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Annual Review of Financial Economics

Volume 15, 2023

Fixing Our Public Discounting Systems

Abstract

Most Western countries use a single discount rate to evaluate public investments and policies. This ignores the differential cost of risk, in a world where most risk markets exhibit surprisingly large prices of risk. The current discounting guidelines generate a misallocation of capital that entails a large welfare cost. We claim that the well-established asset pricing literature provides a strong normative justification in favor of risk-adjusting discount rates. More specifically, project-specific discount rates should be increasing in the income elasticity of the project's net benefit. This will favor projects whose net benefit materializes preferentially in low-income states, thereby recognizing their insurance benefit ex ante. The intuition is simple, the welfare benefit of the reform is large, and the methodology only requires evaluators to estimate an income elasticity on top of what is required in the current approach. It is time to fix our public discounting systems.

Keyword(s): carbon pricing, cost-benefit analysis, discounting, JEL G12, JEL H43, JEL Q54, risk adjustment
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/content/journals/10.1146/annurev-financial-102921-111749
2023-11-01
2024-04-27
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/content/journals/10.1146/annurev-financial-102921-111749
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Fixing Our Public Discounting Systems
Annual Review of Financial Economics 15, 147 (2023); https://doi.org/10.1146/annurev-financial-102921-111749
/content/journals/10.1146/annurev-financial-102921-111749
/content/journals/10.1146/annurev-financial-102921-111749
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  • Article Type: Review Article

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