Research Articles Base: Public And Private Discount Rates

Public and private discount rates

Whether public sector projects should be discounted at a lower rate than private sector projects is a highly contentious issue and one that has spawned an enormous literature. In the last twenty years there has been a major increase in the role of the private sector in the delivery of what were once considered public sector services. Outside of transition economies, probably the single most significant change has been the international wave of privatisation of utilities. Such privatisations typically involve the complete transfer of ownership to the private sector with the role of the state being reduced to policing prices and conduct. More recently, however, there has been a rapid growth in more complex forms of private involvement. In many cases the public sector or its agencies remain the immediate final purchaser of the services but no longer own or operate the assets necessary for the provision of the service.   Such arrangements tend to be referred to as public-private partnerships (PPP). In a typical PPP the government signs a long-term contract with a private consortium to supply a service to the government and the private consortium designs, builds, owns and runs the physical assets required for the delivery of the service. This contrasts with traditional public sector provision where the government builds or purchases physical assets, retains ownership and uses public sector employees or a private contractor to deliver the required service. A PPP can be characterised as a situation where the government becomes a purchaser of services not physical assets. This type of arrangement is now common in the case of roads, prisons, hospitals and schools both in the UK and elsewhere.There are many complex forms of PPPs and the characterisation here focuses on the most basic model.   Writing in the eighties on public sector discount rates and their relation to private sector discount rates Lind pointed out that the profession was no closer to agreement on the theory, on a procedure for computing the discount rate, or on the rate itself than it was in 1966.   Despite this lack of unanimity there is a tendency for economists to favour the use of similar discount rates in the idealised situation of complete markets. Similarly, there is tendency for governments to use the same discount rate for a project whether it is publicly provided or is to be provided to the government by the private sector. For example, in the UK the rate of 6% real is used to discount and compare the cost of public provision with a PPP alternative.   There are several theoretical papers that address the efficiency of PPPs, notably, Bennett and Iossa (2002), Bentz, Grout and Halonen (2002) and Hart (2002). Lind (1982) suggested that the reason for the divergence between private sector and public sector discount rates is not related to the normal arguments given in the literature. Even in a  world of complete capital markets and no distortionary taxation it may still appropriate to use a higher discount rate for the PPP than the public sector equivalent.   As indicated in the introduction the view that the public sector should discount projects at the same rate as the private sector is not without controversy. A large literature developed on this topic in the 1960s and 1970s and several contributors (Arrow 1965, 1966; Arrow and Lind 1970; Samuelson, 1964), Solow (1965) and Vickrey (1964)) took the view that public sector rates should be lower because the public sector can pool risks. These views have been criticised, notably by Bailey and Jensen (1972), Diamond (1967) and Hirshleifer (1964), who have pointed out that the arguments that the private sector cannot pool risks are not theoretically sound and that the nature of risks in the public sector are unlikely to satisfy the Arrow and Lind requirement that the outcomes of public projects are independent of each other and of private investments.   Putting to one side adjustments that may be necessary because of taxation (see Baumol (1968), Sandmo and Dreze (1971) and Harberger (1968)), if there are complete markets then projects should be spanned by existing securities and so, at least theoretically, individuals should be able to divest themselves of their risks at market prices whether these arise in the public or private.   In the standard case for separate currencies with variable exchange rates the exchange rate is seen as an important adjustment mechanism or an important policy instrument. It is argued that fixing the exchange rate, particularly in the form of entry into a monetary union, involves giving up an adjustment mechanism which can deal efficiently and more or less automatically with asymmetric exogenous shocks, and/or which plays an important role in the transmission mechanism; alternatively it involves giving up a policy instrument which the monetary authorities can use in a more deliberate fashion to deal with such shocks (Cobham, 2002). By contrast, advocates of monetary union tend to see the exchange rate more as a “source of extraneous asymmetric shocks” (Buiter, 2000, p. 236), whose flexibility is not worth preserving.       Credit:ivythesis.typepad.com

Public and private discount rates

Whether public sector projects should be discounted at a lower rate than private sector projects is a highly contentious issue and ...