Last week the New Zealand Treasury changed the discount rate required to be used for assessing public-sector investments.
đ´đ´đ´ WAIT â before you fall asleep â this is big news!
The discount rate affects how benefits and costs that occur in the future are reduced (discounted) when making decisions about public investments and policy interventions. Itâs often argued that New Zealand has under-invested in infrastructure, and a high discount rate makes long-term investments look relatively unattractive. The discount rate also has important implications for climate change policies, given that most of the impacts of climate change are in the future but mitigation and adaption cost money now.
Discounting can be motivated in various ways but it boils down to the fact that benefits and costs that are expected to occur in the future are worth less than benefits and costs that occur today. The discount rate captures exactly how much less.
Before this change, the NZ public sector discount rate was 5%. Discounting maths works like the inverse of compounding interest, so at a 5% discount rate, a $1 benefit that occurs 20 years in the future is only worth $0.38 today. At 50 years, itâs worth only $0.09 today and at 100 years itâs worth $0.01 today, i.e. we basically donât care about benefits after 50 years.
The first chart below illustrates how we value benefits and costs that occur 50 and 100 years in the future under different discount rates.
In a big shake-up, the NZ Treasury now requires a much lower discount for public-sector non-commercial projects. It has actually specified a discount rate that reduces over time, starting at 2% for years 1 - 30, reducing to 1.5% in years 31 - 100, and further to 1% from year 101 onwards. Now, $1 that occurs 20 years in the future is worth $0.67 today, $0.41 today at 50 years, and $0.19 today at 100 years.
BUT â the Treasury also requires a mandatory sensitivity test using an 8% discount rate. Previously, a 2% discount rate was used as a sensitivity test against the 5% rate.
So itâs a little unclear how this will play out in practice. Long-term investments will look better at the new standard rate, but the sensitivity test treats them more harshly than the old regime did.
The second chart below compares the amount of discounting (the âdiscount factorâ) applied to future benefits and costs under each of these rates.
As an example of how the discount rate can affect the relative attractiveness of different options, suppose the government is choosing between two ways to spend $1 billion. It could invest in 10 short-term projects that each cost $100 million up front and generate $20 million of benefits per year for 10 years. Or it could invest in one long-term project that costs $1 billion up front and generates $50 million of benefits per year for 100 years.
Under the old 5% discount rate, the short-term option will have a net benefit of $544 million and the long-term option will come in at -$8 million. The short-term option looks a lot better and the long-term option probably wonât be considered because the discounted benefits are less than the cost.
Under the new declining discount rate, the short-term optionâs net benefit increases to $797 million, but the long-term optionâs net benefit increase even more to $1.3 billion. So now the long-term option looks better than the short-term option.
Itâs important to note that lowering the discount rate does not magically give the government more money to make investments. As in the example above, it improves the case for long-term investments, and it may change the relative attractiveness of different investments, depending on the timing of their benefits and costs.
Overall, long-term decision-making looks set to change, but the big gap between the standard rate and the sensitivity test rate leaves some open questions.