Effects of the Discount Rate on the Civil Works Program

Application of a relatively high discount rate adversely affects the economic justification of capital-intensive projects with long design lives or with benefits which grow over time. The adverse effects are less severe for projects with benefits based on alternative costs, with a high proportion of recurrent to capital costs, or which are limited in scale, extent or design life. A high discount rate reduces the potential cumulative level of investment. Not only is the size and capital-intensity of each project reduced, but also fewer projects can be recommended. For instance, if a 10% rate were applied to all pending projects, over half would not be justified without reformulation and it is estimated that nearly half would not be justified even with reformulation. Finally, over time the use of a high discount rate would increase the proportion of the budget allocated to recurrent costs rather than investment costs. The official discount rate now in use is based on nominal interest rates, and changes on an annual basis. During periods of sustained inflation, the official discount rate rises to include an inflation premium, becoming increasingly inconsistent with other economic analysis principles. In addition, the variability of the official rate adds to uncertainty in plan formulation and in programming and budgeting. Any analysis of existing and alternative methods to compute the discount must address not only its magnitude and also the uncertainties and inconsistencies which can result from dependence on nominal interest rates.
This article is from 'Proceedings: Economic and Social Analysis Workshop Held at St. Louis, Missouri on 25-29 October 1982,' AD-A136 867, p255-289.