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When discounting in order to obtain the present value, one has to determine the opportunity cost of capital.

In this case, I don't want to do it for a project (or a comparison of two similar projects), but try to determine it for a government spending/consumption/investing. E.g. buying or renting a federal building, where governmental services take place.

What indicators provided by gouvernemental bodies/financial services, or which calculation can best be considered when determining the discount rate for a country/opportunity cost of capital for a given country?

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    $\begingroup$ Just to clarify, you want to look at the decision [invest in capital/not invest/invest in something else] now, based on future returns from that investment for an economy as a whole? If there is an alternative investment/spending what is that? For example buying government bonds, or just "consuming"? $\endgroup$
    – BrsG
    Jul 19, 2021 at 10:15
  • $\begingroup$ Well, I'm talking about federal funds here, that could be spent, I think, at will, for example by buying any financial product available to the government. The other option is paying for a specific project (this is also non-profit, just a cost/service provided to the government itself or its citizens). So it's not a comparison between two similar projects, but rather the choice is between initiating one project, of just get maximum return on investment on the capital by any means available to the government. If that makes sense. $\endgroup$
    – babipsylon
    Jul 19, 2021 at 12:53
  • $\begingroup$ Although "any means" is maybe limited by law as it concerns government spending. Maybe the more sensible alternative here is just not to obtain the funds at all as a government... . Hardly impossible to calculate the returns on that for the economy for one project... . $\endgroup$
    – babipsylon
    Jul 19, 2021 at 12:54
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    $\begingroup$ Makes sense. If you are looking just at the fiscal side, I suggest to look at fiscal multipliers. They can differ considerably by "project", think about investing into public transport vs investing in schools. Not sure there are official estimates around, but especially for the US there should be some literature. Note that for governments the alternative investment is actually paying off debt. So, treasury yields would be the alternative cost to compare it with. If the focus is on the government, not private investment, I would change the title correspondingly. $\endgroup$
    – BrsG
    Jul 19, 2021 at 13:07
  • $\begingroup$ Yes you are right, paying off governmental debt is probably a sensible way to look at the alternative. I guess I don't really have to determine the return on investment for the specific projects, which is near impossible. Although looking at fiscal multipliers is indeed a nice try at approximating this return on investment. Because if the discount rate is seen as the opportunity cost of capital, knowing the interest payed on the debt of the country each year is probably a nice vector of discount rates to apply.And that's all that is needed or what would you use the fiscal multiplier value for? $\endgroup$
    – babipsylon
    Jul 19, 2021 at 13:44

1 Answer 1

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There is actually no single agreed upon way how to do this. As discussed by Carnot et al in Economic forecasting and Policy pp 215:

The other conceptual problem [in the cost-benefit analysis] concerns the discount rate. First, using discounting mechanically leads to putting less weight on more distant costs and benefits-much less, in fact, when the project has an impact far into the future. This may not be sensible, notably when the project has significant long-run environmental repercussions. Second, there is the issue of the choice of an appropriate discount rate. Opting for a market rate is not a simple solution, given the dispersion of market rates from which to choose. In fact, the discount rate used by private firms is often far above any bond rate, because it reflects high opportunity costs. In the public sector, it is usually lower, albeit still above bond rates, because of budget constraints. That said, the uncertainity about the right discount rate is more of an problem when analyzing the intrinsic costs and benefit of a given project than when comparing those of competing projects pursuing the same objective.

However, typically discount rate is set to be equal to the interest rate on government debt. For example, Congressional Budget Office (CBO) does this as it explains in its primer on how it provides fair value estimates. Nonetheless, as this report shows it will sometimes use different rates depending on the setting (e.g. different rates for military spending, or different rates if some are required to be used by regulation).

Some government bodies make an adjustment to this rate for a long term projects reflecting the issue discussed in the first part of the quote from Carnot et al (e.g. see this HM treasury report).

This is arguably not ideal, but as the quote above says, even though this can create inaccuracies in finding the true value of the project when you just compare two projects to each other, it is not a huge issue since you will use the same discount rate for both projects.

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    $\begingroup$ @babipsylon yes, although one caveat, you should not think that means anything goes, and using interest rate on government bonds of the same maturity as you believe the project will take is de facto widely used standard, but from purely scientific perspective there is no full or even just overwhelming consensus $\endgroup$
    – 1muflon1 ♦
    Jul 23, 2021 at 15:54
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    $\begingroup$ @babipsylon well every person has preferences and desires, like for example you might want to get food, shelter, go to vacation, play some board game etc. utility is a measure of satisfaction of needs people have. From relationship between needs and satisfying the needs you can construct utility function. There are two main types of utility functions ordinal (more realistic but sometimes less useful) which tells you order of preferences for a person. For example, I prefer chocolate cereal to cornflakes so that is part of my ordinal utility. Second type of utility is cardinal utility $\endgroup$
    – 1muflon1 ♦
    Oct 4, 2021 at 13:14
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    $\begingroup$ Which allows you to assign some given number to satisfaction of needs (less realistic to be actually able to calculate but often more useful), for example cardinal utility would allow me to measure that let’s say eating chocolate cereal gives me 20 utils and cornflakes gives me 10 utils so I not only prefer chocolate cereal to cornflakes but also I value choc cereal at 2x the rate that I value cornflakes. Using various statistical measures you can estimate either ordinal or cardinal utilities for various options including how much people value resources now vs future $\endgroup$
    – 1muflon1 ♦
    Oct 4, 2021 at 13:18
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    $\begingroup$ As a consequence, people’s utilities always imply that there some sort of discount factor (i.e. interest rate that gives you the degree of preference for present vs future). Theoretically, this is often the best interest rate to use for public policy as government should not simply maximize the value of public funds or just recoup loss of value of money due inflation but maximize welfare of society. However, it’s not always used as it is very difficult to precisely measure it and to estimate its value, so people might go for a bit more objective measure like rate on gov bonds $\endgroup$
    – 1muflon1 ♦
    Oct 4, 2021 at 13:20
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    $\begingroup$ @babipsylon yes it also depends on different problems but Utils are just some unit of measurement like a meter so utils are simply utils but as mentioned above it’s difficult to measure utils directly so people typically work with ordinal utility but you still can get a discount rate but exactly as you said discount rate can be different for different activities $\endgroup$
    – 1muflon1 ♦
    Oct 4, 2021 at 14:31

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