Risk and the Discount Rate for Public Investment

Abstract

This paper enlarges upon some recent work regarding the appropriate discount rate for public projects and, in particular, shows more fully why risk should enter into the calculation. Indeed, we argue that efficient allocation of risk bearing is usually more difficult for government projects than it is for private ones. Therefore, if anything, the allowance for risk should be greater for government projects than it is for other-wise comparable private ones (assuming no distortions from competitive equilibrium). We then outline the implications of recent mean-variance asset pricing models for the project evaluation framework, providing an integration of the treat-ment of risk with Harberger's (1968) solution to the distortion problem. In the context of this theory we also offer specific arguments on the risks of different types mid classes of govern-ment projects.

Keywords: risk, risk bearing, mean-variance asset pricing model, public investment, discount rate, riskless investment, diversification, distortion