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A History of Discount Rates and Their Use by Government Agencies

Richard O. Zerbe Jr.

Xi Han
David Layton
Tom Leshine
October 2002
1.0 Introduction
This report reflects a history of the se of discont rates by !overnment a!encies
alon! "ith a history of the vales of real interest rates. The ma#or conclsion of this
report is that there is little consistency in !overnment decisions to se or not to se
discont rates or in their choice of particlar rates "hen they are sed. This article is
or!ani$ed as follo"s% section t"o deals "ith the concept of discont rates& section three
e'amines varios discont rates sed by !overnment a!encies& section for analy$es "hy
discont rates differ amon! !overnment a!encies& and section five loo(s at the history of
real interest rate in ).*. +e do not s!!est here "hat discont rates shold be sed.
2.0 hat are Discount Rates!
Discont rates reflect simply the particlar se of interest rates to find the earlier
vale of e'pected retrns. ,nterest rates are sed by lenders and borro"ers to determine
the amont of some ftre payment.
Ths if - is the amont borro"ed today and r is the
interest rate. then the ftre vale /. or the amont to be paid bac( at time T. "ill be
!iven by
/ 0 -123r4
The interest rate r is called the discont rate "hen it is sed to solve for - !iven the
other vales. Ths in sin! the follo"in! e5ation 124 the practice is called discontin!
and r is said to be the discont rate
6 history of interest rates from prehistoric times to 2770. incldin! a history of rates in the )nited *tates
from 28009s thro!h 2770. may be fond in Homer and *ylla 1277:4.
;5ation 2 assmes yearly discontin!. i.e.. the interest rate is paid yearly. ;conomists often se
continos discontin! as it lends itself to more ele!ant mathematics. Then the formla "ill be - 0/<1e
"here e is the natral lo! and r and T as before. Ho"ever. the difference in the final reslts is not lar!e
even if the time period is lon!. /or e'ample the present vale of a ftre sm disconted continosly over
a =00 year>period "ill be abot :0? of the present vale calclated sin! yearly discontin!. ,f the ftre
vale "ere 200 trillion. the present vale difference "old be only abot @:.000 as the disconted fi!res
"old both be in the @A0.000 ran!e.
- 0 /<123r4
Ths the se of discont rates mst be as old as the se of interest rates. +e "ill
focs here simply on the se of sch rates in more modern times and in particlar their
se by !overnment a!encies.
,nterest rates and ths discont rates may be e'pressed in real or nominal terms.
Bominal rates are mar(et rates "hich by their natre contain an e'pected inflation factor.
Real rates are nominal rates from "hich e'pected inflation 1in practice sally actal
inflation4 has been removed. The real rate

R is related to the nominal rate r as thro!h the
e'pected inflation rate. ,
as follo"s%
R 0 123 r4<123,
4 >2 124
"hich may be e'pressed appro'imately as
R r > ,
Ths if the nominal interest rate is 8?. e'pected inflation is 2?. the real interest rate R
"old be C.70? or appro'imately =?.
The conceptally correct procedre is to se real rates to discont real benefits and
costs 1constant>dollar vales4 and to se nominal rates to discont nominal benefits and
costs 1crrent>dollar vales4. To mi' real "ith nominal vales is to allo" inflation in one
part of the calclation bt not in the other.
".0 Rates for Government Agencies
".1 #edera$ Agencies
There is little consistent practice in !overnment both in the choice of a particlar
discont rate. and in the decision of "hether or not to se discont rates. This
inconsistency is fond across different levels of !overnment. amon! different
!overnment a!encies at the same level. and across time "ithin the same a!ency.
Ths not all /ederal a!encies se the same discont rates. nor do they al"ays se
discontin! at all. Da$elon and *metters 12777. p 2274 note that. E,n many cases. federal
a!encies do not discont. F and frther. Gcon!ressional cash>based bd!et plannin! does
not discont either.G /ederal a!encies often treat a dollar spent no" e'actly the same as a
dollar spent ne't year 1e.!. yearly bd!ets. mandatory spendin!4. /rther. Gchan!es in
spendin! beyond the five or ten>year bd!et "indo" . . .are essentially disconted at an
infinite rate
.G The follo"in! then briefly !oes over the history of discont rates sed by
different federal a!encies.
,. Discont Rates )sed by Office of Hana!ement and Dd!et 1OHD4
6ccordin! to the OHD Iirclar Bo. 6>7C. dated Harch 28. 2782 . GDiscont Rates
to be )sed in ;valatin! Time>Distribted Iosts and DenefitsG
. a real rate of 20 percent
"as recommended by OHD for se from Harch 28. 2782 ntil October 27. 2772. This
rate represents an estimate of the avera!e rate of retrn on private investment. before
ta'es and after inflation.
This Iirclar applies to all a!encies of the e'ective branch of the /ederal
Jovernment e'cept the ).*. -ostal *ervice. 6nd the 20 percent real discont rate applies
to the evalation of Jovernment decisions concernin! the initiation rene"al or e'pansion
of all pro!rams or pro#ects. other than those specifically e'empted 1decisions concernin!
"ater resorce pro#ects. the Jovernment of the District of Iolmbia. and non>/ederal
recipients of /ederal loans or !rants4. There have been t"o additional e'ceptions to the
se of this rate accordin! to Lyons 127704. The first is that a!encies "ere allo"ed to se a
different rate "hen an alternative rate can be #stified. Ho"ever. the acceptable basis for
sin! a different rate are not spelled ot. The second e'ception to the 20 percent rle has
been lease or prchase decision. for "hich the OHD Iirclar Bo. 6>20C. dated Jne 2C.
2782. GIomparative Iost 6nalysis for Decisions to Lease or -rchase Jeneral -rpose
Real -ropertyG. specified a real rate of 8 percent. This rate represents an estimate of the
internal rate of retrn on !eneral prpose real property leased from the private sector.
e'clsive of property ta'es and e'pected inflation. This rate is inflenced by ,R* ta'
treatment of real property and by separate handlin! of property ta'es in Iirclar 6>20C&
and it is specific to lease>or>prchase decisions and is not comparable to before ta' rates
of retrn that the OHD specified in Iirclar 6>7C.
,n October 2772. the OHD Iirclar Bo. 6>7C "as e'tensively revised. 6ccordin! to
the OHD Iirclar Bo. 6>7C. dated October 27th. 2772 .GJidelines and Discont Rates
Ihan!es to the bd!et in spendin! beyond =>20 years 1dependin! on the strctre of the bd!et4 in the
ftre often do not enter the calclations and Da$elon notes that this basically disconts the chan!es
/rom 27K:. the Drea of the Dd!et 1DOD4 had nderta(en a revie" of the theoretical fondations for
discontin! and issed Iirclar 6>7C in Jne. 27K7. in "hich a real discont rate of 20? is set for all
!overnment a!encies e'cept those concerned "ith "ater resorces. This means that a real rate of 20? "as
recommended by DOD from 27K7 ntil 2782.
for Denefit>Iost 6nalysis of /ederal -ro!ramsG. t"o basic types of discont rates have
been specified% 124 a discont rate for pblic investment and re!latory analyses& and 124
a discont rate for cost>effectiveness. lease>prchase. internal !overnment investment and
asset sale analyses.
/or the base case of pblic investment and re!latory analyses. OHD no" s!!ests a
real discont rate of 8 percent. This rate is said by OHD to appro'imate the mar!inal
preta' rate of retrn on an avera!e investment in the private sector in recent years.
/or the cost>effectiveness. lease>prchase. internal !overnment investment and asset
sale analyses. OHD discont rates are based on interest rates on Treasry Botes and
Donds "ith matrities ran!in! from A to A0 years. The rate sed may be either nominal or
real. dependin! on ho" benefits and costs are measred. 6nalyses that involve constant>
dollar costs shold se the real Treasry borro"in! rate on mar(etable secrities of
comparable matrity to the period of analysis. This rate is compted sin! the
6dministration9s economic assmptions for the bd!et. "hich are pblished in Janary of
each year. Real Treasry rates are obtained by removin! e'pected inflation over the
period of analysis from nominal Treasry interest rates.
The history of nominal interest rates sed by OHD is presented in Table 2. These
nominal rates are sed for discontin! nominal flo"s. "hich are often encontered in
lease>prchase analysis.
6nd the history of real interest rates sed by OHD is presented in Table 2. These real
rates are sed for discontin! real 1constant>dollar4 flo"s. as is often re5ired in cost>
effectiveness analysis.
(from the annual budget assumptions for the first ear of the budget fore!ast"
Table #$ %ominal Treasur Interest Rates
#orecast Date "%&ear '%&ear (%&ear 10%&ear "0%&ear
/ebrary 2772 K.2 K.= K.8 8 8.2
/ebrary 277A =.K K K.A K.8 K.:
/ebrary 277C = =.A =.= =.8 =.:
/ebrary 277= 8.A 8.K 8.8 8.7 :.2
/ebrary 277K =.C =.= =.= =.K =.8
/ebrary 2778 =.: =.7 K K.2 K.A
/ebrary 277: =.K =.8 =.: =.7 K.2
/ebrary 2777 C.8 C.: C.7 C.7 =
/ebrary 2000 =.7 K K K.2 K.A
/ebrary 2002 =.C =.C =.C =.C =.A
/ebrary 2002 C.2 C.= C.: =.2 =.:
Table &$ Real Treasur Interest Rates
#orecast Date "%&ear '%&ear (%&ear 10%&ear "0%&ear
/ebrary 2772 2.8 A.2 A.A A.K A.:
/ebrary 277A A.2 A.K A.7 C.A C.=
/ebrary 277C 2.2 2.A 2.= 2.8 2.:
/ebrary 277= C.2 C.= C.K C.: C.7
/ebrary 277K 2.K 2.8 2.: 2.: A
/ebrary 2778 A.2 A.A A.C A.= A.K
/ebrary 277: A.C A.= A.= A.K A.:
/ebrary 2777 2.K 2.8 2.8 2.8 2.7
/ebrary 2000 A.: A.7 C C C.2
/ebrary 2002 A.2 A.2 A.2 A.2 A.2
/ebrary 2002 2.2 2.: A A.2 A.7
LThese are the rates that have appeared annally in 6ppendi' I of OHD Iirclar 6>7C since 2772.The discont
rates in 6ppendi' I are dra"n from OHD9s assmptions for interest rates sed in the bd!et.
,,. Discont Rates )sed by Department of ;ner!y 1DO;4
*ince 277K. the Department of ;ner!y reports its discont rate yearly. The DO;
discont rate is based on lon!>term Treasry bond rates avera!ed over the previos 22
months. The nominal. or mar(et rate. is converted to a real rate sin! the pro#ected rate of
!eneral price inflation from the ;conomic Report of the -resident9s Ioncil of ;conomic
6dvisors. to correspond "ith the constant>dollar analysis approach that is sed in most
federal life>cycle cost 1LII4 analyses. /ederal a!encies and contractors to federal
a!encies are re5ired by 20 I/R CAK to se the DO; discont rate "hen condctin! LII
analyses related to ener!y conservation. rene"able ener!y resorces. and "ater
conservation pro#ects for federal facilities.
6ccordin! to B,*T,R :=>A28A>20. October 277=. the Department of ;ner!y ses a
real discont rate of C.2 percent or a nominal discont rate of 8.K percent for 277K 1the
pro#ected rate of !eneral price inflation "as A.C?4.
6ccordin! to B,*T,R :=>A28A>22. Jly 277K. the Department of ;ner!y ses a real
discont rate of A.C percent or a nominal discont rate of K.K percent for 277K 1the
pro#ected rate of !eneral price inflation "as A.2?4.
