced consumption, investment, savings, based on empirical analysis.

      Cheers
      Chris

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