Search Results

Unless defined benefit pension plans are managed much better and more cost-effectively, they will be replaced by defined contribution plans. Benefit and contribution policies need to be carefully evaluated to make sure that a reasonable level of ongoing contributions, together with investment income, are adequate to fund the defined benefit plan without unpleasant surprises. Unless valuation and contribution conventions change to market-valued economically based quantities, decision makers will lack the right information with which to make informed policy decisions.

This chapter addresses issues regarding the use of cost-benefit analyses in shaping environmental policies. It defines an ecological discount rate compatible with social welfare when the representative agent cares about both the economic and ecological environments faced by future generations. This ecological rate at which future environmental damages are discounted may be much smaller than the economic rate at which economic damages are discounted, because of the integration of a potentially increasing willingness to pay for the environment into the ecological discount rate. This increased interest in environmental assets is modeled in this chapter by the potential for increased scarcity of these assets, which drives their value upward through time. The chapter shows that the uncertainties surrounding the future evolution of environmental quality and the economy tend to reduce the discount rates, in particular if they are positively correlated.

This chapter reviews the ethical foundations of both national and international policies designed to counter global climate change. Four moral theories are identified and are shown under certain circumstances to recommend the same formula for determining policies. The discussion is focused on the idea of social discount rates. The moral theories are then applied to discount rates. It is shown that disagreements among economists over energy policies that shape the long run can be traced to differences in the quantitative values used for discount rates. It is argued that the common formula in use is based on defective reasoning: it has no place for the idea of personhood. It is shown that personhood can be accommodated in a moral theory that takes justice among the generations seriously. The proposed theory involves the use of two sets of discount rates, one for the short run, the other for the long run. It is shown that disagreements among economists writing on global climate change can be traced to one group using short‐run discount rates, and the other group using long‐term discount rates, which would be expected to be considerably lower. Projects that have an impact on both the short and long run should be evaluated by means of discount rates that lie somewhere between the pair of sets in current use among economists.

This chapter illustrates that the shape of the term structure of discount rates is determined by the way the wealth effect and the precautionary effects evolve with the time horizon. When the growth rate of consumption is constant, then consumption increases exponentially, and the intertemporal rate of substitution, which is the discount factor, decreases exponentially. This requires that the discount rate is constant. The simplest extension of this to uncertainty is to assume that the growth rate of the economy follows a random walk. In that case, the variance of log consumption increases linearly, which yields an exponentially increasing precautionary effect for the discount factor. This justifies a constant precautionary effect on the discount rate, yielding a crucial result for the theory of efficient discount rates.

Many policies impact on inter-temporal consumption choices, with taxes on capital income being the most obvious example. This chapter examines the welfare effects of linear and non-linear personal income taxes, as well as taxes on corporate income, in a two-period setting. The shadow discount rate obtained by Harberger (1969) and Sandmo and Dre_ze (1971) is personalized in the presence of non-linear income taxes, while the corporate tax is included using the Miller (1977) equilibrium, in which consumers specialize in holding debt or equity, solely on the basis of their tax preferences. A risk premium is included in the social discount rate using the capital asset pricing model (CAPM), and arguments by Arrow and Lind (1970) for using a lower risk premium for public sector projects are also examined.

This chapter presents the main argument in favor of a positive discount rate. In a growing economy, future generations will consume more goods and services than we do. In this context, investing for the future is equivalent to asking poor consumers to sacrifice more of their consumption for the benefit for wealthier people. Because of inequality aversion, one would be ready to do so only if the rate of return of these investment projects is large enough to compensate for the increased intertemporal inequalities that these projects would generate. The Ramsey rule quantifies this wealth effect. In fact, several experts have used the Ramsey rule to make recommendations on the choice of the discount rate to evaluate public policies, in particular toward climate change.

This chapter analyzes the risks and rewards of moving from an unfunded defined benefit pension system to a funded plan for civil servants in Germany, allowing for alternative portfolio mixes using a Monte Carlo framework and a Conditional Value at Risk metric. The authors identify an investment strategy for plan assets that will minimize worst-case pension costs; this turns out to be 22 percent in equities, 47 percent in bonds, and 31 percent in real estate. The authors show that moving toward a funded pension system for German civil servants can be beneficial to both taxpayers and civil servants.

Liabilities for pension and retiree health-care benefits provided by US state and local governments are causing concerns for taxpayers and for those holding government bonds. Many question whether the methodology used to calculate these liabilities is appropriate, since the private sector calculates retirement system liabilities using different methods and assumptions. This chapter reviews and critiques current actuarial and accounting standards under which governmental retiree liabilities are calculated and compares and contrasts these standards to those used by private sector employers.

