Solutions Manual to accompany Cost-Benefit

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Solutions Manual to accompany Cost-Benefit Analysis 4th edition 0137002696

CHAPTER 10: THE SOCIAL DISCOUNT RATE

Purpose: This chapter deals with the theoretical issues pertaining to the selection of an
appropriate real social discount rate (SDR). When evaluating government policies or projects,
analysts must decide on the appropriate weights to apply to policy impacts that occur in different
years. Given these weights, denoted by wt, and estimates of the real annual net social benefits,
NBt, the estimated net present value (NPV) of a project is given by:

n
NPV = wt NBt (10.1)
t=0

Selection of the appropriate social discount rate (SDR) is equivalent to deciding on the
appropriate set of weights to use in equation (10.1). Sometimes the weights are referred to as
social discount factors.

Discounting reflects the idea that a given amount of real resources in the future is worth less
today than the same amount is worth now because:
1) Via investment, one can transform resources that are currently available into a greater
amount in the future.
2) People prefer to consume a given amount of resources now, rather than in the future.
Thus, it is generally accepted that the social discount weights decline over time; specifically, 0 <
wn  wn-1  ...  w1  w0 = 1. However, there is less agreement about the values of the weights.
The key issue in this chapter concerns these values.

Three unresolved issues are pertinent:

1) Whether market interest rates can be used to determine the weights.
2) Whether to include unborn future generations in determining the weights and, if so, what
weight they should have.
3) Whether society values a unit of investment the same as a unit of consumption.
Different assumptions about these issues lead to different approaches towards determining the
SDR, which, in turn, lead to different discount weights. There is disagreement about the
underlying assumptions and, therefore, about the most appropriate approach. There is reasonable
consensus over the discount weights appropriate once the approach is selected.

DOES THE CHOICE OF DISCOUNT RATE MATTER?

Yes – choice of the rate can affect policy choices. Generally, low discount rates favor projects
with the highest total benefits, while high SDRs rates favor projects where the benefits are front-
end loaded.

THE THEORY BEHIND THE APPROPRIATE SOCIAL DISCOUNT RATE (SDR)

To understand the theoretical foundation of discounting, one must recognize that it is rooted in
the preferences of individuals. Individuals tend to prefer to consume a given amount of benefits
immediately, rather than in the future. Individuals also face an opportunity cost of forgone
interest if they postpone receiving a given amount of funds until later because they could

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potentially invest these funds once they are received. These two considerations of importance to
individual decisions -- the marginal rate of time preference and the marginal rate of return on
private investment -- provide a basis for deciding how costs and benefits realized by society in
the future should be discounted so that they are comparable to costs and benefits realized by
society today.

An Individual’s Marginal Rate of Time Preference (MTRP)

An individual’s MRTP is the proportion of additional consumption that an individual requires in

order to be willing to postpone (a small amount of) consumption for one year.

Equality of Discount Rates in Perfect Markets

In a perfectly competitive capital market, an individual’s MRTP equals the market interest rate, i,
as shown in Figure 10.1. In this two-period model, an individual may consume her entire budget
(T) in the first period, she may invest it all in the first period and consume T(1 + i) in the second
period, or she may consume at any intermediate point represented by the budget constraint in
Figure 10.1, which has a slope of -(1 + i). Consumption is maximized at the point at which the
indifference curve is tangent to the budget constraint, i.e. at point A. At point A, the slope of the
indifference curve is -(1+p), the marginal rate of substitution (MRS) is 1+p, and the MRTP is p.
Consequently, i = p. Note that as current consumption increases, MRS and MRTP decrease.

A Simple Two-Period Model with Production: Rate of Return on Private Investment

Equals the Market Rate Equals MRTP

The text next presents a more general two-period model that pertains to a group of individuals in
a hypothetical country and that incorporates production. It is assumed that this country does not
trade with other counties. Moreover, the chapter initially ignores taxes and transaction costs
associated with making loans. Consequently, the net rate of return on savings corresponds to the
market interest rate. In addition, the chapter initially ignores market failures such as externalities
and information asymmetry, which could cause private and social discount rates to diverge from
one another.

