Optimal Discount Rates for Government Projects

Project selection based on the net present value can be optimal only if the discount rate is optimal. The optimal discount rate for a government project can be a risk-free rate, a comparable market rate (market interest rate corresponding to the risk of cash flows to the government), or an adjusted market rate, depending on circumstances. This paper clarifies the conditions for each case. Provided that the optimal discount rate is the comparable market rate, it varies across intervention methods and changes with the subsidy rate. 1. Introduction The government should allocate its budget to maximize social welfare. When the net present value (NPV) is used as the basis of project choice, the discount rate critically influences budget allocation. Yet there is no consensus on the optimal discount rate that would maximize social welfare. An old debate is whether the discount rate for a government project should reflect the risk premium (compensation for uncertainty) that is normally demanded in the market, in addition to the time preference of individuals. Another line of research focuses on determining the social discount rate that reflects the society time preference best. Both issues have attracted considerable attention in recent years. In the USA, the Federal Credit Reform Act of 1990 has explicitly incorporated discounting into the federal budget, although it is limited to credit programs. Under the act, expected cash flows from government credit programs are discounted by Treasury rates of comparable maturities. Assuming that the Treasury rate approximates the risk-free rate, the government discount rate does not contain the risk premium in this case. The Emergency Economic Stabilization Act of 2008, however, mandates that cash flows from the Troubled Asset Relief Program be discounted by market risk-adjusted discount rates (Treasury rates plus risk premiums that would be demanded by private investors), rekindling the old debate in the policy arena. Increased concerns about climate changes and needs for environmental regulation have heightened the importance of the social discount rate. For environmental policies, which typically have large effects in a very distant future, cost-benefit analyses are extremely sensitive to the discount rate. Important issues arising from the long time horizon include uncertainty about the discount rate itself, intergenerational inequality in consumption, and rationales for applying a lower discount rate to a farther future. The focus of this paper is on the market risk premium. Research in the social discount rate has