Chapter 10: The Social Discount Rate, Cost of Public Funds, and the Value of Information © Harry Campbell & Richard Brown School of Economics The University of Queensland BENEFIT-COST ANALYSIS BENEFIT-COST ANALYSIS Financial and Economic Financial and Economic Appraisal using Spreadsheets Appraisal using Spreadsheets Three reasons why NPV>0 may not be the appropriate rule to identify projects which are efficient from a social viewpoint: • the social discount rate may be lower than the market rate of interest; • the marginal cost of public funds may exceed unity (ie. $1 of public funds costs more than $1); • undertaking an irreversible investment involves a loss of option value. The Social Discount Rate Why does the market discount future benefits and costs? • impatience: people value utility today more highly than utility tomorrow. In making choices, future utility is discounted in comparison with utility in the present; • diminishing marginal utility of consumption: people expect to be wealthier in the future. An extra dollar in the future will add less to utility than an extra dollar today. The observed market rate of interest is the sum of the utility discount factor (reflecting impatience) and the utility growth factor (reflecting diminishing marginal utility of consumption). Example: economic growth rate: 2% elasticity of marginal utility of income: 1.5 utility growth factor: 1.5 x 2% = 3% utility discount factor: 1% real market rate of interest: 3% + 1% = 4% Why do people argue that a social discount rate, lower than the market rate of interest, should be used to discount public projects? We should not be discounting the utility of future generations who are not able to participate in markets which determine levels of current investment, and, hence, future utility levels. It is argued that there is, in effect, a ‘missing market’ and we need to use non-market methods to determine the appropriate price (in this case an inter-temporal price in the form of a discount factor). What is the appropriate discount rate for public projects? It is reasonable to employ a utility growth factor in discounting public projects: if future generations are going to be wealthier than us, we should take this into account in sacrificing present consumption to make provision for the future. It is not reasonable to employ a utility discount factor in discounting public projects: we should not treat the utility of future generations as any less important than that of the present generation. Developing our simple example: instead of using the real market rate of interest of 4% as the discount rate for public projects, we would adjust it downwards by the amount of the utility discount factor (1%) to get a social discount rate equal to the utility growth factor (3%). Using a social discount rate would tend to make investment projects more attractive, but the 1% difference in discount rate would be crucial in only a few cases. The Marginal Cost of Public Funds Raising public funds to undertake investment projects involves three types of costs: • collection costs: costs of running the tax office; • compliance costs: costs incurred by taxpayers; • deadweight loss: costs of misallocation of resources as people respond to prices distorted by taxes. Compliance and collection costs are largely fixed costs: they do not change when the amount of tax collected changes by a small amount. Since any given project will involve relatively small changes in the flow of public funds, compliance and collection costs can be ignored in social benefit-cost analysis. The amount of deadweight loss tends to rise (fall) as the amount of public funds raised rises (falls). A project which requires additional public funds imposes an additional deadweight loss on the economy; and a project which contributes to public funds reduces the amount of deadweight loss. When the additional deadweight loss is taken into account, the NPV rule becomes: NPV = B - C - D > 0 where: B is the PV of project benefits C is the PV of project costs D is the additional deadweight loss The NPV rule could also be written as: B - C[(C+D)/C] >0, or B/C > (C+D)/C where (C+D)/C is the marginal cost of public funds. [...]... increase on the quantity of labour supplied and he quantity of leisure demanded Estimates of the marginal cost of public funds: In Australia and other OECD countries most estimates of the marginal cost of public funds are in the 1.2 - 1.3 range In other words, there is an additional deadweight loss of around 25 cents per dollar of extra tax revenue raised Implications of the marginal cost of public funds... out the cost to the economy of displacing $50 worth of private consumption and $50 worth of private investment: • the loss of $50 worth of private consumption costs $50 • the $50 worth of private investment would have yielded an annual before-tax return of $50r* The present value of this return (at the market rate of interest) is $50(r*/r) = $50*1.5 = $75 The cost to the economy of raising $100 of public. .. that the project should not go ahead immediately? There might be uncertainty about the values of some of the variables used to calculate the NPV e.g future prices Delaying the project might resolve these uncertainties To investigate the value of delaying the project we compare the NPV (at time 0) of undertaking the project immediately (at time 0) with the NPV (at time 0) of delaying the start of the. .. public funds for social benefitcost analysis: All flows of public funds resulting from a project should be shadow-priced (at around 1.25 in Australia) This increases the cost of outflows and increases the benefits of inflows of funds as a result of a project The Value of Information Suppose that you have undertaken a social benefit -cost analysis and find that NPV>0 Is there any reason (other than a budget... illustrates the expected NPVs of the two options Figure 10.2 The benefit and cost of delaying an investment Wait q RH/r – K/(1+r) Invest (1-q) 0 [since {RI/r) – K/(1+r)} . Chapter 10: The Social Discount Rate, Cost of Public Funds, and the Value of Information © Harry Campbell & Richard Brown School of Economics The University. types of costs: • collection costs: costs of running the tax office; • compliance costs: costs incurred by taxpayers; • deadweight loss: costs of misallocation