6ccordin! to B,*T,R :=>A28A>22. 6pril 2778. the Department of ;ner!y ses a real
discont rate of A.: percent or a nominal discont rate of K.7 percent for 2778 1the
pro#ected rate of !eneral price inflation "as 2.7?4.
6ccordin! to B,*T,R :=>A28A>2A. 6pril 277:. the Department of ;ner!y ses a real
discont rate of C.2 percent or a nominal discont rate of K.K percent for 277: 1the
pro#ected rate of !eneral price inflation "as 2.C?4.
6ccordin! to B,*T,R :=>A28A>2C. Jly 2777. the Department of ;ner!y ses a real
discont rate of A.2 percent or a nominal discont rate of =.8 percent for 2777 1the
pro#ected rate of !eneral price inflation "as 2.=?4.
6ccordin! to B,*T,R :=>A28A>2=. 6pril 2000. the Department of ;ner!y ses a real
discont rate of A.C percent or a nominal discont rate of K.A percent for 2000 1the
pro#ected rate of !eneral price inflation "as 2.:?4.
6ccordin! to B,*T,R :=>A28A>2K. 6pril 2002. the Department of ;ner!y ses a real
discont rate of A.A percent or a nominal discont rate of K.2 percent for 2002 1the
pro#ected rate of !eneral price inflation "as 2.8?4.
6ccordin! to B,*T,R :=>A28A>28. 6pril 2002. the Department of ;ner!y ses a real
discont rate of A.2 percent or a nominal discont rate of =.K percent for 2002 1the
pro#ected rate of !eneral price inflation "as 2.A?4.
The follo"in! table sms p all the discont rates sed by DO; from 277K ntil
Tab$e ") Discount Rates Used by D*+
&ear *fficia$ Document
Discount Rate
Discount Rate
-ro.ected 10%year
Average Inf$ation Rate
11//' ana$ysis2
B,*T,R :=>A28A>20 C.2? 8.K? A.C?
11//0 ana$ysis2
B,*T,R :=>A28A>22 A.C? K.K? A.2?
1//( B,*T,R :=>A28A>22 A.:? K.7? 2.7?
1//3 B,*T,R :=>A28A>2A C.2? K.K? 2.C?
1/// B,*T,R :=>A28A>2C A.2? =.8? 2.=?
2000 B,*T,R :=>A28A>2= A.C? K.A? 2.:?
2001 B,*T,R :=>A28A>2K A.A? K.2? 2.8?
2002 B,*T,R :=>A28A>28 A.2? =.K? 2.A?
,,,. Discont Rates )sed by Other /ederal 6!encies
The Ion!ressional Dd!et office 1IDO4 since 2770 has sed a real rate of 2?
1Thompson and Jreen. 277:& Da$elon and *metters. 2777. p2224. 6nalysts are directed
to perform sensitivity analysis sin! pls and mins 2 percent arond this rate 1Da$elon
and *metters. 2777. p2224.
The Jeneral 6ccontin! Office 1J6O4 !enerally ses lo"er discont rate than the
OHD recommended rates based on the avera!e nominal yield on treasry debt mins the
inflation rate. They recommends the se of a very lo" discont rate "hen analy$in!
policies "ith lar!e inter!enerational effects involvin! hman life. They se especially
lo"er rates 1close to $ero4 for pro#ects "ith stron! inter!enerational health effects
. The
lo!ic seems to be that the individal9s !ro"th in prodctivity "old offset the interest
rate. Ths if the discont rate is 2.=? and the prodctivity !ro"th rate is 2?. the J6O
"old s!!est "hat is sally called a net discont rate of 0.=?.
+ater resorce pro#ects. contractin! ot. and federal ener!y mana!ement pro!rams
are e'empt from J6O and OHD !idelines. These pro#ects fall nder different
re!lations. +ater resorce pro#ects have been #stly critici$ed in the past for sin!
nominal interest rates "ith real dollar benefits and costs 1see Lyons. p*>A24. The crrent
!idance for "ater resorce pro#ects is the approved ;conomic and ;nvironmental
-rinciples and Jidelines for +ater and Related Land Resorces ,mplementation
*tdies 1-rinciples and Jidelines. 27:A4
. ,t re5ires the a!encies to calclate present
vales of pro#ects sin! the discont rate established annally for the formlation and
economic evalation of plans for "ater and related land resorces plans. 6nd the
!idance for federal ener!y pro!rams can be fond in the /ederal Re!ister of Janary
2=. 2770. and Bovember 20. 2770 1Molme ==4
. ,n these !idances. the Department of
*ee /ootnote 2
Da$elon and *metters 127774 mention that Gthe J6O !idelines recommend the se of a very lo"
discont rate "hen analy$in! policies "ith lar!e inter!enerational effects involvin! hman lifeG. 6nd in
J6O. 2772. Gthe !idelines note that if the vale of hman life increases "ith increases in prodctivity. the
effective discont rate for evalatin! the present vale of ftre hman lives is ro!hly $eroG.
,mplementation stdies of the follo"in! a!ency activities are covered by these principles% 1a4 Iorps of
;n!ineers 1Iivil +or(s4 "ater resorces pro#ect plans& 1b4 Drea of Reclamation "ater resorces pro#ect
plans& 1c4 Tennessee Malley 6thority "ater resorces pro#ect plans& 1d4 *oil Ionservation *ervice "ater
resoces pro#ect plans.
,n the /ederal Re!ister of Janary 2=. 2770. the Department of ;ner!y proposes to amend 20 I/R part
CAK. "hich sets forth !idelines applicable to /ederal a!ency in>hose ener!y mana!ement pro!rams. ,n
the /ederal Re!ister of Bovember 20. 2770. the Department of ;ner!y !ives notice of final amendments to
20 I/R part CAK to pdate the !idelines applicable to /ederal a!ency in>hose ener!y mana!ement
;ner!y 1DO;4 states that measrin! the interest rate on ).*. Treasry bonds and
removin! the effects of inflation is the appropriate procedre for settin! a mar(et>based
discont rate to be sed in performin! life cycle cost analyses for prposes of estimatin!
and comparin! the cost effects of investin! in !reater ener!y efficiency in /ederal
bildin!s. The discont rate "ill be set by DO; for one>year intervals coincidin! "ith
the /ederal fiscal year. and the spportin! tables for se in life cycle cost analysis are to
be made available in an annal spplement to the Life Iycle Iostin! Hanal for the
/ederal ;ner!y Hana!ement -ro!ram 1B,*T :=>A28A4 issed at the be!innin! of each
fiscal year
The rates sed by the Iorp of ;n!ineers have varied from as lo" as 2.=? to as hi!h
as :.8=? over the period from 27=8 thro!h 27:0 . 1Zerbe and Dively. 277C. p288>28:.4
There also have been pecliar practices re5ired of the 6rmy Iorp and the Drea of
Reclamation by "hich real rates are to be sed "ith nominal benefits and costs. This
practice of combinin! real and nominal vales ma(es no sense and economists at the
Iorp and at the Drea of Reclamation "ith "hom "e 1Zerbe4 have tal(ed reco!ni$e
this. +e are nable to determine the ori!in of this practice.
,n short. there is a lac( of consistency for /ederal !overnment se of discont rates.
The ran!e of federal rates sed by federal a!encies is then from 2? to 8? in real terms.
tho!h the effective real rate sed by the Drea of Reclamation and the Iorp of
;n!ineers cold be even hi!her "hen mar(et rates . "hich inclde an e'pected inflation
component. are applied to e'pected real benefits and costs.
,n so far as !overnment rates are based on Treasry bond rates "hich is the case "ith
OHD lease prchase decision and "ith the rates sed by the Drea of Reclamation and
the Iorp of ;n!ineers. it is recommended that bonds be chosen "hose terms correspond
"ith the time period of the pro#ect. This means that lon!er lived pro#ects "old be
evalated "ith lar!er interest rates.
The yields on Treasry instrments 1over the period from Janary 2787 to /ebrary
20024 "old yield a lo" real rate of 2.2? in /ebrary 2002 on A>year notes and a hi!h
real rate of 8.7? in /ebrary 27:2 for A0>year pro#ects 1the crrent OHD circlar 6>7C4.
*ee the previos -art G,,. Discont Rates )sed by Department of ;ner!y 1DO;4G.
*ch rates normally increase "ith time de to inflation ris(. ,f this lo!ic is e'tended to
very lon! lived pro#ects it s!!ests 5ite lar!e discont rates.

".2 Rates Used by 4tate and 5unici6a$ Governments
6s far as "e can discern no one has systemically collected information for discont
rates sed by varios state !overnments. There appears to be no !eneral (no"led!e of
ho" the se of discont rates vary across state !overnments or "hat rates they se.
altho!h this (no"led!e can be !athered state by state.
The #stification for !overnment
rates has ran!ed from sin! the rate on !overnment bonds 1the !overnment cost of
capital4 to sin! the rate on private capital to sin! the social rate of time preference.
Little has been pblished abot mnicipal se of discont rates. Ionse5ently "e
attach an 6ppendi' that contains an npblished srvey of mnicipal rates that some of
s ndertoo( 1Zerbe and Dively. 277A4. 6 random sample of 82 cities "ith poplations
over 200.000 "ere as(ed a series of 5estions of their se and nderstandin! of the se of
capital bd!etin! and discont rates. 6bot A8? reported they se sch rates and as
many as CK? may se them indirectly thro!h consltants. That is. over half of
mnicipal !overnments "ith poplations over 200.000 do not se discont rates in their
plannin!. The ro!hly C0? of mnicipal !overnments that se rates !enerally se a real
rate in the 2.=? > A.=? ran!e.
The only variable "e fond that is correlated "ith the se
of discont rates is that cities "ith independently elected officials are more li(ely to se
1and to nderstand4 discont rates than other cities.
*ome mnicipal !overnment
consciosly avoid benefit cost analysis and the se of discont rates. ,nterestin!.
e'pressed rationale in many cases is the desire to ma(e decisions on a prely political
basis "hich they find is complicated by the se of benefit cost analysis and the attendant
se of discont rates.
*ee 6ppendi' I. OHD Iirclar Bo. 6>7C. Tesday. 6!st K. 2002
*ee for e'ample. GHanal for Discontin! Oil and Jas ,ncomeG. Te'as Iomproller of -blic 6cconts.
Dively. D"i!ht D.. Zerbe. Richard O.. EDenefit Iost 6nalysis ,n Theory and -racticeF. HarperIollins
Iolle!e -blishers. 277C.
Technically one says that havin! independently elected officials increases the lo! odds of sin! discont
rates by the amont !iven by the beta coefficient 1Jd!e et al. 4. 1*ee betas in 6ppendi' tables4.
Differences "ere also tested sin! chi>s5are tests "ith similar reslts.
7.0 hy Rates Differ Among Agencies
The basis for the choice of discont rates varies amon! a!encies and appears to have
been si!nificantly inflenced by academic literatre at the /ederal level. The isses that
have motivated these debates involve 5estions of "hether ris( shold be treated
differently for !overnment investments than for private investments. and "hether the rate
of time preference on the one hand or the opportnity cost of capital on the other is the
more appropriate for !overnment rates. ,n the case of mnicipal !overnments. ho"ever.
the drivin! force appears to simply be the rate the mnicipality mst pay on its bonds.
