Time and Discounting in Private and Public Decision Making
Edited by David J. Pannell and Steven G.M. Schilizzi
Chapter 5: Risk, Discounting and the Public Sector
5. Risk, discounting and the public sector John Quiggin SUMMARY The problem of discounting under uncertainty has given rise to a large and complex literature. Arguments about the appropriate discounting procedure for public sector investments are particularly tangled. Much of the confusion can be resolved by the observation that the purpose of discounting is to define a ‘common currency’, in which benefits and costs received in different possible future states of nature can be valued. In considering the discount rate for public investments, two competing intuitions arise. The first is that, since aggregate consumption is not very risky, the discount rate for public investments should not be sensitive to risk. The second is that public investments should be evaluated in the same way as private investments with similar risk characteristics. Since the evaluation of private investments is highly sensitive to risk, these intuitions are in conflict. The most plausible resolution of these conflicts is to observe that, because of widespread market failure, the private cost of risk is higher than the cost of risk borne collectively through the tax system. It follows that governments should use a discount rate close to the real bond rate and that, other things being equal, the public sector has a comparative advantage in undertaking risky investments. 5.1 RISK, DISCOUNTING AND THE PUBLIC SECTOR The central problem of discounting arises from the need to compare flows of income accruing in different time periods and different states of nature, and possibly involving claims on different bundles...
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