The Social Discount Rate for Provincial Government Investment Projects

Abstract

The social discount rate (also known as the economic opportunity cost of capital) seeks to mimic the rate of return that would be earned on private sector investments. Inefficiencies in the government’s use of capital are minimized by requiring government investments to meet a rate of return hurdle analogous (with appropriate adjustments) to what is earned in the private sector.

There is no universally accepted method for choosing the discount rate, and a number of different approaches have been recommended. Some use the social rate of time preference while others argue for a crowding-out opportunity cost of capital. The choice depends on philosophical issues and views about the sources and alternative uses of the funds. These go beyond merely empirical questions to more fundamental issues about the choices that are (or ought to be) open to various entities.

The approach taken in this paper is a compromise between the alternative viewpoints. The discount rate should approximate the rate of return that could be earned on a notional balanced portfolio of financial investments, even if in practice this might not be its most likely alternative use. To earn a lower rate of return than on a passive investment could be characterized as poor stewardship, which clearly fails to maximize real wealth in the economy. The numerical estimate derived using the approach in this paper is close to half way between the high and low ends of the alternative approaches to social discount rates.

The social discount rate is not cast in stone like a law of nature. The supply and demand conditions in the economy that determine the social discount rate can change substantially over time. It is appropriate to regularly review the value of the social discount rate by examining changes in financial market indicators of the return on capital.

Keywords: social discount rate, benefit cost analysis, infrastructure, investment, real interest rate, real return bond

JEL Classification: H43, E4