There has been a debate in the economics literatre for some time "hether rates
shold reflect the social rate of time preference 1*RT-4 or the opportnity cost of capital
1OIR4. The *RT- is the rate at "hich individals are "illin! to trade off present for
ftre consmption. *ome a!encies base their choice of rates on a social rate of time
preference 1e.!.. Ion!ressional Dd!et Office. and Jeneral 6ccontin! Office4. This
rate is commonly e5ated "ith the ris( free rate of retrn on !overnment bonds. tho!h
there is no definitive *RT- rate.
Other federal a!encies sch as OHD. base their rates
on the price of capital in the private sector>the before ta' rate of retrn to private capital.
Others. most commonly mnicipal !overnments. base their rate on their o"n costs of
capital "hich they see as the interest they mst pay to isse bonds so that in practice
those that base their rate on the *RT- and pra!matically on the cost of !eneratin!
!overnment capital tend to choose abot the same rates. The OIR rates tend to be
si!nificantly hi!her than the rates based on the yield on !overnment bonds so that OIR
rates are !enerally si!nificantly hi!her than rates sed by mnicipalities or rates based on
the *RT-.
6 parallel debate has concerned "hether or not !overnment discont rates shold
inclde a ris( premim as they do in the private sector. ,n !eneral. private rates of retrn
are said to e5al the ris(>free rate pls a ris( premim dependin! on the mar(et ris( of
the e5ity. The retrn to e5ities above !overnment bills is said to have avera!ed K
percenta!e points a year drin! the past centry. an astronomical difference "hen
componded over time 1Da$elon and *metters. 27774
. Da$elon and *metters conclde
,ndividals sho" 5ite different ran!es of time preference in revealed choice e'periments dependin! on
the type of decision they mst ma(e 1e.!. consmption verss savin! for retirement4 and on their level of
edcation. I,T;*4.
Da$elon is the -rincipal 6nalyst. Ion!ressional Dd!et Office. +ashin!ton. D. I.
that there is no !ood reason for the !overnment to se different rates from the private
6 paper by Lind and 6rro" 127804. ho"ever. s!!ests that !overnment shold se a
ris(>free rate. Da$elon and *metters note that this vie" has Ghad considerable inflence
inside the +ashin!ton Delt"ayG 1p22C4.
'.0 Interest Rates in the United 4tates
'.1 Rea$i8ed Rea$ Rates
Delo" "e sho" reali$ed real discont rates in the )nited *tates over lon! time
periods. These rates can be reported in either real or nominal terms. ,f reported
in real terms. the isse arises as to "hat inflation measre to se to convert
nominal to real data. Typically nominal interest rates have been ad#sted to real
rates sin! actal. that is real rates of inflation. 6ltho!h Tables C and = report
real rates sin! actal rates of inflation. as is the sal practice. this practice is
Tab$e 7) Rea$i8ed Rea$ Rates *ver 9ong -eriods
A : ; D + # G
L -6-;R
2 N;6R
A N;6R
20 N;6R
I-, =
2:=8>K0 7.A:
2:K=>:7 :.:K
2::2>272= C.28
2::=>2:7A C.K2
C.28 0
2:70>272= =.2C
2720>27 =.A: =.2K
27=A>::>:7 2.7K 2.7 2.2A 2.CK
2788>:7 2.72 A.2 A.=K A.78
27:0>:7 C.28
C.27 C.K7 =.28
/i!res in brac(ets are standard deviations.
2. Historical *tatistics of the )nited *tates. Dicentennial ;dition. Iommerce. Drea of the Ienss. +ashin!ton
DI. 27::. p!. 77K. 2002. series X>CC=.
2. Historical *tatistics of the )nited *tates. *eries XC=K>CK=. p!. 2002.
A. The ;conomic Report of the -resident. +ashin!ton. DI 27::. 2770. /ederal Reserve Dlletin. selected
C. 6nalytic record of Nields and Nield *preads from 27C=. *almon Drothers ,nc.
=. Historical *tatistics of the )nited *tates. *eries ;. p!s. 220>222. The ;conomic Report of the -resident.
selected years.
Table C sho"s reali$ed real interest rates. that is actal interest rates mins actal
inflation. for varios yields and time periods. The actal real rates for 20>year )nited
*tates Treasry Donds varies from 2.CK? to =.28?. The rates are similar tho!h sli!htly
hi!her for A0>year Treasry Donds. Rates for periods "ith little inflation and "ith little
chan!e in inflation have a particlar appeal since rates drin! these periods are li(ely to
be less inflenced by e'pectations of inflation or by chan!es in inflation. Decase of lo"
levels of inflation and<or a lo" variance in inflation rates. three periods of particlar
interest are the periods 2::2>27=2. 2::=>7A. 2:70>272=. Drin! these periods. actal real
rates on 6merican Railroad bonds varied bet"een A.8K? to C.K2?. Rates on -rime
Iommercial -aper in the latter period avera!ed =.2C?. ,n the period 2::=>7A. inflation
"as $ero thro!hot. ,n this ei!ht>year period. the avera!e yield on 6merican Railroad
bonds "as C.K2? "ith a standard deviation of 0.2A?. The ran!e of rates t"o standard
deviations to either side of this C.K2? rate is bet"een C.AK? to C.::?.
The smallest actal real rates mentioned in Table C are for the period 27=A>::>:7
and are abot 2.=? for 20>year bonds. Dt. as is no" "ell reco!ni$ed. part of this period
inclded e!re!ios mis#d!ments abot "hat the rate of inflation "old be. The hi!hest
rates in Table 2 are those for the period before 2700. These shold not be !iven as mch
"ei!ht as more recent rates. The rate of C.K2? for the period of !reatest economic
stability. 2::=>2:7A. lays "ell "ithin the ran!e of rates derived from the e'pected real
rates in Table 2 of A.=? to =.=?. 6 ran!e of rates drin! this period of !reater economic
stability based on for standard deviations arond the mean is inclded in this ran!e.
The fi!res here are spported by calclations from another sorce. Table =
sho"s lon!>term reali$ed real interest rates calclated by Darro 1277A4.
Tab$e ') Rea$ Interest Rates 1-ercent2
-eriod Real ,nterest Rate 1percent4
2:C0>2:K0 7.2
2:K8>2::0 7.2
2::0>2700 K.A
2700>272K A.2
2720>27C0 C.7
27C8>27K0 >0.2
27K0>27:0 2.2
27:0>2770 C.:
+ei!hted 6vera!e 2:C0>2770 C.:8
+ei!hted 6vera!e
2:C0>2770 "ithot 27C8>K0
Dased on Rates for for to si' months commercial paper and the JB- deflator.
/rom Darro 1277A. Table 22.2. p. 2:=4. Decase of price controls drin! the Qorean "ar. the fi!res
bet"een for the early =09s are probably not representative on a non>price controlled period.
'.2 Rea$i8ed Rea$ Rates <ersus +=6ected Rea$ Rates
The above data se reali$ed real interest rates "hich sbtract actal inflation from
the nominal discont rate. This reslts in a bias "hen the reali$ed or actal rates differ
from the e'pected rates. +e can ma(e this clearer thro!h the follo"in! relationships.
The expected real rate of retrn 1;RR4 is reco!ni$ed to be the conceptally correct
measre of the discont rate to se "ith inflation ad#sted income streams becase it
represents the rate at "hich people are "illin! to lend or to borro". This is appro'imately
e5al to the mar(et or nominal rate of retrn mins e'pected inflation. That is. the
e'pected real rate is appro'imately calclated as follo"s 1see e5ation 24
;RR 0 Bominal Rate > ;'pected ,nflation 1K4
The realized real rate of retrn 1RRR4 is different& it is the nominal rate of retrn mins
actal inflation. That is%
RRR 0 Bominal Rate >6ctal ,nflation 184
This is an appro'imation of the correct calclation "hich is %
;RR 0 O12 3 nominal rate4< 12 3 e'pected inflation4P >2
6 similar e'pression is the correct e'pression for the RRR. The e'pressions sed in the body of the te't
are. ho"ever. more intitive.
The difference in the e'pected real rate and the reali$ed real rate is then e5al to
;RR > RRR 0 16ctal ,nflation > ;'pected ,nflation4 1:4
That is. the reali$ed real rate of retrn is !iven by
RRR 0 ;RR 3 1;'pected ,nflation > Reali$ed ,nflation4 174
;5ation 174 sho"s the sorce of the bias. The reali$ed real rate "ill only be the nbiased
rate "ith e'pected inflatioin e5als reali$ed inflation. ,f reali$ed inflation e'ceeds
e'pected inflation. the reali$ed real rate "ill be lo"er than the e'pected real rate of retrn
by the difference bet"een actal and e'pected inflation. The estimate of the e'pected real
rate of retrn "ill then be too lo". ,f e'pected inflation e'ceeds actal inflation. the
reverse is tre. *ystematic bias bet"een the e'pected real rate and the reali$ed real rate
"ill be smaller in the lon! rn& other"ise people "ill learn to !ain from e'ploitin! this
bias. Ths. in calclatin! real rates of retrn. the lon!er the time period sed the better.
,n practice often short period discont rates are sed as representative of the rates
applyin! over lon!er periods. The se of short periods can reslt in biased estimates
"hen there is a si!nificant diver!ence bet"een actal and e'pected inflation. /or
e'ample. real discont rates are lo" drin! the 27=09s and 27K09s becase e'pected
inflation "as less than actal inflation. *ince actal inflation e'perienced is sally sed
to calclate real interest rates. the sbtracted amont is too lar!e in this sitation.
*imilarly. net discont rates 1nominal retes mins prodctivity !ro"th4 drin! the period
from 27=0 thro!h 278A are lo" by historical standards becase the rate of !ro"th of
capital relative to the rate of !ro"th of labor "as nsally hi!h by historical standards
not only in the )nited *tates bt also in most other developed contries. These
differential rates of !ro"th prodced a relatively hi!h rate of !ro"th of "a!es and a
relatively lo" rate of retrn to capital so that the net discont rate drin! this period
contains a do"n"ard bias "hen #d!ed by lon!>term historical standards and by the
e'perience since 27:0.
Be"ell and -i$er 12000. 2002. 20024. have compiled a series of e'pected real
interest rates over the t"o centry period 278: thro!h 2777
. /or most of the period
Their data are based on Tables A:. C=. C:. =2 and :C of Homer and *ylla 1277:4. "ith recent data for
277K>2777 from the /ederal Reserve 120004.
278:>2777 they se mar(et yields on lon!>term ).*. federal !overnment bonds. /or years
"hen federal !overnment bonds "ere navailable 12:27>2:CA4 or distorted 12:K=>27204
they se mar(et yields for mnicipal bonds. Dased on these nominal rates. they create a
series of real interest rates by sbtractin! a measre of e'pected inflation. 6nd their
inflation ad#stment is based on the srveyed e'pectations of professional economists and
several historical facts that are described in more detail in Homer and *ylla 1277:4 and
*piro 127:74. *tartin! 27==. Be"ell and -i$er ad#st the nomial mar(et interest rates for
inflation by sbstractin! a movin! avera!e of the e'pected inflation rate of the I-, over
the pervios ten years. as measred by the Livin!ston *rvey of professional economists.
Defore 27==. they assme e'pectations "ere that inflation "old be $ero so that the
nominal and the real rates are e5al. Then Be"ell and -i$er point ot that these real
interest rates reveal pesistent chan!es. incldin! a seclar decline from near K percent in
2:00 to A percent at the end of 20th centry alon! "ith five noticeable shifts to at least 2
percent lastin! ten years or more.