This chapter examines the conditions under which the multiproduct firm should use market share as a metric for resource allocation. It distinguishes short- and long-run effects, analyze the effects of competition, and show how the discount rate affects the firm's revenue- and volume-based market shares. In particular, it shows how the firm can use marketing-finance fusion to choose the optimal performance metrics for managers so that they focus on maximizing long-run performance.

Scrutinizes a class of accounting prices that has been the object of regular misunderstanding: social discount rates. The topic is over 40 years old, yet controversy rages over matters that have long been settled, involving as they do technical economics. Many who express views on social discount rates overlook the literature and make incorrect claims. I point to a few as the occasions warrant.

This introductory chapter considers the problem of investment project selection, i.e. which projects should be implemented to maximize intergenerational welfare. To address the challenge of allocating present sacrifices for the future in the way that maximizes the increase in welfare of future generations, the chapter introduces the cost-benefit analysis (CBA). The CBA is a set of valuation techniques that enables priorities to be put on the set of investment opportunities to be compatible with maximizing intertemporal welfare. The focus here is on how to compare temporally distributed valuations of different projects’ impacts, once these valuations have been made. One key ingredient in the CBA toolkit is the discount rate, which can be interpreted as the minimum rate of return required from a safe investment project to make it socially desirable to implement.

This chapter examines a model in which the exogeneous rate of return of capital is constant but random. Safe investment projects must be evaluated and implemented before this uncertainty can be fully revealed, i.e., before knowing the opportunity cost of capital. A simple rule of thumb in this context would be to compute the net present value (NPV) for each possible discount rate, and to implement the project if the expected NPV is positive. If the evaluator uses this approach, this is as if one would discount cash flows at a rate that is decreasing with maturity. This approach is implicitly based on the assumptions that the stakeholders are risk-neutral and transfer the net benefits of the project to an increase in immediate consumption. Opposite results prevail if one assumes that the net benefit is consumed at the maturity of the project.

This chapter shows how to estimate the required return for a closely held firm. It begins by reviewing the required return for a public firm. It then focuses on additional adjustments required to adapt the method for use on a closely held firm. This approach deals specifically with the lack of liquidity and diversification of the owner and the lack of market information for small firms. Finally, the chapter shows how the discount rate should be estimated for a closely held firm.

This chapter examines the effects of a dramatic switch in the dynamics of economic growth for the term structure of the discount rate over the longer term. Economies undergo radical transformations. One such radical transformation was called the “industrial revolution” which has had a long-lasting effect on economic growth. The chapter considers the possibility of a reversion to the pre-industrial age, at least in terms of an absence of growth, in the distant future, or any other effects on the current economic growth rate. Other less persistent—but more frequent—transformations observed in the past were wars or great economic depressions. It is thus important to include the possibility of such changes in the dynamics of growth in the analysis of the term structure of the discount rate.

Discount rates have a profound effect on estimates for costs and benefits that accrue over time or in the future. Given that minute differences in discount rates can result in enormous differences in future values, discounting implicates moral as well as technical issues. This chapter reviews some of the main issues that discounting presents and discusses some important recent debates over time-varying discount rates and the importance of relative prices when examining effects of public policy in the far future. The authors also collect and discuss the discount rates currently used by decision makers around the world, and explain how differences in level of development should and should not affect the discount rates used by analysts.

This concluding chapter summarizes the principles set forth in this volume. It argues that the discount rate is a key parameter in economics because it determines how our societies value their future. The chapter aims to use the discount rate in the net present value (NPV) decision rule: to find the discount rate which gives a positive NPV only for those projects that raise the sum of present and future generations’ felicity. In that light, this chapter briefly touches upon the basic principles of discounting, the discounting of safe real cash flows, the term structure of real discount rates, the evaluation of uncertain projects, and the adaptability of projects.

This chapter sketches some serious disputes between rival economic analyses of climate change. Such disputes result in vastly different policy recommendations, and involve serious differences in fundamental assumptions. The chapter argues that, contrary to initial appearances, these differences do not reflect narrow technical issues within economic theory, but rather deep ethical claims that fill fundamental gaps in that theory. Moreover, it claims that the most common recent arguments do not fill these gaps, and neither does the (perhaps heroic) claim that some appropriate kind of economic modeling must in principle be possible. While this does not mean that good climate economics is not worth pursuing, it does suggest that we are far from the position where we can confidently rely on such analysis when deciding how to shape the future of the planet.

This chapter addresses how future benefits should be discounted in the context of project evaluation, or cost–benefit analysis, and addresses the role played by the choice of discount rate with respect to long-term policies. The chapter focuses on theoretical arguments for a declining discount rate (DDR) schedule, in which the rate used to discount benefits and costs declines over time. The governments of France and the United Kingdom use a DDR, but the United States does not. The chapter reviews models of long-term interest rates that have been estimated for the United States and used to forecast US DDR schedules. It then applies them to calculating the social cost of carbon emissions.