A Generalized Approach to Multigeneration Project Evaluation

Abstract

1. IntroductionIt is well-known that the choice of discount rate plays a significant role in the ranking of projects with varying time paths of costs and benefits. For public projects, the choice of the appropriate social discount rate (SDR) is not clear-cut even in the context of short-lived projects in which costs and benefits occur within a single generation. In particular, when capital taxes produce a wedge between gross and net rates of return, should one discount at the economy's rate of return (the before tax rate) or the individual's rate of return (the after tax rate)? In the single-generation context, the literature falls in two camps.1 One camp argues that the appropriate SDR is a weighted average of the gross and net rates of return with weights typically determined by the fractions of resources drawn from consumption and private investment, respectively.2 A second camp argues that future benefits should be discounted at the net rate of return, but that the initial investment should be multiplied by a scale factor so that the direct costs of the project can be expressed in terms of consumption units.3Both approaches suffer from severe implementation problems. For the first approach, there is no general formula for the weights needed to calculate the SDR as a weighted average of two market rates of return (Dreze 1974). Indeed, the appropriate SDR to use is project-specific (Stiglitz 1982). Without a systematic methodology to derive project specific SDRs, the weighted average approach is hard to implement. For the second approach, which equalizes the SDR to the net rate of return, the scale factor--the opportunity cost of public investment--must be quantified. The opportunity cost of public investment depends on whether resources come from private investment or consumption and on the calculation of the present value of the future consumption yielded by a unit of capital discounted at the net rate of return; that is, the shadow price of capital. As Lind (1997) points out, however, there is no general agreement on a specific procedure for calculating the shadow price of capital. Indeed, the concept of the opportunity cost of public investment suffers the same project dependence problem as the first view of the SDR (Diamond 1968).Multigeneration projects such as nuclear waste disposal, natural resource conservation, or even Social Security reform further complicate discount rate choice. Specifically, intergenerational equity, in addition to intertemporal efficiency, plays a role in determining the appropriate social discount rate for multigeneration public project evaluation.4 As in the single-generation context, there are two competing views on the appropriate discount rate when evaluating multigeneration projects: the descriptive and the prescriptive approaches.5The descriptive approach to discounting is a market-based approach. It does not rely on an explicit social welfare function (SWF) or the pure time preference rate embedded in the SWF. However, the descriptive approach works under the assumption that intergenerational compensation through changes in the tax/debt policy is available.6 It is argued that, under appropriate intergenerational compensation, the market rates of return are still relevant for calculating the SDR for multigeneration project evaluation, and, in general, the SDR should be a weighted average of the gross and net rates of return. This descriptive view of setting the SDR equal to the market return appears to underlie the Office of Management and Budget's (OMB) adoption of 7% as the appropriate discount rate for federal programs.7The intent of the prescriptive approach is to use the social discount rate as an expression of ethical judgment on how consumption of future generations should be compared to consumption of current generations. …