Governmental Discount Rate
The proper discount rate for governmental investments stands at the heart of a stubborn controversy in the academy and among policy makers for the last 50 years. On the one hand, some claim that the government should simply apply the discount rates used by the private sector, which translates into relatively high discount rates and, as a result, the diminishing of public investments. On the other hand, others discount public investments according to the government cost of debt – meaning the interest it pays for its bonds. These discount rates, which include no risk premium, reflect the assumption that the government is more efficient than the market in bearing risks. Alongside of these two competing views we also find a third perspective, which holds that the discount rate should be grounded in normative considerations regarding the value of consumption in the future compared to its value in the present (social time preference).
The research sets the ground for determining the discount rate used for public investment in Israel by a thorough examination of each one of these three views. Each view is analyzed by the assumptions that underlie it, its expected implications, the way it is used in the world, and the way it might be applied in Israel.
The research studies the use of the governmental discount rate in ten developed countries, and finds that none of them have adjusted their discount rates to the low interest environment found across the globe in recent years. This implies that Israel is facing two problematic alternatives: either it can determine a discount rate while ignoring the interest environment, or it can determine a discount rate which is very low (less than 2%) compared to the ones used in other developed nations.
The research concludes by suggesting two methods for deciding upon a discount rate in Israel. The first method relies on the CAPM model and distinguishes investments that are correlated with the market, that are discounted with a risk premium of 7%, from those that are not correlated, that are discounted according to the government debt price. A second method, which was developed by the Dutch government, is to discount all investments according to the government debt price, and to add a 1% market risk premium. Debt price are measured by the average returns on a government zero-coupon bond in the last 10 years (0%-2.5%). In addition, the research recommends discounting long-term investments (more than 20 year) by determining the social time preference.