'i>table here
'." The Use of Rates *ver a 4hort -eriod 5ay be :iasesed +stimators of Rates
+ith the above definitions in hand "e can establish the proposition that real interest
rates drin! the 27=A>2770 period nderstate the real discont rate to be applied to ftre
/rom the previos discssion it is sfficient to establish that drin! most of the 27=0>
2772 period. actal inflation e'ceeded e'pected inflation by si!nificant amonts. That
this is the case that is "ell reco!ni$ed 1Darro. 277A& Theis. 27:2& +alsh. 27:8& Hi$an!a
and His(in. 27:C& Belson and -losser. 27:2.4 Table K sho"s the difference bet"een
e'pected inflation accordin! to the Livin!ston ,nde' and actal inflation by decade.
ne!ative nmber means that actal inflation e'ceeded e'pected inflation. and a positive
nmber indicates that e'pected inflation "as lar!er.
Table K% Difference Det"een ;'pected and 6ctal ,nflation
/rom abot 2:K= ntil 2720. ).*. !overnment bond yields "ere distorted de to ma#or chan!es in
ban(in! policies. ,n order to establish a sin!le national crrency. ban(s "ere re5ired to hold !overnment
bonds in e'chan!e for the ri!ht to circlate !overnment notes. This "as follo"ed by a period "hen
!overnment srplses lead to reprchase of otstandin! debt and a shorta!e of !overnment bonds.
6 comparison of the Livin!stone ,nde' "ith others 1see Table X4 s!!ests that it prodces a smaller
difference than others bet"een e'pected and actal inflation so that the bias may be !reater than is
indicated in Table C.
-eriod Difference bet>een e=6ected and actua$ inf$ation
27=0>=7 >2.CA?
27K0>K7 >0.:8?
2780>87 >2.==?
27:0>:7 0.7:?
2770>72 0.02?
L Ialclated from Darro 1277A4 p28K>288.
LL Ialclated by O123,e4<1,3,a4P>2 "here ,e is e'pected inflation for the year and ,a is
actal inflation.
Table K s!!ests that a real interest rate calclated sin! actal inflation drin! the
period 27=0>2787 "old nderestimate the real interest rate by abot 2.A percenta!e
points. The do"n"ard bias is probably !reater than this since the Livin!stone inde' sed
to calclate e'pected inflation prodces less of a difference bet"een e'pected and actal
interest rates than other measres. Real interest rates drin! the period 27C8>27:0 "ere
abot 2?. /or the "hole period 2:C0 thro!h 2770. omittin! the "ar years. the real
interest rates avera!ed =?.
Table K s!!ests the proposition that the reali$ed real rates of the 27:09s. 2770 and
2772 "ill be better predictors of rates in the ftre than earlier post>"ar rates. Table K
s!!ests that the real interest rate calclated sin! actal inflation in the 27:09s and
27709s has a p"ard bias bt that this p"ard bias is mch smaller than bias of the
previos three decades. ,n addition. Hi$in!a and Hish(in 127:C4. Belson and -losser
127:24. and +alsh 127:84 present evidence to s!!est there has been a shift in the
strctral real rate process be!innin! abot October 2787. This s!!ests that e'pected
real rates drin! the post>"ar period. before the 27:09s. nderstate e'pected real rates in
the near ftre. ;'pected real rates have been hi!her drin! the 27:09s than earlier in the
post>"ar period 1+alsh. 27:84. +alsh finds that a 2? chan!e in nominal rates drin! the
period 2787 R,M to 27:C R,,, "as on the avera!e prodced by a 0.:? chan!e in
e'pected real rates and by a 0.2? chan!e in e'pected inflation.
;ven aside from a chan!e in strctre. to some e'tent. chan!es in rates have a
random "al( component. That is. if the rate !oes p there is no tendency to retrn to any
avera!e or trend line vale 1*ee Belson and -losser. 27:2. for e'ample4. Ths. the se of
the 27=A>70 period to calclate actal real rates "ill lead to sbstantial errors in the
calclation of the real discont rate becase it incldes a sbstantial period "ith a
do"n"ard bias for e'pected real interest rates. and becase the most recent period. the
period since 2787. has sho"n hi!her e'pected real rates "hich shold be !iven !reater
"ei!ht !iven the evidence of a chan!e in the strctral rate process and in the e'istence
of ato correlation amon! rates. These considerations. ta(en to!ether. s!!est the real
discont rate drin! the 27:09s shold be !iven more "ei!ht than the 27=A>70 period as a
'.7. A ;orrect A66roach
+e have s!!ested that e'aminin! actal real rates in the post>"ar period. e'cept for
the 27:0>70 period. "ill yield biased estimates of real discont rates and that net discont
rates drin! this period may also be biased. *everal alternatives are possible. +e can
e'amine e'pected instead of actal discont rates. and "e can e'amine lon!er time
periods. +e do both of these belo". Table 8 sho"s e'pected real rates calclated from
several sorces.
Tab$e () +=6ected Rea$ Rates
A : ; D + # G
R;6L R6T;*
2 N;6R
; 6DJ)*T;D4
R;6L R6T;*
2 N;6R
R;6L R6T;*
A N;6R
R;6L R6T;*
20 N;6R
R;6L R6T;*
-R,H; R6T;*
2= N;6R*
R;6L R6T;*
2 N;6R
TH,;* 127:K4
6M. O/
27=A>:7 2.02
27=A>:C 2.:=
27:0>:C =.:2
278=>:7 A.22 C.28
2788>:7 A.=C A.:2 C.C0
*ept 8:>
Bov :8
27:0>:7 C.=0 C.K: =.==
2. The Livin!stone ad#sted fi!res are calclated from Darro 1277A4 p!. 28K>88.
2. Treasry yields to matrity for one year notes mins one year e'pected inflation as calclated from 5arterly
mins one year e'pected inflation data provided by Data Resorces ,nc. Treasry yields are from the /ederal
Reserve Dlletin.
A. Treasry yields to matrity for three year notes mins three year e'pected inflation as calclated from 5arterly
data provided by Data Resorces ,nc. treasry yields are from the /ederal Reserve Dlletin.
C. Ialclated by mltiplyin! the ratio of the nominal yield of t"enty year treasry bonds to that of 2 and treasry
bonds by the yields in colmns b and c. Nields are from data pblished by *almon Drothers yields are
arithmetic avera!es.
=. Data are appro'imately bi>"ee(ly. There are =2 observations.
K. Treasry yields to matrity for one year notes mins one year e'pected inflation as calclated by Thies. for
bsiness e'pectations of byin! and sellin! price inflation.
The rates sho"n in Table 8 vary from 2.07 to =.:2?. The 2.07? real rates reslt
from se of the Livin!stone poll. )nli(e all of the other polls this is based on a srvey of
economists. The other polls based on e'pectations of bsinessmen and may more
accrately reflect "hat the mar(et e'pects. These real rates are si!nificantly hi!her than
the 2? or less that is sometimes cited.
0.0. The ,et Discount Rate
0.1 A Definition
,n cort cases. the vale of life is sally determined by ta(in! the present vale of
e'pected lifetime earnin!s. or. in some states. of earnin!s mins consmption. 6n isse is
"hat discont rate to se. One "ay of avoidin! the isse of sin! reali$ed verss
e'pected real interest rates is to calclate the net discount rate. The net discont rate is
fond by sbtractin! the !ro"th in earnin!s from the nominal or mar(et interest rate.
This procedre has led to ar!ments for a total offset method. "hich is simply the se of
a $ero discont rate applied to the assmption of the contination of the e'istin! earnin!s
level. perhaps "ith a life cycle earnin!s ad#stment. The net discont rate may be defined
appro'imately as%
Bet Discont Rate 0 Har(et ,nterest Rate > Bominal +a!e Jro"th 1C4
6n e'act definition can be made by referrin! to e5ation 1A4. ,f "e define ( as O123R4<
123J4P >2. "e can more formally define ( as the net discont rate. Bote that the above
e'pression for Q "ill appro'imately e5al R>J. ,f R and J contain the same inflation
component. then ( "ill also e5al r >! "here the lo"er case letters refer to real
components. ;5ation 1A4 may no" be "ritten solely in terms of real components as%
( 1 + k )
( 1 + k )
+ . . .
W o
( 1 + k )
Ilearly the se of the net discont rate "ill !ive the same ans"er as the se of nominal or
real rates since e5ation 1=4 is the same as e5ation 1A4.
The net discont rate "ill be inflenced by capital labor ratios and by technolo!ical
pro!ress. ,f the !ro"th of capital relative to labor "ere especially hi!h drin! some
historical period the rate of !ro"th of "a!es to the interest rate "old be particlarly
lar!e. and the se of this period as a !ide to the ftre net discont rate "old be biased
do"n"ard. The se of a time period sch as from 27=A to 2770 to calclate net discont
rates raises the 5estion of "hether or not this is reasonably representative of the ftre.
0.2 The -rob$em >ith the 1/'"%/0 -eriod for ;a$cu$ation of the ,et Discount Rate
The period from abot 27=0 to abot 278A "as the G!olden a!e of !ro"thG for a
period rnnin! from abot the end of the Bapoleonic +ars. say from 2:20. to the present
for all of the developed contries. /or developin! nations incldin! the )nited *tates. as
sho"n in Table :.
Table :% -ercenta!e Jro"th in -er Iapita JD- and
in Bon>Residential Iapital *toc( for Developed IontriesL
Time -eriods 2:80>272A 272A>=0 1/'0%(" 278A>:8>:7L
JD- -er -ersonLL 2.C 2.2 ".3 2.K
Iapital *toc(LLL A.C 2.0 '.3 C.2
L/rom Haddison. Table C.7 p!22:.
LL/or 2K contries. 6 listin! of these is !iven in Haddison. Table A.2. p! C7.
LLL /or K contries incldin! the )*. /or a listin! see Haddison. Table =.C. p!. 2C0.
JD- per person drin! this period increased at si!nificantly hi!her rate than in other
periods. an avera!e rate of A.: ? per person per year for all developed contries. a rate
far !reater than occrs else"here in this period. /or e'ample. the !ro"th rate drin! the
period from 2:80 to 27=0 is abot 2.A? per year in JD- per person. ,n the ). *. this
period is not 5ite as dramatic bt nevertheless clearly stands ot as is sho"n in Table 7.
Table 7% Iompond Rates of Jro"th of -er Iapital JD-.
Bet Iapital *toc( and Labor -rodctivity in the )*.
2 Time -eriod 2:20>80 2:80>272A 272A>=0 1/'0%(" 278A>:7
2 JD-
C.= A.7 2.: ".0 2.8
A JD- per Head
2.= 2.: 2.K 2.2 2.K
C Bet Bon>Residential
Iapital *toc(
2.K7 ".37 2.=7
= 6dsted Labor ,npts
0.:= 1.0( 2.:8
K Iapital. mins Labor
0.:C 2.1( 0.82
8 -rodctivity%
Otpt per Han Hor
S 2.7 2.C 2.' 2.0
a. /rom Haddison Table A.2. p!. =0
b. /rom Haddison Table A.2 p!. C7
c. /rom Haddison. Table =.= p!. 2C2
d. /rom Haddison Table =.A. p!. 2A=
e. /rom Haddison Table A.A p! =2
Table K sho"s that the period 27=0>278A "as a period of nsal !ro"th in capital
relative to labor and that therefore "a!es shold be nsally hi!h drin! this period
relative to the retrn to capital. that is relative to interest rates.
0." . +=amining The ,et Discount Rate
+e no" e'amine the net discont rate over a lon!er period than the post "ar>period.
