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Editor's Choice Should Governments Use a Declining Discount Rate in Project Analysis?

Author

Listed:
  • Kenneth J. Arrow
  • Maureen L. Cropper
  • Christian Gollier
  • Ben Groom
  • Geoffrey M. Heal
  • Richard G. Newell
  • William D. Nordhaus
  • Robert S. Pindyck
  • William A. Pizer
  • Paul R. Portney
  • Thomas Sterner
  • Richard S. J. Tol
  • Martin L. Weitzman

Abstract

Should governments use a discount rate that declines over time when evaluating the future benefits and costs of public projects? The argument for using a declining discount rate (DDR) is simple: if the discount rates that will be applied in the future are uncertain but positively correlated, and if the analyst can assign probabilities to these discount rates, then the result will be a declining schedule of certainty-equivalent discount rates. There is a growing empirical literature that estimates models of long-term interest rates and uses them to forecast the DDR schedule. However, this literature has been criticized because it lacks a connection to the theory of project evaluation. In benefit-cost analysis, the net benefits of a project in year t (in consumption units) are discounted to the present at the rate at which society would trade consumption in year t for consumption in the present. With simplifying assumptions, this leads to the Ramsey discounting formula, which results in a declining certainty-equivalent discount rate if the rate of growth in consumption is uncertain and if shocks to consumption are correlated over time. We conclude that the arguments in favor of a DDR are compelling and thus merit serious consideration by regulatory agencies in the United States. (JEL: D61)

Suggested Citation

  • Kenneth J. Arrow & Maureen L. Cropper & Christian Gollier & Ben Groom & Geoffrey M. Heal & Richard G. Newell & William D. Nordhaus & Robert S. Pindyck & William A. Pizer & Paul R. Portney & Thomas Ste, 2014. "Editor's Choice Should Governments Use a Declining Discount Rate in Project Analysis?," Review of Environmental Economics and Policy, Association of Environmental and Resource Economists, vol. 8(2), pages 145-163.
  • Handle: RePEc:oup:renvpo:v:8:y:2014:i:2:p:145-163.
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    References listed on IDEAS

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    1. Christian Gollier, 2012. "Pricing the Planet's Future: The Economics of Discounting in an Uncertain World," Economics Books, Princeton University Press, edition 1, number 9894.
    2. Geoffrey Heal & Antony Millner, 2013. "Discounting under Disagreement," NBER Working Papers 18999, National Bureau of Economic Research, Inc.
    3. Narayana R. Kocherlakota, 1996. "The Equity Premium: It's Still a Puzzle," Journal of Economic Literature, American Economic Association, vol. 34(1), pages 42-71, March.
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    More about this item

    JEL classification:

    • D61 - Microeconomics - - Welfare Economics - - - Allocative Efficiency; Cost-Benefit Analysis

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