This blog post explores how companies use market interest rates and social discount rates to reflect the value of future generations when evaluating public works.
Business investment and the role of the discount rate
When a company invests in a project, it evaluates the feasibility of the project by comparing the costs it will incur in the present with the benefits it will receive in the future. This process isn’t just about comparing current investments to future returns; it takes into account a number of economic factors. For example, you must factor in discounting factors, including inflationary price increases, the cost of giving up other investment opportunities, and the uncertainty of the economic environment. If these factors are not taken into account, investment decisions can be distorted, which can negatively impact a company’s long-term growth prospects.
In this case, discounting factors, including inflation, investment opportunities, and uncertainty, should be taken into account to convert future values into present values to fairly compare costs and benefits. This allows companies to make optimal investment decisions based on different scenarios. The concept that translates these complex economic factors is the discount rate. Think of the discount rate as a concept similar to interest rates, but in reverse. If the current interest rate is 10% per annum, $100 today will be worth $110 next year multiplied by (1 + 0.1), and if the discount rate is 10% per annum, the present value of $110 next year will be $100 divided by (1 + 0.1).
Analyzing the feasibility of public projects
When analyzing the feasibility of a public project, it is especially important to apply a public discount rate that takes into account future generations. This discount rate is called the social discount rate. Ideally, the social discount rate should be determined by accurately identifying the discounting factors felt by members of society, but this is very difficult in practice. The social discount rate is not just an economic factor, but a combination of factors such as environmental impact, social welfare, and the public good. Therefore, it is sometimes argued that the market interest rate or the rate of return on private capital should be used as the social discount rate.
Debating the use of market interest rates and the private rate of return on capital
The market interest rate is a value determined by the supply and demand for capital through savings and borrowing. Those who save pay the market interest rate to have their principal called at a greater amount in the future, and those who borrow pay the market interest rate to borrow. The market interest rate can also be used as a discount rate for converting future amounts to present value, which is why it is argued that it should be considered the social discount rate. On the other hand, there is an argument for using the rate of return of private capital as the social discount rate. This argument is that the capital that is to be invested in public projects at the level of society as a whole can also be utilized in the private sector, so public projects should require a rate of return as high as the private sector.
However, this argument overlooks the nature of public works. The purpose of public works is not simply to seek economic returns, but to create social value and promote the well-being of future generations. For example, public projects such as expanding transportation infrastructure or protecting the environment may seem to have minimal benefits in the short term, but in the long term, they have a positive impact on society as a whole. In this sense, when evaluating the feasibility of a public project, it is important to consider its long-term social value, not just its short-term benefits.
Social discount rate reflects the long-term value of public projects
However, the argument for using market interest rates or the rate of return on private capital as the social discount rate is difficult to accept. For one thing, if the public sector’s rate of return is as high as the private sector’s, it raises the question of why the government should invest in areas where private investment is available. More importantly, market interest rates, or the rate of return on private capital, are determined by capital markets, where private interests are realized in the relatively short term. Public works, on the other hand, are subject to a social discount rate, meaning that the benefits are generally realized slowly over a longer period of time. In this sense, public projects reflect the ideology of sustainable development that considers future generations. If the social discount rate were to be as high as the market interest rate or the rate of return on private capital, the interests of future generations would be undervalued.
The importance of the social discount rate
Therefore, the social discount rate is more than just an economic calculation, it should serve as a tool to ensure public benefits for future generations. This means that determining the social discount rate requires a social consensus on how to balance current and future generations. The social discount rate should preferably be determined from a public interest perspective that takes into account future generations, which is essential for sustainable development and fair resource allocation.