Table 20 belo" sho"s the net discont rate from 2:70 to 2770. Iolmn / sho"s the net
discont rate sin! "a!e compensation. Iolmn ; sho"s the net discont rate sin! total
compensation. Total compensation fi!res are not reported before 27C:& they differ from
"a!es in incldin! frin!e benefits. Denefits "ere not increasin! as a percenta!e of "a!es
before +.+.,,. and immediately follo"in! . This is s!!ested by the fact that the
percenta!e increase in "a!es is the same as for total compensation for the 27=A>=7
period. Ths the "a!e shold !ive an accrate fi!re for the net discont rate for the pre>
"ar period. ,n the post>"ar period. the yearly increase in frin!e benefits has been abot
0.K percenta!e points !reater than the increase in "a!es. This is sho"n by Table 20
,f "e se the !ro"th of "a!es before the "ar. not contin! the depression. "e
find that real earnin!s !re" at abot 2.28 ? per year. *ince these are chan!es in real
compensation. they mst be sbtracted from chan!es in real interest rates to obtain a net
discont rate. Iomparin! this "ith or e'pected real rate of abot A.= to = percent in
Table 8 !ives a rate of abot 2.A? to 2.:? as the net discont rate.
6 direct determination of real rates earnin!s and total compensation !ives a
similar reslt as sho"n in Tables 20 and 22.
Table 20% Bet Discont Rates
A : ; D + #
-rime -ercentage -rime ;om. -ercentage -rime ;om.
;ommercia$ ;hange in -a6er minus ;hange in Tota$ -a6er minus
-a6er 5ftg. ages ? change in ;om6ensation ? ;hange in
1;-I ad.usted2 1Average2 5fg. ages 1;-I ad.usted2 ;om6ensation
&+AR4 1;-I
;o$umn : % ; ;o$umn : % +
13/0%// K.70? 2.22? =.K7?
1/00%0/ C.:2? 2.K7? A.22?
1/10%17 A.2=? 2.22? 2.0A?
1/1/%2/ C.2C? A.72? 0.22?
1/"0%"/ A.:K? A.C2? 0.C=?
1/70%7' >A.==? A.:A? >8.A7?
1/70%7/ >=.=C? 0.=7? >K.2A?
1/'0%'2 >2.=8? 2.A0? >A.::?
1/'"%'/ 2.C8? 2.:=? >2.A:? 2.:K? >2.A7?
1/00%0/ 2.2K? 2.C:? 0.88? 2.C=? >0.20?
1/(0%(/ 0.07? 0.K2? >0.=2? 0.02? 0.08?
1/30%3/ C.02? >0.K7? C.82? 0.A2? A.82?
1//0%/1 2.2=? >2.AC? A.=0? >0.2C? 2.27?
*newzerbe *earning
*eries X *eries D :02 6las(a La" Rev.
CCC>C== Hf!. 6vera!e Dec. 27:= T
H*)* part 2 Horly ;arnin!s economic rept.
p. 2002 of pres. 972
*orce% Doard of
Jovs. of the /R*.
also. ;conomic
Rept. of -res.
/eb. 972
p!. A8:
Iolmn D in Table 20 sho"s the net discont rate. Iolmn I sho"s the fi!res
sin! the rate of retrn on commercial paper and manfactrin! "a!es. Iolmn ;
sho"s the net discont rate sin! total compensation. The shaded areas sho" the
applicable net discont rate for the indicated periods. The se of Iommercial paper rates
!ive a do"n"ard bias to the rates since these are very short term rates and are sed only
becase they are available for lon! time periods. Table 22 sho"s the net discont rate for
selected periods. /or the period before +.+.,, . the rate of !ro"th in earnin!s is sed in
calclatin! the net discont rate. and for the period after the "ar. the !ro"th in total
compensation is sed. The "ar periods shold be disre!arded becase controls on "a!e
and interest rates do not allo" the calclation of accrate fi!res. 6 depression as severe
as that drin! the 27A09s is nli(ely to occr a!ain so the depression years shold also be
eliminated. The ar!ment for treatin! the period 27=0>as special has already been made
here. /inally. the period 27CK>C7 sho"s ne!ative real interest rates and represents the
effect of a contination of "ar time controls so that this period also shold not be
inclded. The fi!re of 2.C8 ? appears to represent the better fi!re. The period
prodcin! this rate eliminates the "ar periods. the depression years. the period from
27=0>2780 becase of its special natre. and the period 27CK>C7 "hen controls led to a
ne!ative real discont rate. This rate is especially spportable becase of the do"n"ard
bias from sin! commercial paper rates. 6 net discont rate of $ero or less than 2.0
percent appears to be "ithot #stification.

Table 22% 6vera!e Bet Discont Rates for *elected -eriods
Table :% 6vera!e Bet Discont Rates for *elected -eriods
6v. Bet Discont Rate "<o +ar -eriods 2.CC ?
The calclations here do not ta(e into accont life>cycle effects and some economists incorporate these
into the net discont rate. On the other hand. the calclations here do not ta(e into accont any increase in
interest rates to accont for financial ris(.
6v. Bet Discont Rate "<o +ar -eriods T 27=0>80 2.82?
6v. Bet Discont Rate "<o +ar -eriods T Depression 2.72 ?
6v. Bet Discont Rate "<o +ar. Depression and -eriod 27CK>27K7 2.C8 ?
(.0 ;onc$usions
/ederal Jovernment a!encies are inconsistent. amon! themselves and sometimes
internally and sometimes over time. in their se of discont rates.
,n some cases /ederal a!encies se nominal discont rates "ith real benefits and
costs in defiance of lo!ic and theory.
/ederal Jovernment a!encies have no recommendations as to the se of discont
rates "hen considerin! the far ftre.
Little information is available on the se of discont rates by state !overnments.
6 bit less than half of mnicipal !overnments "ith poplations over 200.000
appear to se discont rates.
Hnicipalities sometimes avoid the se of benefit>cost analysis "ith its
associated discont rates for polictical reasons.
Their se is positively correlated "hen the presence of independly elected
finanacial e'aminers.
-ro#ects analysis shold se real discont rates "ith real benefits and costs.
Real rates shold be calclated sin! e'pected inflation rather than actal
inflation. tho!h the se of actal inflation is the sal practice.
Over the 27=A>27:7 period. e'pected real rates vary bet"een abot 2? and =?.
Over the period from 2:=8>27:7. e'pected real rates vary bet"eeen abot 2?
and 7.C?.
Ths. there is considerable volatiliaty in e'pected real rates over lon! periods.
The se of post "ar reali$ed or actal real rates. particlarly in the 27=0>278=
period reslt in rates that are biased do"n"ard.
Bet discont rates over the 2:70>2772 period vary be"een K.7? and >2.AC?.
6vera!e net discont rates over this period eliminatin! periods of "ar and
depression are abot 2.=?.
Bet discont rates drin! the 27=0>278A period are lo"er than drin! other historical
periods probably since 2:20.
Bet discont rates drin! the period 27=0>8A are biased do"n"ard "hen applied to
ftre net discont rates.
6 fi!re of abot =? is a reasonable estimate of the real discont rate.
Bot only is this abot the lon! term historical avera!e. bt it is abot the rate that has
prevailed in the most recent period. Lon!>term real prodctivity !ro"th has been abot
2.=>2.0 percent per year "hich s!!ests a net discont rate of abot A.0 to A.= percent.
Darro. Robert J. Macroeconomics 1Ard T Cth ;dition4. John +iley T *ons. Be" Nor(.
2772 and 277A.
Da$elon. Ioleman and Qent *metters. EDiscontin! ,nside the +ashin!ton D.I.
Delt"ay.F Journal of Economic Perspectives. 2A. Bo.C 127774. 22A>22:.
Doardman. Jreenber!. Minin!. and +eimer. Cost Benefit nal!sis in Practice" 2002.
Department of ;ner!y. Office of Ionservation and Rene"able ;ner!y. 20 I/R -art CAK.
G/ederal ;ner!y Hana!ement and -lannin! -ro!rams& Life Iycle Iost
Hethodolo!y and -rocedresG. /ederal Re!ister ==. Janary 2=. 2770.
Department of ;ner!y. Office of Ionservation and Rene"able ;ner!y. 20 I/R -art CAK.
G/ederal ;ner!y Hana!ement and -lannin! -ro!rams& Life Iycle Iost
Hethodolo!y and -rocedresG. /ederal Re!ister ==. Bovember 20. 2770.
/ller. *ie!linde Q. and -etersen. *tephen R. GLife>Iycle Iostin! Hanal. for the
/ederal ;ner!y Hana!ement -ro!ramG. /ebrary 277K.
/ller. *ie!linde Q. G;ner!y -rice ,ndices and Discont /actors for Life>Iycle Iost
6nalysis > 6pril 2778G. B,*T,R :=>A28A>22. 6nnal *pplement to B,*T
Handboo( 2A= and BD* *pecial -blication 807. 6pril 2778.
/ller. *ie!linde Q. G;ner!y -rice ,ndices and Discont /actors for Life>Iycle Iost
6nalysis > 6pril 277:G. B,*T,R :=>A28A>2A. 6nnal *pplement to B,*T
Handboo( 2A= and BD* *pecial -blication 807. 6pril 277:.
/ller. *ie!linde Q. G;ner!y -rice ,ndices and Discont /actors for Life>Iycle Iost
6nalysis > 6pril 2777G. B,*T,R :=>A28A>2CR. 6nnal *pplement to B,*T
Handboo( 2A= and BD* *pecial -blication 807. 6pril 2777.
/ller. *ie!linde Q. and Doyles 6my *. G;ner!y -rice ,ndices and Discont /actors for
Life>Iycle Iost 6nalysis > 6pril 2000G. B,*T,R :=>A28A>2=. 6nnal *pplement to
B,*T Handboo( 2A= and BD* *pecial -blication 807. 6pril 2000.
/ller. *ie!linde Q. and Doyles 6my *. G;ner!y -rice ,ndices and Discont /actors for
Life>Iycle Iost 6nalysis > 6pril 2002G. B,*T,R :=>A28A>2K. 6nnal *pplement to
B,*T Handboo( 2A= and BD* *pecial -blication 807. 6pril 2002.
/ller. *ie!linde Q. and Rshin! 6my *. G;ner!y -rice ,ndices and Discont /actors for
Life>Iycle Iost 6nalysis > 6pril 2002G. B,*T,R :=>A28A>28. 6nnal *pplement to
B,*T Handboo( 2A= and BD* *pecial -blication 807. 6pril 2002.
Homer. *idney and Richard *ylla. #istor! of $nterest %ates" &rd edition. 277:. Be"
Drns"ic(% Rt!ers )niversity -ress
Hi$in!a. John and /rederic *. Hish(in. G,nflation and Real ,nterest Rates or 6ssets "ith
Different Ris( IharacteristicsG. '(e Journal of )inance. Mol. A7. Bo. A. Jly 27:C.
pp. K77>822. Reprinted as BD;R. Reprint Bo. K22.
Qlein. Linda. GDiscontin! Jide. Report Bo. 02>22>02G. Iost 6nalyst Division.
Lyons. Randolph. E/ederal Discont Rate -olicy. The *hado" -rice of Iapital and
Ihallen!es for Reforms.F Journal of Environmental Economics and Management.
2:. *27>*=0. 2770.
Harcs. +illiam D. GBote on the )se of Discont Rates in the /ederal JovernmentG.
2788. John /. Qennedy *chool of Jovernment. Harvard )niversity. B2=>88>2CA.0.
Belson. Iharles and Iharles -losser. GTrends and Random +al(s in Hacroeconomic
Times *eries% *ome ;vidence and ,mplications.G Journal of Mone! Credit and
Ban*ing. Mol. 20. Bo. 2. *eptember. 27:2.
