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Governments Should Not Use Declining Discount Rates in Project Analysis

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  • Szekeres, Szabolcs

Abstract

A number of governments have already adopted the policy of applying Declining Discount Rates (DDRs) to long lived projects, a move that could affect public sector investment decisions. Arguments for the use of Declining Discount Rates are based on the consideration of uncertainty, both for discount rates derived from social welfare functions, and for those derived from the characteristics of capital markets. The case for the latter is based on Martin L. Weitzman’s assertion that certainty equivalent discount rates are a declining function of time and tend to the lowest possible interest rate when interest rates are stochastic but perfectly auto-correlated. This paper finds that this conclusion is the consequence of Weitzman’s use of time reversed negative compounding, rather than of discounting, in the definition of net present value. When discounting is used instead, Weitzman’s conclusions are reversed, and do not support the use of Declining Discount Rates.

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  • Szekeres, Szabolcs, 2015. "Governments Should Not Use Declining Discount Rates in Project Analysis," MPRA Paper 63438, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:63438
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    References listed on IDEAS

    as
    1. Gollier, Christian, 2004. "Maximizing the expected net future value as an alternative strategy to gamma discounting," Finance Research Letters, Elsevier, vol. 1(2), pages 85-89, June.
    2. Gollier, Christian & Weitzman, Martin L., 2010. "How should the distant future be discounted when discount rates are uncertain?," Economics Letters, Elsevier, vol. 107(3), pages 350-353, June.
    3. Gollier, Christian, 2010. "Expected net present value, expected net future value, and the Ramsey rule," Journal of Environmental Economics and Management, Elsevier, vol. 59(2), pages 142-148, March.
    4. Newell, Richard G. & Pizer, William A., 2003. "Discounting the distant future: how much do uncertain rates increase valuations?," Journal of Environmental Economics and Management, Elsevier, vol. 46(1), pages 52-71, July.
    5. Szekeres, Szabolcs, 2015. "When should the distant future not be discounted at increasing discount rates?," MPRA Paper 63437, University Library of Munich, Germany.
    6. Sterner, Thomas & Tol, Richard S. J. & Weitzman, Martin L. & Pizer, William A. & Portney, Paul R. & Arrow, Kenneth J. & Cropper, Maureen L. & Gollier, Christian & Groom, Ben & Heal, Geoffrey M. & Newe, 2014. "Should Governments Use a Declining Discount Rate in Project Analysis?," Scholarly Articles 33373349, Harvard University Department of Economics.
    7. Martin L. Weitzman, 2007. "Subjective Expectations and Asset-Return Puzzles," American Economic Review, American Economic Association, vol. 97(4), pages 1102-1130, September.
    8. Weitzman, Martin L., 1998. "Why the Far-Distant Future Should Be Discounted at Its Lowest Possible Rate," Journal of Environmental Economics and Management, Elsevier, vol. 36(3), pages 201-208, November.
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    Cited by:

    1. Szekeres, Szabolcs, 2015. "When should the distant future not be discounted at increasing discount rates?," MPRA Paper 63437, University Library of Munich, Germany.
    2. Szekeres, Szabolcs, 2015. "The Mechanics of the Weitzman-Gollier Puzzles," MPRA Paper 64286, University Library of Munich, Germany.

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    More about this item

    Keywords

    Discount rate; uncertainty; declining discount rate; benefit-cost analysis; negative compounding;
    All these keywords.

    JEL classification:

    • D61 - Microeconomics - - Welfare Economics - - - Allocative Efficiency; Cost-Benefit Analysis
    • H43 - Public Economics - - Publicly Provided Goods - - - Project Evaluation; Social Discount Rate

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