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The social discount rate
JOURNAL
OF ENVIRONMENTAL
ECONOMICS
AND
MANAGEMENT
18,
s-1-s-2 (1990)
INTRODUCTION The Social
Discount
Rate
The four papers and two discussions that follow were presented at the joint AERE/AEA session, “Discount Rates: Theory and Practice,” in December 1988. The session was arranged by Randolph Lyon of the U.S. General Accounting Office to bring to the profession the cutting edge of theory and practice. The first paper by Robert Hartman of the Congressional Budget Office describes with candor and humor the complexities that confront an operating agency carrying out different types of project or program evaluation and the pragmatic (but defensible) procedures adopted. Various arguments are given for the use of a real rate around 256, with a higher rate for net benefit streams positively correlated over time with GNP and a reduction for negatively correlated streams. A tangential but important observation is the bias among federal agencies towards nonbudgeted loan guarantees as a way of eluding budget constraints. Robert Lind’s paper draws out the implications of various capital market structures, methods of financing, and types of projects for the appropriate social discount rate. In particular, he emphasizes the possible implications of global capital markets and the free movement of capital for the opportunity cost of funds used by the public sector. The crowding out of domestic investment and consumption need not occur under these circumstances. Lind concludes, in the company of the other authors, that no single discount rate will be appropriate for all applications. Indeed, he questions the appropriateness of very long term discounting. Randolph Lyon of the General Accounting Office first presents the current practices of OMB, CBO, and GAO in discounting public investments, lease -purchase alternatives, asset divestitures, and the imposition of regulations that involve private sector costs. In summary, he finds many inconsistent practices. He also exhibits the sensitivity of frequently used average discount rates to various parameters including tax rates. His main argument is that the “shadow price of capital” approach is the most defensible approach to project evaluation, incorporating as it does the division of project costs into streams of foregone consumption and investment that, as consumption equivalents, can be discounted using a consumers’ time preference rate. The sensitivity of this approach to many needed parameters (especially depreciation rates, reinvestment rates, and marginal propensities to consume) makes its application difficult and opens the possibility of masking manipulation of the analysis. However, as Joel Scheraga later points out, there may exist certain classes of projects for which standardized, simplified assumptions can be made. Michael Moore and Rip Viscusi use household data from the 1982 University of Michigan Panel Study of Income Dynamics to carry out a wage hedonic study of discount rates implicit in observed wage-health risk tradeoffs. They conclude that the implied discount rate is approximately 276, the same figure arrived at by CBO and consistent with long term real financial rates. The excellent discussions by Joel Scheraga and Paul Portney serve to integrate the findings of the papers and to introduce new issues. Scheraga is particularly concerned with the evaluation of environmental regulations that impose costs on the S-l 0095~0696/90$3.00 Copyright 0 1990 by Academic Press, Inc. Au right.9 of reproduction in any form reserved.
s-2
INTRODUCTION
private sector. For this class of decisions, he argues for a specialization and simplification of the shadow price of capital approach developed by Kolb and Scheraga. Portney points to special problems that may arise in discounting nonmonetary benefits and costs. Where does this leave us for practical applications in the natural resources and environmental area? All agree that discount rates, like all other prices, must be tailored to particular times, locations, types of projects and methods of financing. There seems to be general consensus that the benefit-cost procedures implied by the “shadow price of capital” approach are most defensible theoretically. While the complexities and sensitivities of that approach are intimidating, the derivation of special, simplified cases seems hopeful. Under current U.S. conditions, a real rate of about 2% seems to have support, but analysts must remain sensitive to the effects of methods of financing and type of project on this figure. A defensible philosophical basis for long term, intergenerational discounting has yet to be found. Charles W. Howe Session Chair President, Association of Environmental and Resource Economists
Environment and Behavior Program University of Colorado Boulder, Colorado 80309
OF ENVIRONMENTAL
ECONOMICS
AND
MANAGEMENT
18,
s-1-s-2 (1990)
INTRODUCTION The Social
Discount
Rate
The four papers and two discussions that follow were presented at the joint AERE/AEA session, “Discount Rates: Theory and Practice,” in December 1988. The session was arranged by Randolph Lyon of the U.S. General Accounting Office to bring to the profession the cutting edge of theory and practice. The first paper by Robert Hartman of the Congressional Budget Office describes with candor and humor the complexities that confront an operating agency carrying out different types of project or program evaluation and the pragmatic (but defensible) procedures adopted. Various arguments are given for the use of a real rate around 256, with a higher rate for net benefit streams positively correlated over time with GNP and a reduction for negatively correlated streams. A tangential but important observation is the bias among federal agencies towards nonbudgeted loan guarantees as a way of eluding budget constraints. Robert Lind’s paper draws out the implications of various capital market structures, methods of financing, and types of projects for the appropriate social discount rate. In particular, he emphasizes the possible implications of global capital markets and the free movement of capital for the opportunity cost of funds used by the public sector. The crowding out of domestic investment and consumption need not occur under these circumstances. Lind concludes, in the company of the other authors, that no single discount rate will be appropriate for all applications. Indeed, he questions the appropriateness of very long term discounting. Randolph Lyon of the General Accounting Office first presents the current practices of OMB, CBO, and GAO in discounting public investments, lease -purchase alternatives, asset divestitures, and the imposition of regulations that involve private sector costs. In summary, he finds many inconsistent practices. He also exhibits the sensitivity of frequently used average discount rates to various parameters including tax rates. His main argument is that the “shadow price of capital” approach is the most defensible approach to project evaluation, incorporating as it does the division of project costs into streams of foregone consumption and investment that, as consumption equivalents, can be discounted using a consumers’ time preference rate. The sensitivity of this approach to many needed parameters (especially depreciation rates, reinvestment rates, and marginal propensities to consume) makes its application difficult and opens the possibility of masking manipulation of the analysis. However, as Joel Scheraga later points out, there may exist certain classes of projects for which standardized, simplified assumptions can be made. Michael Moore and Rip Viscusi use household data from the 1982 University of Michigan Panel Study of Income Dynamics to carry out a wage hedonic study of discount rates implicit in observed wage-health risk tradeoffs. They conclude that the implied discount rate is approximately 276, the same figure arrived at by CBO and consistent with long term real financial rates. The excellent discussions by Joel Scheraga and Paul Portney serve to integrate the findings of the papers and to introduce new issues. Scheraga is particularly concerned with the evaluation of environmental regulations that impose costs on the S-l 0095~0696/90$3.00 Copyright 0 1990 by Academic Press, Inc. Au right.9 of reproduction in any form reserved.
s-2
INTRODUCTION
private sector. For this class of decisions, he argues for a specialization and simplification of the shadow price of capital approach developed by Kolb and Scheraga. Portney points to special problems that may arise in discounting nonmonetary benefits and costs. Where does this leave us for practical applications in the natural resources and environmental area? All agree that discount rates, like all other prices, must be tailored to particular times, locations, types of projects and methods of financing. There seems to be general consensus that the benefit-cost procedures implied by the “shadow price of capital” approach are most defensible theoretically. While the complexities and sensitivities of that approach are intimidating, the derivation of special, simplified cases seems hopeful. Under current U.S. conditions, a real rate of about 2% seems to have support, but analysts must remain sensitive to the effects of methods of financing and type of project on this figure. A defensible philosophical basis for long term, intergenerational discounting has yet to be found. Charles W. Howe Session Chair President, Association of Environmental and Resource Economists
Environment and Behavior Program University of Colorado Boulder, Colorado 80309