Be"ell. Richard and -i$er +illiam. GDiscontin! the Distant /tre "ith )ncertain
RatesG. Jly 2K. 2000. +or(in! -aper.
Be"ell. Richard and -i$er +illiam. GDiscontin! the Denefits of /tre Ilimate Ihan!e
Hiti!ation% Ho" Hch Do )ncertain Rates ,ncrease MalationsUG -repared for the
-e" Ienter on Jlobal Ilimate Ihan!e. December 2002.
Be"ell. Richard and -i$er +illiam. GDiscontin! the Denefits of Ilimate Ihan!e
-olicies )sin! )ncertain RatesG. +inter 2002. %esources. 2CK% 2=>20.
-etersen. *tephen R. G;ner!y -rice ,ndices and Discont /actors for Life>Iycle Iost
6nalysis 277KG. B,*T,R :=>A28A>20. 6nnal *pplement to B,*T Handboo( 2A=
and BD* *pecial -blication 807. October 277=.
-etersen. *tephen R. G;ner!y -rice ,ndices and Discont /actors for Life>Iycle Iost
6nalysis 2778G. B,*T,R :=>A28A>22. 6nnal *pplement to B,*T Handboo( 2A=
and BD* *pecial -blication 807. Jly 277K.
*piro. -eter *. 27:7. Real ,nterest Rates and ,nvestment and Dorro"in! *trate!y. Be"
Nor(% Rorm Doo(s.
Thies. Ilifford. GDsiness -rice ;'pectationsG. Journal of Mone!" Credit and Ban*ing.
Mol. 2:. Bo. A. 6!st 27:K. pp. AAK>A=C.
).*. Office of Hana!ement and Dd!et. Iirclar Bo. 6>7C 1Revised4. Harch 28. 2782.
).*. Office of Hana!ement and Dd!et. Iirclar Bo. 6>7C 1Revised4. October 27. 2772.
).*. Office of Hana!ement and Dd!et. Iirclar Bo. 6>20C. Jne 2C. 2782.
).*. +ater Resorces Ioncil. G;conomic and ;nvironmental -rinciples and Jidelines
for +ater and Related Land Resorces ,mplementation *tdiesG. Harch 20. 27:A.
+alsh. Iarl ;. GThree Restions Ioncernin! Bormal and Real ,nterest Rates.G Economic
%eview. *an /rancisco /ederal Reserve. /all. 27:8. pp. =>27.
Zerbe. Richard O. and D"i!ht Dively. Benefit Cost nal!sis in '(eor! and Practice"
Harper Iollins. Be" Nor(. 277A 1in press4.
The )se of Discont Rates for Iapital Dd!etin! by 6merican Iities


D>ight Dive$y
Richard *. @erbe Ar.
6lmost nothin! is (no"n abot mnicipal se of techni5es for evalation of
capital pro#ects and the associated discont rate for pro#ect evalation.
,n response to
this lac( of specific (no"led!e "e srveyed mnicipal se of discont rates for capital
pro#ect analysis thro!h telephone and "ritten srveys for 82 6merican cities in the fall
of 2770 and the *prin! of 2772.
The reslts s!!est that sbstantial efficiency !ains are available from the
introdction of capital bd!etin! techni5es into mnicipal decision ma(in!. and that one
"ay in "hich efficiency can be reali$ed is by providin! for independently elected
financial officials. The presence of these officials is associated "ith the !reater se of
discont rates by cities. and 5ite probably "ith !reater efficiency in capital bd!etin!
decisions. The srvey sho"ed that most cities do not se discont rates. bt instead a
variety of ad hoc and political techni5es to choose capital pro#ects. The most common
techni5e for choosin! a discont rate "as the city9s cost of capital.
T"o types of discont rate srveys "ere sed. /irst. telephone intervie"s "ere
held "ith officials from the bd!et offices of 28 randomly selected cities "ith
poplations !reater than 20=.000 scattered thro!hot the contry. *econd. "ritten
srveys "ere sent to the bd!et directors of :2 randomly selected cities. of "hich =2
L+e "old li(e to than( Qitty Belson "ho at ZerbeVs s!!estion be!an the ori!inal telephone srvey as
part of her de!ree pro#ect. and Traci Jones. Harie(a Qla"itter. Robert -lotnic(. and Dill Zmeta for most
sefl comments. +e "old li(e to especially than( *ally Hc/arlane for statistical "or(.
6n informal srvey that "e condcted amon! academic collea!es at several )niversities and "ith
le!islative analysts at the Iity of *eattle leads s to sspect that most analysts believe cities ma(e se of
discont rates in evalatin! ma#or pro#ects. *ee also /orrester 1277A4
"ere retrned. representin! a KA percent response rate.
+e sed both telephone and
"ritten srveys to determine if there "ere differences in replies by type of srvey
instrment. +e cold determine no differences. *i' cities "ere dplicated bet"een the
t"o !rops in order to assess the validity of combinin! the srveys. Ths. a total of 82
different cities responded to the srvey.
The sample of cities provide a diverse sample of ma#or ).*. mnicipalities. Only
cities "ith poplations in e'cess of 200.000 "ere inclded since smaller cities are less
li(ely to have the types of pro#ects that re5ire discont rate analysis. The respondin!
cities represented A8 states and ran!ed in poplation from ;!ene. Ore!on at 222.KK7 to
Los 6n!eles. Ialifornia at A.C:=.A7:. The list of cities is sho"n in Table 2.
Doth the telephone and "ritten srveys as(ed the same 5estions abot the
discont rate. The telephone srveys contained a sbstantial introdctory discssion to
elicit the level of nderstandin! abot benefit>cost techni5es for capital bd!etin!
techni5es. +e fond in discssions that lac( of (no"led!e abot the fnction of
discont rates seems a very !ood pro'y for lac( of (no"led!e abot evalative capital
bd!etin! techni5es in !eneral. The specific discont rate 5estions "ere%
2. Does the city se discont rates for evalatin! pro#ectsU
2. ,f so. "hat is the crrent discont rateU
A. Ho" is the discont rate establishedU
C. 6re different discont rates sed for different types of pro#ectsU
=. Ho" often is the discont rate re>evalatedU
,n addition. the srveys !athered information abot the types of tilities operated
by the respondin! cities. This information "as collected since tilities often have capital
pro#ects that are the sb#ect of detailed financial analysis.
There are appro'imately 200 cities in the )nited *tates "ith !reater than 20=.000 poplation
6t the conclsion of the srvey processes. the reslts for the si' cities that "ere in
both the telephone and "ritten samples "ere compared. ,n !eneral. the responses to the
t"o types of srveys "ere sfficiently similar to allo" the samples to be combined.
Use of Discount Rates
The srveys revealed that the se of discont rates amon! ma#or cities is less
prevalent than had been assmed. Less than half of the cities sampled 1A8.= percent4 se
discont rates for pro#ect evalation. and several of these indicated that the se is
infre5ent. /rthermore. the srveys s!!ested that many mnicipal finance officials are
completely na"are of the concept of discont rates or of benefit cost analysis. Officials
in abot 2= cities indicated that they had never heard of the term. and several others
confsed it "ith the lendin! rates set by the /ederal Reserve Doard. The same lac( of
(no"led!e sho"ed p in telephone intervie"s "e condcted in "hich "e attempted
assidosly to ma(e sre "e "ere spea(in! "ith the hi!hest level and best 5alified city
6s part of the telephone srvey. cities that do not se discont rates "ere as(ed to
e'plain ho" they evalate pro#ects. Host of the responses indicated that pro#ects "ere
identified based on perceived needs or political priorities. "ithot any form of
comparative 5antitative analysis. ,n a fe" cases. cities indicated that they relied on
recommendations from e'perts. "ho mi!ht se cost>benefit analysis in ma(in! those
recommendations. Ths. the actal se of discont rates may be !reater than A8.=
percent. "ith an pper bond of CA?. if this implicit se by consltants is inclded.
6bot half of the cities sin! discont rates indicated that different rates may be
sed in some cases. This typically involves rates sed for pro#ects paid for by special
enterprise fnds. incldin! airports or "ater systems. The approach for settin! discont
rates is sally the same re!ardless of the fndin! sorce. bt the actal rate may vary.
,n t"o cases. there "ere minor differences in response. apparently de to havin! different individals
respond to the srveys. /ollo">p calls "ere made to clarify these differin! responses.
/or e'ample. cities that se the crrent cost of capital for settin! the discont rate may
have different costs of capital for different prposes.
4e$ection of Discount Rates
Iities se a "ide ran!e of approaches for selectin! discont rates. "ith a fe"
cities relyin! on a combination of approaches. Bine distinct types of approaches "ere
identified. These are listed belo" in the order of fre5ency%
2. The cityBs current cost of ca6ita$ is sed by nine cities to select a discont
rate. This is typically a mi' of short>term and lon!>term ta'>e'empt
borro"in! rates. These cities are !enerally amon! the lar!er cities in the
2. The cityBs current return on invested funds is sed by ei!ht cities. This is
sally defined as the crrent short>term rate earned by the city9s invested
cash. Host of the cities sin! this approach are in the lo"er poplation ran!e
amon! the sample.
A. +stimates by consu$tants are sed by for cities. These sally involve
consltin! "ith a financial advisor or accontin! firm to identify an
appropriate rate. These for cities all have poplations in the 200.000 to
C00.000 ran!e.
C. :ond yie$ds for other cities are sed by three of the respondin!
mnicipalities. This sally means the se of crrent lon!>term borro"in!
costs for ne" debt isses.
=. The cityBs cost of e=isting debt is sed by t"o cities 1-ittsbr!h.
-ennsylvania and *an /rancisco. Ialifornia4. Ho"ever. both of these cities
also se other approaches as part of settin! the discont rate.
K. A combination of an inf$ation estimate and a rea$ discount rate is sed by
t"o cities 1*an /rancisco. Ialifornia and *eattle. +ashin!ton4. altho!h *an
/rancisco also ses other approaches. The real discont rate is set in the 2.00
to A.00 percent ran!e.
8. The cityBs $ong%term bond rate is sed by one city 1-hiladelphia.
-ennsylvania4. This is similar to the city9s cost of capital. bt incldes only
lon!>term debt.
:. The ta=6ayerBs cost of ca6ita$ is sed by one city 1Hinneapolis. Hinnesota4.
This rate is a combination of consmer borro"in! rates. sch as mort!a!es
and personal loans. and lendin! rates for savin!s instrments. This approach
acconts for Hinneapolis havin! the hi!hest discont rate in the srvey.
since consmer debt typically carries an interest rate hi!her than that of
mnicipal debt.
7. The $oca$ inf$ation rate is sed by one city 1Lincoln. Bebras(a4.
The avera!e discont rate sed by the A: percent of cities that sed a discont rate
"as a nominal rate of 8.:7 percent. "ith a ran!e bet"een =.00 and 20.00 percent. The
real rate appears to have been abot A percent !iven that e'pected inflation "as abot =?
at the time.
6 real discont rate of A? is consistent "ith the ran!e of 2.=? to =?
recommended by Lyons 127704. by Zerbe127724 and by Lesser and Zerbe 1277C4.
real 1inflation ad#sted4 cost of capital can be reasonably represented by the after ta' rate
on lon! term 120 year bonds4 !overnment bonds and by the rate of retrn of safe financial
instrments sch as lon! term railroad bonds or the rate of retrn on commercial paper.