The optimal point is at X in Figure 10.2. At X, the slope of the social indifference curve, -(1 +
px), equals the slope of the consumption possibility frontier, -(1 + rx). Consequently, the
marginal social rate of time preference, px equals rx, the marginal rate of return on investment.
Furthermore, at point X these rates would also equal the economy-wide market interest rate, i.
Finally, at X, all individuals have the same MRTP because, if their MRTP > i, they would
borrow at i and consume more in the current period until their MRTP = i and, if MRTP < i, they
would postpone consumption by saving until their MRTP = i. Since everyone’s MRTP equals i,
it would be the obvious choice for the SDR.

Real Economies: Problems with the Two-Period Model

An actual economy (with taxes and transaction costs) would not operate at the optimal point X,
but at a point such as Z. Here, society would under invest and rz > pz. Furthermore, because

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different people face different tax rates, risk and costs, numerous values exist for both the
MRTPs and the marginal rate of return on investment. Thus, there is no obvious choice for the
social discount rate that can be derive from market rates of interest.

An Infinite-Period Model: Discounting Using the Optimal Grow Rate

In 1928, Frank Ramsey proposed a model with infinite periods in which society (or a single
representative individual) attempts to maximize a social welfare function that reflects the values
that society places on per capital over time. Through investment, consumption increases over
time. Following Ramsay it was shown that if an economy was on its optimal (welfare
maximizing) growth path, the SDR would be given by:
px = d + ge (10.6)
where, px is the SDR, d is the pure rate of time preference, g is the growth in per capita
consumption, and e is an elasticity that measures how fast the social marginal utility of
consumption falls as per capita consumption rises. This model is known as the “optimal growth
rate method.” Society discounts future consumption for two reasons: (1) society is impatient and
prefers to consume more now than in the future; (2) there is economic growth and social welfare
would increase if consumption were “smoothed out” (made more equal) over time: made more
equal than it otherwise would be. This adjustment should be proportional to the product of the
per capita growth rate and e, an elasticity that measures how fast the social marginal utility of
consumption falls as per capita consumption rises. For example, if e = 1, a 10 percent reduction
in consumption today from (say) $40,000 to $36,000 would be viewed as an acceptable trade-off
for a 10 percent increase in consumption (say) from $80,000 to $88,000 at some future point.

DERIVING THE SDR FROM THE MARKET

This section discusses four potential social discounting rates that are derived from rates
observable in markets. SDRs based on the optimal growth rate method are discussed later.) Use
of all these market rates presume that that resources used for a public project should return more
than they would if these resources remained in the private sector, an opportunity cost concept.

Using the Marginal Rate of Return on Private Investment (rz)

The argument for using the marginal rate of return on private investment as the social discount
rate is that, before the government takes resources out of the private sector, it should be able to
demonstrate that society will receive a greater rate of return than it would have received had the
resources remained in the private sector. Therefore, the return on the government project should
exceed rz, the marginal return on private investment.

The most compelling case for the use of rz was made by Arnold Harberger, who analyzed a
closed domestic market for investment and savings, such as the one presented in Figure 10.4. In
the absence of taxes and government borrowing, the demand curve for investment funds by
private-sector borrowers is represented by Do and the supply curve of funds from lenders (or
savers) is represented by So. With corporate taxes and personal income taxes, the demand and
supply curves would shift to DI and DS, respectively, resulting in a market clearing rate of i and a
divergence between rz and pz, as discussed previously. Harberger assumed that a government

