Should CBA use descriptive or prescriptive discount rates? It should use both!

Szekeres, Szabolcs (2021): Should CBA use descriptive or prescriptive discount rates? It should use both!

Abstract

Discounting project net flows that exclude financing costs with prescriptive rates fails to reflect costs of capital; discounting them with descriptive rates fails to reflect intertemporal preferences. A hybrid discounting method is proposed by which descriptive rates are used to forecast costs of capital and prescriptive rates are used to discount all-inclusive net welfare flows. An agent-based capital market model audits the performance of alternative discounting approaches. There is no need to reconcile the discounting approaches. They should be viewed as complementary, not as competing. For projects to be economically feasible their rate of return should exceed both the STPR and the SOCR. Following this rule will ensure that proposed public sector projects will be no less effective at converting present consumption into future consumption than what the public can already manage and that the benefits of proposed projects will exceed all their direct and indirect costs.

• Item Type: MPRA Paper
• Language: English
• Keywords: Social discount rate; Prescriptive discounting; Descriptive discounting; Hybrid discounting; Declining discount rates.
• Subjects: D - Microeconomics > D6 - Welfare Economics > D61 - Allocative Efficiency ; Cost-Benefit Analysis; H - Public Economics > H4 - Publicly Provided Goods > H43 - Project Evaluation ; Social Discount Rate

References

Arrow, Kenneth J. and Robert C. Lind (1970), “Uncertainty and the Evaluation of Public Investment Decisions,” The American Economic Review, Vol. 60, No. 3 (Jun., 1970), pp. 364-378. https://www.jstor.org/stable/1817987

Baumol, William J. 1968. “On the Social Rate of Discount”, American Economic Review, Volume 58, No. 4 (September 1968), https://www.jstor.org/stable/1815533

Becker, Gary, Kevin Murphy and Robert Topel. (2011). “On the Economics of Climate Policy.” The B.E. Journal of Economic Analysis & Policy. 10. 19-19. 10.2202/1935-1682.2854. https://doi.org/10.2202/1935-1682.2854

Broome, John (1992). Counting the Cost of Global Warming. Strond: White Horse Press.

Chichilnisky, Graciela. (1997). “What is Sustainable Development?” Land Economics 73, 467–491. http://www.jstor.org/stable/pdfplus/3147240

Freeman, Mark C. and Ben Groom, “Gamma Discounting and the Combination of Forecasts” (2010). http://dx.doi.org/10.2139/ssrn.1676793

Gandelman, Néstor and Rubén Hernáandez-Murillo (2014). “Risk Aversion at the Country Level,” Federal Reserve Bank of St. Louis, http://research.stlouisfed.org/wp/2014/2014-005.pdf

“Green Book:” HMT (2020). Guidelines on Cost-benefit Analysis. HM Treasury, UK, https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/938046/The_Green_Book_2020.pdf

Groom, Ben, Cameron Hepburn, Phoebe Koundouri, and David Pearce (2005). “Declining Discount Rates: The Long and the Short of it.” Environ Resource Economics 32, 445–493 https://doi.org/10.1007/s10640-005-4681-y

Marglin, Stephen A. (1963) “The Opportunity Costs of Public Investment.” The Quarterly Journal of Economics, May, 1963, Vol. 77, No. 2 (May, 1963), pp. 274-289 https://www.jstor.org/stable/1884403

Nordhaus, William (2019). “Climate Change: The Ultimate Challenge for Economics.” American Economic Review, 2019, 109(6): 1991–2014, https://doi.org/10.1257/aer.109.6.1991

Pigou, Arthur C. (1932). The Economics of Welfare, 4th edition. Macmillan, London

Rubinstein, Mark, (1976), “The Strong Case for the Generalized Logarithmic Utility Model as the Premier Model of Financial Markets,” Journal of Finance, 31, issue 2, p. 551-71, https://doi.org/10.1111/j.1540-6261.1976.tb01906.x

Szekeres, Szabolcs (2020). “Checking the Evidence for Declining Discount Rates,” MPRA Paper No. 102233, https://mpra.ub.uni-muenchen.de/102233/

Weitzman, Martin L. (1998). “Why the Far Distant Future Should Be Discounted at its Lowest Possible Rate”, Journal of Environmental Economics and Management 36, 201–208. https://doi.org/10.1006/jeem.1998.1052