The rates on these instrments over the period from 2700 to 2770 sho" a ran!e of real
rates of bet"een abot 2.= to = ? 1Zerbe. 27724. +e thin( this is a reasonable ran!e to
se as the discont rate for !overnment pro#ects. Only three cities have rates otside of
. Data Resorces reports three year e'pected real rates of abot =.= as the avera!e for the 27:0>27:7
period. Havriles(sy 127::4 reports an avera!e e'pected rate for the ne't 2= years of abot C.2 percent for
the late 27:09s
*everal athors recently have s!!ested that in practical terms the leadin! approach to the discont rate
derivation. the *hado" -rice of Iapital 1*-I4 approach can reasonably appro'imated by one that in "hich
pro#ects are evalated sin! the cost of capital 1Lind. 2770. Lyons. 2770& Zerbe. 277A. Lesser and Zerbe.
277C4. .
or recommended ran!e. and one 1Daltimore4 is ri!ht at the ed!e of the lo"er ran!e.. and
one is a bit less than 0.= percenta!e points belo" or lo"er ran!e. The third city. Lincoln
Bebras(a. has a real rate of $ero. "hich seems clearly inappropriate.
Lincoln is also the only city that ses discont rates that clearly has an
inappropriate method 1ses the inflation rate4. The ei!ht cities 1cate!ory 24 that se the
crrent retrn on invested fnds se short term rates for lon! term pro#ects. and their
rates tend to fall into the bottom of the ran!e. Bevertheless. these rates tend to be "ithin
the recommended ran!e.
Revision of the Discount Rate
There is no nanimity amon! the cities re!ardin! the fre5ency "ith "hich the
discont rate shold be revised. /ive different approaches "ere mentioned%
2. Revisions as needed "ere listed by 22 cities. This typically means that the rate is
re>evalated as part of the revie" of each ma#or pro#ect. /or a fe" #risdictions.
the rate is revised "henever there appear to be ma#or chan!es in the local
2. Annua$ revisions are made by nine cities.
A. ;ontinuous revisions are made by for cities. This term means that the discont
rate is chec(ed re!larly by a bd!et official responsible for overseein! capital
pro#ects. The cities sin! this approach are typically amon! the lar!er ones in the
C. 5onth$y revisions are made by one city 1Loisville. Qentc(y4.
=. Revisions after each bond issue are made by one city 1Daton Ro!e. Loisiana4.
,n practice. revisions as needed. continos revisions. revisions after each bond
isse. and monthly revisions probably amont to the same thin!. Nearly revisions
presmably !ive less variability in rates sed. bt probably do not yield a difference in
avera!e rates.
Determinants of Discount Rate Use
+e considered the follo"in! variables in connection "ith the se of discont
-o6u$ation. Lar!er cities typically have lar!er and more sophisticated
bd!et and finance staffs. Hence. sch cities mi!ht be e'pected to ma(e more
e'tensive se of discont rates. The avera!e poplation of cities sin! discont
rates "as =AK.=22. "hile the avera!e for cities not sin! discont rates "as
A:A.K20. The overall srvey avera!e "as CC0.7C0. +ithin any poplation si$e
ran!e. there "ere some cities sin! discont rates and some not sin! them. 6 t
test of the differences bet"een means of the poplations of cities !roped
accordin! to "hether or not they sed a discont rate is only si!nificant at the
2C? level. belo" the sal level of scientific si!nificance. +e can not then re#ect
the hypothesis of no relationship tho!h a lar!er sample si$e mi!ht allo"
re#ection of this hypothesis.
Gro>th in 6o6u$ation. Discont rates are commonly sed to help choose
amon! options for capital pro#ects. Ths. it mi!ht be e'pected that !ro"in! cities
"old ma(e more se of discont rates since they need to set priorities amon! the
many capital facilities needed to respond to !ro"th. Ho"ever. the srvey
s!!ested an opposite conclsion. Det"een 27:0 and 2770. the cities sin!
discont rates had an avera!e poplation !ro"th of only 2.=0 percent. "hile those
not sin! discont rates !re" by an avera!e of 20.0C percent. The difference 1t
test4 is si!nificant at the 2? level of si!nificance. /aster !ro"in! cities do appear
less li(ely to se a discont rate contrary to "hat "e e'pected.
;ity Age ,n order to frther e'plore this conclsion. the cities in the
sample "ith poplations of more than 200.000 in 2700 "ere identified. These are
!enerally older. more established cities. T"enty>t"o of the 82 respondin! cities
5alified nder this standard. Of these 22. 22 se discont rates. This =2 percent
sa!e rate is !reater than the A: percent rate 12= ot of C74 for the sample as a
"hole. and far !reater than the rate for ne"er cities of only A2?. The difference
in sin! discont rates bet"een older and ne"er cities is close to si!nificance 1at
22? level4. Jiven the small sample si$e "e are relctant to re#ect the hypothesis
of no relationship bet"een city a!e and se of a discont rate. 6 lar!er sample
may sho" si!nificance and if so there are several possible e'planations for this
W The older cities have !reater needs to repair and rehabilitate infrastrctre. These
lon!er term pro#ects may encora!e the se of discont rates in pro#ect
evalation. Ho"ever. if this is the case. "e "old also e'pect a positive
correlation bet"een mnicipal o"ned tilities and the se of a discont rate and
"e do not find this.
W The older cities have more comple' pblic decision ma(in! processes. and
possibility some"hat different strctres of !overnment that may !enerate more
controversy. "hich creates a demand for 5antitative analysis.
W The older cities have lar!er and perhaps better trained finance staffs. "hich
increases the probability of sin! 5antitative tools.
+e leave these as hypotheses to be e'plored in sbse5ent "or(.
-resence of uti$ities. *ome mnicipal !overnments have responsibility for
"ater. electric. or natral !as tilities. *ince these fnctions often re5ire
e'tensive capital facilities. it mi!ht be e'pected that cities "ith these tilities
"old ma(e !reater se of discont rates. 1The cities "ith tilities "ere lar!er
than the rest of the sample. "ith an avera!e poplation of ==8.:=04. Ho"ever.
there is no statistically si!nificant difference bet"een cities that had and did not
have tilities in their li(elihood of sin! a discont rates 1t si!nificant only at the
::? level4. 6bot =2 percent of the cities that sed discont rates had tilities.
"hile =0 percent of those that did not se discont rates had tilities.
:ond rating. The se of 5antitative financial methods is often discssed
as one of the important factors in settin! a #risdiction9s bond ratin!. ,n order to
test this hypothesis. bond ratin!s for the cities in the sample "ere collected and
analy$ed. The 6!st 2772 ratin!s by Hoody9s ,nvestors *ervice "ere sed for
this prpose. Ratin!s "ere not available for all of the cities since some cities have
not issed debt recently. There is not si!nificant difference in sin! a discont
rate bet"een the half of cities "ith the hi!her bond ratin! and the half "ith the
lo"er 1si! nificant at K:? level4. Ho"ever. the sample si$e for this variable is
only C2 and the difference in discont rate sa!e is. ho"ever. close to si!nificance
bet"een the cities "ith a bond ratin! of 6 or better and those "ith a D or "orse
ratin! 1si!nificant at 22?4. The cities "ith lo"er bond ratin!s may be more li(ely
to se a discont rate. 1There is a "ea( correlation bet"een 1r0 0.2:84 "ith lo"er
bond ratin!s.4 There is a possibility that cities "ith a lo"er bond ratin! are sin!
more formal capital bd!etin! techni5es to improve their ratin! or that there
capital constraints are !reater and they are attemptin! to se them more
Hi!her bond ratin!s are tho!ht to lo"er interest rates paid on debt. "hich
shold also lo"er the cost of capital and therefore also probably lo"er discont
rates 1Zerbe .277A4. Ho"ever. the srvey revealed that this effect is very modest
at least for or sample. and not statistically si!nificant. since the cities "ith 6a
ratin!s or hi!her sed an avera!e discont rate of 8.:2 percent. compared 8.72
percent for cities "ith lo"er bond ratin!s.
-resence of inde6endent$y e$ected officia$s. *ome cities have
independently elected finance officials. sch as an aditor. comptroller. treasrer.
or revene commissioner. ,t mi!ht be e'pected that the presence of sch officials
"old increase the se of discont rates since there "old be a hi!her standard of
revie" of proposals. This hi!her standard often "old reslt becase of
discssions bet"een different finance staffs% one reportin! to the mayor or city
mana!er. and one reportin! to the independently elected official. The srvey
reslts spport this hypothesis. ;i!ht of the cities srveyed have independently
elected finance officials. and si' of the ei!ht 18=.0 percent4 se discont rates.
This se of discont rates is doble the rate for the sample as a "hole. The
difference in discont rate sa!e bet"een cities "ith and "ithot independently
elected officials is si!nificant at the 2.K? level.
Ths. there appears to be a
statistically si!nificant difference in the se of discont rates dependin! on the
presence of independently elected officials.
-erhaps also the independently
elected official crates a sin!le accontable post "hich is responsible for decision
ma(in!. ths increasin! the incentive to ma(e the best decision.
Geogra6hica$ $ocation. Iities in some sections of the contry mi!ht ma(e more
e'tensive se of discont rates becase of prevailin! practices or the presence of
edcational instittions emphasi$in! sch techni5es. The srvey revealed some sch
!eo!raphical differences. Discont rates seem to be sed more often by cities in the +est
Ioast. Jreat La(es. and Hiddle 6tlantic states. Discont rates seem to be the least sed
by cities in the Be" ;n!land and *othern states. The srveys revealed no obvios
reason for these differences.
6s a more sophisticated statistical approach a lo!it e5ation "as rn in "hich the
dependent variable "as a binary variable. the se or non>se of the discont rate. ,n a
lo!it e5ation the coefficients represent the effect of the variable on the lo! of the odds>
here the odds of sin! a discont rate. ,n each e5ation there "ere t"o independent
variables& independently elected financial officials "as rn separately "ith poplation.
This is the si!nificance level assmin! the t"o !rops have the same variance. assmin! ne5al
variances the level of si!nificance is better than =? 1at 0.0A4.
The cities "ith independently elected officials tend to be lar!er than those "ithot and this may also play
a role. .
poplation !ro"th and city a!e. ,n all of these t"o variable rns. independently elected
financial officials is si!nificant at better than the =? level. The cities !ro"th rate is close
to si!nificance at the 22? level. and the other variables are not si!nificant.
The Tables
in the 6ppendi' report the statistics for three of the rns "ith t"o variables.
The ma#or reslt of the data analysis to compare differences in means is that cities
"ith independently elected officials are more li(ely to se 1and to nderstand4 discont
rates than other cities.
6 test of the differences in means s!!ests that cites "ith hi!her
poplation !ro"th rates are less li(ely to se discont rates. Older cities may be more
li(ely to se discont rates. bt cities "ith lar!er poplations may be more li(ely to se
them. The presence of tilities and bond ratin! appear not to be correlated "ith the se of
discont rates. The srvey also revealed that discont rates appear to be sed more
fre5ently in cities in the +est Ioast. Jreat La(es and Hiddle 6tlantic states. They are
least sed by the Be" ;n!land and *othern states.
The srvey revealed no obvios
reason for these differences.
Host mnicipal !overnments may not se discont rates and appear not to
nderstand present vale analysis. 6 nmber of these "ere rather forthri!ht abot
political concerns dominatin! investment decisions and !ave as a reason for not sin!
discont rates that their se "old ma(e politically based decisions more difficlt. This
+hen all variables are entered only C2 observations are available. and the small nmber of observations
ma(e it less li(ely that si!nificant relationships "ill be e'hibited by the data. /or the lo!it e5ation "ith all
variables entered none of the variables reaches si!nificance at the 20? level. altho!h the presence of
independently elected officials "as close to si!nificance 1at the 2A? level4. and "as follo"ed in
si!nificance by the percenta!e poplation !ro"th rate 1at the .2: level 4. 6 rn "ithot bond ratin! allo"s
the se of the fll sample of 82 and in this rn independently elected officials is si!nificant bt no other
Technically one says that havin! independently elected officials increases the lo! odds of sin! discont
rates by the amont !iven by the beta coefficient 1Jd!e et al. 4. 1*ee betas in 6ppendi' tables4.