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project would be financed entirely by borrowing in a closed domestic financial market. The
demand for funds for the new project would shift the market demand curve to DI', the market rate
of interest would rise from i to i', private-sector investment would fall by ΔI and private-sector
savings would increase by ΔC. As the increase in private-sector savings exactly equals the
decrease in private-sector consumption, the project would "crowd out" both investment (by ΔI)
and consumption (by ΔC). Harberger suggests that the social discount rate should be obtained
by weighting rz and pz by the respective size of the relative contributions that investment and
consumption would make toward funding the project. That is, he suggests that the social
discount rate should be computed based on the weighted average cost of capital:

WSOC = arz + bpz (10.8)

where a = ΔI/(ΔI + ΔC) and b = (1 - a) = ΔC/(ΔI + ΔC). Finally, Harberger asserts that savings
are not very responsive to changes in interest rates. This assertion, which has some empirical
support, implies that the SS curve is close to vertical and, as a consequence, ΔC is close to zero.
This, in turn, suggests that the value of the parameter a is close to one and, hence, the value of (1
- a) is close to zero. In other words, almost all of the resources for public-sector investment are
obtained by crowding out private-sector investment. Thus, Harberger suggests that the marginal
rate of return on investment, rZ, is a good approximation of the true social discount rate.

Numerical Values of rz. Perhaps, the best proxy for rz is the real before-tax rate of return on
corporative bonds, which is on the order of 4.5 percent.

Criticisms of the Calculation and use of rz. There are several criticisms of both the use of rz and
of its estimation, suggesting that using an SDR of 4.5 percent is an upper limit.
1) Private sector returns may be pushed upward by distortions caused by negative
externalities and market prices that exceed marginal costs.
2) Private sector rates of return incorporate a risk premium. Therefore, if benefits and costs
are measured in “certainty equivalents,” as recommended by the text, then using private
sector rates would result in “double counting,” i.e. it would account for risk in two ways.
3) A project might be financed by taxes, rather than by loans – hence, consumption would
also be crowded out.
4) A project may be partially financed by foreigners at a lower rate than 4.5 percent.
2) There may not be a fixed pool of investment so that government may not displace private
investment dollar for dollar. If the government is not fully employing all its resources,
then complete crowding out of private investment is unlikely.

Using the Marginal Social Rate of Time Preference Method (pz)

Many analysts hold that the SDR should be thought of as the rate at which individuals in society
are willing to postpone a small amount of current consumption in exchange for additional future
consumption (and vice versa). In principle, pz represents this rate. Consequently, many believe
that the SDR should equal pz. This rate can also be justified if a government project is financed
entirely by domestic taxes and if taxes reduce consumption, but not investment. It is then
appropriate to set a = 0 and b = 1 in equation (10.8), yielding an SDR equal to pz.

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Numerical Values of pz. In practice, the best return that many people can earn in exchange for
postponing consumption is the real after-tax return on savings. Starting with the nominal, pre-tax
interest rate on government bonds and adjusting for taxes on savings and inflation suggests an
estimate of pz of around 1.5 percent, with values of 1.0 percent and 2.0 percent appropriate for
use in sensitivity analysis.

Criticisms of the Calculation and Use of pz.:

1) As pz < rz, the use of pz as the SDR may justify very long-term investments that provide
low returns at the expense of higher-returns in the private sector, thereby harming
efficiency.
2) Individuals differ in their preferences and opportunities – some save and some borrow
and some save by reducing debt. Since reducing some debt isn’t taxed, people who do
this earn a much higher after-tax return than other people. It is not clear how one can
aggregate these different individual rates into a single SRTP.
3) Individuals are not always consistent and rational. Because many individuals
simultaneously pay mortgages, buy government bonds and stocks and borrow on credit
cards at high interest rates, it is unclear whether individuals have a single MRTP.

Using the Government’s Borrowing Rate (i)

The case for using government’s long-term borrowing rate, i, is that it reflects the government’s
actual cost of financing a project.

Numerical Values of i. Starting with the average monthly yield on 10-year U.S. Treasury bonds
for the period between April 1953 and December 2001 and then adjusting for inflation yields a
value for i of 2.7 percent, with a plausible range for sensitivity analysis of 1.7 to 3.7 percent.

