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Should governments use a declining discount rate in project analysis?

Arrow, K. J. and Cropper, M. L. and Gollier, C. and Groom, B. and Heal, G. M. and Newell, R. G. and Nordhaus, W. D. and Pindyck, R. S. and Pizer, W. A. and Portney, P. R. and Sterner, T. and Tol, R. S. J. and Weitzman, M. L. (2014) Should governments use a declining discount rate in project analysis? Review of Environmental Economics and Policy, 8 (2). pp. 145-163. ISSN 1750-6824

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Identification Number: 10.1093/reep/reu008

Abstract

Should governments use a discount rate that declines over time when evaluating the future benefits and costs of public projects? The argument for using a declining discount rate (DDR) is simple: if the discount rates that will be applied in the future are uncertain but positively correlated, and if the analyst can assign probabilities to these discount rates, then the result will be a declining schedule of certainty-equivalent discount rates. There is a growing empirical literature that estimates models of long-term interest rates and uses them to forecast the DDR schedule. However, this literature has been criticized because it lacks a connection to the theory of project evaluation. In benefit-cost analysis, the net benefits of a project in year t (in consumption units) are discounted to the present at the rate at which society would trade consumption in year t for consumption in the present. With simplifying assumptions, this leads to the Ramsey discounting formula, which results in a declining certainty-equivalent discount rate if the rate of growth in consumption is uncertain and if shocks to consumption are correlated over time. We conclude that the arguments in favor of a DDR are compelling and thus merit serious consideration by regulatory agencies in the United States. (JEL: D61)

Item Type: Article
Official URL: http://reep.oxfordjournals.org/
Additional Information: © The Author 2014. Published by Oxford University Press on behalf of the Association of Environmental and Resource Economists. All rights reserved.
Subjects: G Geography. Anthropology. Recreation > GE Environmental Sciences
Sets: Departments > Geography and Environment
Date Deposited: 19 Aug 2014 14:55
Last Modified: 19 Aug 2014 14:55
URI: http://eprints.lse.ac.uk/id/eprint/59068

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