social rate of discount
Because the benefits and costs of most government programs and public-sector investment projects extend beyond 1 year, it is necessary to convert these benefits and costs into present-day dollars to accurately compare decision alternatives. Determining the appropriate social rate of discount, or interest-rate cost of public funds, is critical to the selection of appropriate alternatives. A low rate favors long-term investments with substantial future benefits; a higher rate favors short-term projects with benefits that accrue soon after the initial investment.
A common approach is to discount the benefits and costs associated with public projects based on the government's cost of borrowed funds. Because government loans are considered risk-free, the government's cost of borrowing is much lower than the private cost of borrowing. An important disadvantage of these low public-sector rates is that they fail to recognize the opportunity cost of funds transferred from the private sector to the public sector. Competition between public-sector and private-sector projects for resources is essential to the efficient allocation of investment capital. Most economists argue that because private-sector resources are used to fund public-sector projects, the marginal private-sector opportunity cost of funds of roughly 10 percent is the appropriate social rate of discount. The opportunity cost of funds transferred from private investment to the public sector is computed from the average pretax rate of return on private corporate investments. This rate includes a risk premium for the uncertainty about the returns accruing as a result of allocating funds for a given venture. The pretax rate of return for private investments must be used because returns from public-sector projects are not taxed.
The average pretax rate of return on government securities is a very conservative estimate of the opportunity cost of private-sector consumption that is diverted to public use. This is a conservative basis because the interest rate on government securities does not embody any default risk premium, as would be true of long-term corporate bonds. The average pretax rate of return on private-sector investment is a similarly useful estimate of the opportunity cost of funds diverted from private investment. In both cases, the pretax rate of return is used because personal and corporate income taxes simply represent a redistribution of income from the private to the public sector. Because funds for public investments are likely to come from both private consumption and private investments, the weighted average of the opportunity cost of funds coming from these two components of the private sector should be used to compute the social rate of discount.
During recent years, a typical pretax rate of return on long-term government bonds is 7.5 percent, a standard after-tax return on investment in the private sector is 10 percent, the marginal corporate and individual tax rate is roughly 40 percent, and consumption averages 94 percent of total income. Using the assumptions provided, an appropriate average social rate of discount of 8 percent is calculated as follows:
Social rate of discount
Percentage of \ funds diverted I from private-sector I consumption
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