Criticisms of the Calculation and Use of i

1) The above estimate of i may be biased upwards due to market failures
2) Government projects may be funded by taxes (which reduce consumption rather than at
the expense of private sector investment), not borrowing
3) The U.S. may not be able to borrow at an unchanging real interest rate. Government
borrowing will raise real interest rates and also crowd out some private sector investment.
The use of i as the SDR would be most reasonable if all the government’s borrowed funds were
foreign, but this is unlikely.

Using the Weighted Average Approach (WSOC)

If a is the proportion of a project's resources that displace private domestic investment, b is the
proportion of the resources that displace domestic consumption, and 1-a-b is the proportion of
the resources that are financed by borrowing from foreigners, then this approach, called the
weighted social opportunity cost of capital (WSOC), computes the social discount rate as the
weighted average of rz, pz, and i. Specifically:

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 WSOC = arz + bpz + (1 - a - b)i (10.9)

As pz < i < rz, it follows that pz < WSOC < rz. Obviously, the previous methods are special cases
of this more general approach.

Numerical Values of WSOC.

If a project is financed by taxes, which seems to be the usual case, then b would be large and a
and (1-a-b) would be small and the value of the WSOC would be about 2.5 percent. If the
project is deficit financed, then (1-a-b) would be large, a would be small and b would be very
small, suggesting that the value of the WSOC would be about 2.75 percent.

Criticisms of the Calculation and Use of WSOC. Criticisms about the calculation of pz and rz
and i also apply to calculating the WSOC. In addition, the value of the WSOC depends on the
source of a project’s funding and thus would vary among projects. Governments usually prefer a
single discount rate.

THE SHADOW PRICE OF CAPITAL (SPC)

If all the resources used in a project displace current consumption and all the benefits produce
additions to future consumption, then the social discount rate should reflect social choices in
trading present consumption for future consumption and pZ would be the natural choice for the
discount rate. However, projects could produce costs and benefits in the form of consumption
or investment. Due to market distortions, the rate at which individuals are willing to trade
present for future consumption, pZ, differs from the rate of return on private investment, rZ, as
previously discussed. Thus, flows of investment should be treated differently from flows of
consumption. The shadow price of capital converts investment gains or losses into consumption
equivalents. These consumption equivalents, like consumption flows themselves, are then
discounted at pZ.

The shadow price of capital method requires that discounting be done in four steps:
1) Costs and benefits in each period are divided into those that affect consumption and those
that affect investment.
2) Flows into and out of investment are multiplied by the SPC to convert them into
consumption equivalents.
3) Changes in consumption are added to changes in consumption equivalents.
4) Resulting amounts are discounted at pz.

A general expression for the shadow price of capital is:

(r z +  )(1 − f)
SPC = (10.11)
pz − r z f +  (1 − f)

where rz is the net return on capital after depreciation, δ is the depreciation rate of the capital
invested, f is the fraction of the gross return on capital that is reinvested, and pz is the marginal
social rate of time preference.

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Numerical Values of the SPC. Estimates of rz and pz (4.5 percent and 1.5 percent, respectively)
are provided above. For reasons discussed in the text, 17 percent appears to be a reasonable
estimate of f and 10.0 percent seems to be a reasonable estimate of δ. Using these values and
equation (10.11), the SPC equals 1.33. For sensitivity analysis, a value of 1.47 should be used if
pz is set equal to 1.0 percent and 1.21 if pz is set equal to 2.0 percent.

Using the SPC. It is unnecessary to apply the SPC if a project is strictly tax financed and all of
the impacts affect consumption. The case for the SPC is strongest for deficit-financed projects.

Criticisms of the Calculation and Use of the SPC. Although this method is theoretically
appropriate:
1) It is difficult to explain to policymakers how and why NPV calculations are made.
2) The method has heavy information requirements relative to other discounting approaches.
3) The allocation of costs and benefits to investment and consumption may be subjective.
4) The value of the SPC depends on the values of pz and rz and there can be subject to the
criticisms that apply to determining these parameters.

USING THE OPTIMAL GROWTH RATE APPROACH TO DISCOUNTING (PX)

Problems using Market Based Rates to Derive the SDR

Above we discussed some reasons why many economists now think that the SDR should not be
inferred from market rates—the presence of many different market rates, the problem of
aggregating different individuals with different preferences, the problem that individuals do not
behave rationally and consistently, and the problem that market rates do not appropriately reflect
market failures. In addition, market rates do not reflect the preferences of those currently alive
and thus fail to account appropriately for the effects of long-term projects on future generations.
Because market rates do not provide an appropriate basis for determining the SDR, one should
use an alternative approach -- the optimal growth rate method

Numerical Values of px using the Optimal Growth Rate Method

As discussed earlier, the SDR based on the optimal growth rate method, px, can be computed
from the following formula:
px = d + ge,
where
d = the pure rate of time preference
g = the growth in per capita consumption
e = the absolute value of the rate at which the marginal value of consumption declines as
per capita consumption increases

The authors of the text estimate that real per capita consumption grew at 2.3 percent per annum
between1947-2002. The authors suggest that e = 1.3 and, following Arrow, suggest that d =1
percent. These values imply that px = 3.5 percent approximately. Using alternative values for g,
e, and d suggests a range for px of between 2.0 and 6.0 percent for sensitivity analysis.

Criticisms of the Calculation and Use of the Optimal Growth Rate

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1) The estimate of g (the growth in consumption) used to compute px may be inaccurate.
2) The selection of the values for d and e depend on value judgments

The Shadow Price of Capital to Use with the Optimal Growth Rate
Given px = 3.5 percent, equation 10.11 suggests that the SPC = 1.1. For sensitivity analysis with
px = 2.0, SPC = 1.32 and with px = 6.0 percent, SPC = 1.0.

INTERGENERATIONAL DISCOUNTING

So far we’ve discussed only constant (time-invariant) SDRs. There are at least four reasons,
however, to suggest the use of time-declining SDRs instead:
1) Empirical evidence suggests that people are time inconsistent – they use lower discount
rates for events that occur farther into the future.
2) Long-term environmental and health consequences have very small present values when
discounted using a constant rate, often implying that spending a relatively small amount
today to avert a costly disaster several centuries in the future is not cost-beneficial.
3) Constant rates do not appropriately take into account the preferences of future, as yet
unborn, generations.
4) Constant rates do not appropriately allow for uncertainty as to market discount rates in
the future. The text demonstrates that allowing for this uncertainty implies that lower and
lower discount rates should be used to discount consumption flows that occur father and
farther in the future. This results from averaging the discount factors, not the discount
rates.

Numerical Values for Time-Declining Discount Rates

Based on research by Newell and Pizer, the text suggests the following time-declining rate
schedules:

Year px
0 - 50 3.5 percent
50-100 2.5 percent
100-200 1.5 percent
200-300 0.5 percent
Over 300 0.0 percent

THE SOCIAL DISCOUNT RATE IN PRACTICE

Discounting practices in government vary enormously. Many government agencies do not

discount at all. Often the discount rate is prescribed by government review and monitoring
agencies (e.g., OMB, CBO). In the U.S. and Canada, prescribed rates have been as high as 10
percent but have been trending lower. OMB now uses 7 percent. CBO uses lower rates; it favors
the MRTP approach and uses 2 percent (based on the U.S. Treasury borrowing rate), with
sensitivity tests based on 0.0 and 4 percent. The GAO favors the average nominal yield on
Treasury debt maturing between one year and the life of project, less the forecast rate of

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Solutions Manual to accompany Cost-Benefit Analysis 4th edition 0137002696

inflation. In 2003, the British Treasury recommended using an SDR of 3.5 percent, which is
based on the optimal growth rate method. It also recommended using a time-declining discount
rate for projects with effects that occur after 30 years.

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