Differences "ere also tested sin! chi s5are tests "ith similar reslts.
6 variable that mi!ht be of interest is the level of schoolin! of city officials.
e'planation is consistent "ith the ma#or findin! that the presence of independently
elected finance officials si!nificantly increases the se of discont rates and the
nderstandin! of present vale analysis. *ch officials may redce the discretion of
others in an administration. ,t seems possible that the e'istence of sch officials is cost>
effective from a financial perspective.
6 potentially important findin! is that cities "ith independently elected finance
revie" officials are more li(ely to se a discont rate. s!!estin! the possibility that the
presence of these revie" officials prodces a hi!her standard of analysis. +hat this stdy
stron!ly s!!ests most stron!ly is that there is sbstantial opportnity for improvin! the
efficiency of capital bd!etin! by mnicipal !overnments. ,t also s!!ests that one "ay
to do this is to have an independently elected financial official.
Of the appro'imately C0? of mnicipal !overnments that se discont rates
almost all se some variant of the cost of capital to determine the rate. The ran!e of rates
they e'hibit. at least at the point in time "e e'amined. is almost entirely "ithin the ran!e
"e have determined to represent the ran!e for the real after ta' retrn to !overnment
bonds "hich in trn appears consistent "ith social rate of time preference rate s!!ested
by economic theory 1Zerbe and Lesser. 277C4 Ths. mnicipal se of discont rates is
more consistent amon! mnicipalities and more consistent "ith theory than are rates sed
by different divisions "ithin the /ederal !overnment. The /ederal Office of Hana!ement
and the Dd!et 1OHD4 1in circlar 6>7C4 at the time this srvey "as "ritten
recommended and often re5ired a real 1inflation ad#sted4 rate of 20?. far hi!her than
theory "old s!!est.
Ion!ressional a!encies se other rates 1Lyons. 27704.
6 complete e'planation of "hy certain cities se discont rates "old re5ire
frther research. *ch research mi!ht focs on the role of state la"s in inflencin! city
bd!et practices. the form of city !overnment. a more comprehensive revie" of the types
. *ince this srvey OHD has redced its recommended real rate to 8?.
of capital pro#ects nderta(en by cities. and on the edcational bac(!ronds of bd!et
officers in different parts of the contry.
There is no nanimity amon! cities re!ardin! the fre5ency "ith "hich the
discont rate shold be revised or ree'amined. +e fond no statistically si!nificant
relationship bet"een poplation si$e and the probability of sin! a discont rate.
altho!h there is some s!!estion that there is a "ea(. positive correlation. Older cities
appear are more li(ely to se a discont rate. +e do not (no" "hy older cities may be
more li(ely to se a discont rate. Iities that are !ro"in! faster are less li(ely to se
discont rate. and this appears to be de mainly to the fact that older cities are more
slo"in! !ro"in! and are more li(ely to se a discont rate than ne"er cities. Beither the
importance of city tilities nor the cities bond ratin! are correlated "ith the se of a
discont rate.
Tab$e 1. Resu$ts of Discount Rate 4urvey
of ,omina$ Rea$ 5ethod
;ity Rate Rate Rate for 4etting Revision

6lb5er5e. BH Bo S S S S
6naheim. I6 Nes 7.00 C.00 Irrent retrn on fnds
6nchora!e. 6Q Bo S S S S
6rlin!ton. TX Bo S S S
6tlanta. J6 Nes 8.=0 2.= Irrent cost of capital
Daltimore. HD Nes 8.C: 2.C: Irrent cost of capital 6s
Daton Ro!e. L6 Nes 8.02 2.02 ;stimate by consltant ;ach
bond isse
Dirmin!ham. 6L Bo S S S S
Doise. ,D Bo S S S
Doston. H6 Bo S S S
Drid!eport. IT Bo S S S S
Dffalo. BN Nes :.00 A.0 ;stimate by consltant
Iharlotte. BI Bo S S S S
Iincinnati. OH Nes :.00 A.0S Irrent cost of capital
Iolmbs. OH Bo S S S S
Iorps Ihristi. TX Bo S S S S
Dallas. TX Bo S S S S
Dayton. OH Nes 8.8= 2.8=S Irrent retrn on fnds 6s
Denver. IO Nes varies variesS Irrent cost of capital& 6s
crrent retrn on fnds
Des Hoines. ,6 Bo S S S S
Detroit. H, Bo S S S S
;!ene. OR Nes :.=0 A.= Irrent retrn on fnds 6s
/ort +ayne. ,B Bo S S S S
/resno. I6 Bo S S S S
Hartford. IT Bo S S S S
Honoll. H, Bo S S S S
Hoston. TX Bo S S S S
,ndianapolis. ,B Nes 8.=0 2.= Dond yields for other cities
Jac(son. H* Bo S S S S
Jersey Iity. BJ Bo S S S S
Qansas Iity. HO Bo S S S S
Qno'ville. TB Bo S S S S
Lincoln. B; Nes =.00 0 ,nflation rate 6nnally
Little Roc(. 6R Bo S S S
Los 6n!eles. I6 Nes varies S Irrent cost of capital
Loisville. QN Nes :.00 A.0 Dond yields for other cities
Hadison. +, Bo S S S S
Hemphis. TB Bo S S S S
Hiami. /L Nes 8.00 2.00 ;stimate by consltant
Tab$e 1. Resu$ts of Discount Rate 4urvey 1continued2
of ,omina$ Rea$ 5ethod
;ity Rate Rate Rate for 4etting Revision

Hil"a(ee. +, Nes 8.00 2.00 Irrent cost of capital
Hinneapolis. HB Nes 20.00 =.00 Ta'payer cost of capital 6s
Hobile. 6L Bo S S S S
BashvilleSDavidson. TB Bo S S S S
Be" Orleans. L6 Bo S S S S
Oa(land. I6 Bo S S S S
Omaha. B; Bo S S S S
Orlando. /L Bo S S S S
-aterson. BJ Bo S S S S
-eoria. ,L Bo S S S S
-hiladelphia. -6 Nes varies S Lon!>term bond rate 6s
-hoeni'. 6Z Bo S S S S
-ittsbr!h. -6 Nes :.=0 A.=0 Irrent cost of capital&
cost of e'istin! debt
-ortland. OR Nes 8.=0 2.=0 Irrent retrn on fnds 6s
Ralei!h. BI Bo S S S S
Richmond. M6 Bo S S S S
Rochester. BN Nes varies A.8= ;stimate by consltant 6s
*acramento. I6 Nes :.8= A.8=S Irrent retrn on fnds 6s
*aint -al. HB Bo S S S S
*aint -etersbr!. /L Bo S S S S
*alt La(e Iity. )T Bo S S S S
*an Die!o. I6 Bo S S S S
*an /rancisco. I6 Nes 8.=0 2.=0S Irrent cost of capital&
cost of e'istin! debt&
inflation pls real rate
*an Jose. I6 Bo S S S
*anta 6na. I6 Bo S S S S
*eattle. +6 Nes 8.=0 2.=0S ,nflation pls real rate 6s
*po(ane. +6 Nes :.=0 A.=0S Irrent retrn on fnds 6s
*toc(ton. I6 Bo S S S S
*yracse. BN Bo S S S S
Tcson. 6Z Nes 20.00 =.00S Irrent cost of capital.
modified by ris( of pro#ect
Tlsa. OQ Nes varies S Irrent retrn on fnds 6s
+instonS*alem. BI Bo S S S S
Non(ers. BN Nes 8.=0 2.=0S Dond yields for other cities
6vera!e :.0K A.0K
Tab$e 2. ;haracteristics of Res6onding ;ities
;ity Use of Rate 1//0 -o6u$ation Uti$ities
6lb5er5e. BH Bo A:C.8AK Nes
6naheim. I6 Nes 2KK.C0K Bo
6nchora!e. 6Q Bo 22K.AA: Nes
6rlin!ton. TX Bo 2K2.822 Nes
6tlanta. J6 Nes A7C.028 Nes
Daltimore. HD Nes 8AK.02C Nes
Daton Ro!e. L6 Nes 227.=A2 Bo
Dirmin!ham. 6L Bo 2K=.7K: Bo
Doise. ,D Bo 22=.8A: Bo
Doston. H6 Bo =8C.2:A Bo
Drid!eport. IT Bo 2C2.K:K Bo
Dffalo. BN Nes A2:.22A Bo
Iharlotte. BI Bo A7=.7AC Nes
Iincinnati. OH Nes AKC.0C0 B6
Iolmbs. OH Bo KA2.720 Nes
Iorps Ihristi. TX Bo 2=8.C=A Nes
Dallas. TX Bo 2.00K.:88 Nes
Dayton. OH Nes 2:2.0CC Bo
Denver. IO Nes CK8.K20 Bo
Des Hoines. ,6 Bo 27A.2:8 Bo
Detroit. H, Bo 2.028.78C Nes
;!ene. OR Nes 222.KK7 Bo
/ort +ayne. ,B Bo 28A.082 Nes
/resno. I6 Bo A=C.202 Nes
Hartford. IT Bo 2A7.8A7 Bo
Honoll. H, Bo AK=.282 Nes
Hoston. TX Bo 2.KA0.==A Bo
,ndianapolis. ,B Nes 8C2.7=2 Bo
Jac(son. H* Bo 27K.KA8 Nes
Jersey Iity. BJ Bo 22:.=A8 Bo
Qansas Iity. HO Bo CA=.2CK Bo
Qno'ville. TB Bo 2K=.222 Bo
Lincoln. B; Nes 272.782 Nes
Little Roc(. 6R Bo 28=.87= Bo
Los 6n!eles. I6 Nes A.C:=.A7: Nes
Loisville. QN Nes 2K7.0KA Bo
Hadison. +, Bo 272.2K2 Nes
Tab$e 2. ;haracteristics of Res6onding ;ities 1continued2
;ity Use of Rate 1//0 -o6u$ation Uti$ities
Hemphis. TB Bo K20.AA8 Bo
Hiami. /L Nes A=:.=C: Bo
Hil"a(ee. +, Nes K2:.0:: Nes
Hinneapolis. HB Nes AK:.A:A Nes
Hobile. 6L Bo 27K.28: B6
Bashville>Davidson. TB Bo =20.8:C Bo
Be" Orleans. L6 Bo C7K.7A: Bo
Oa(land. I6 Bo A82.2C2 Bo
Omaha. B; Bo AA=.87= Bo
Orlando. /L Bo 2KC.K7A Bo
-aterson. BJ Bo 2C0.:72 Bo
-eoria. ,L Bo 22A.=0C Bo
-hiladelphia. -6 Nes 2.=:=.=88 Nes
-hoeni'. 6Z Bo 7:A.C0A Nes
-ittsbr!h. -6 Nes AK7.:87 B6
-ortland. OR Nes CA8.A27 Nes
Ralei!h. BI Bo 208.7=2 Nes
Richmond. M6 Bo 20A.0=K Bo
Rochester. BN Nes 2A2.KAK Bo
*acramento. I6 Nes AK7.AK= Bo
*aint -al. HB Bo 282.2A= Nes
*aint -etersbr!. /L Bo 2A:.K27 Nes
*alt La(e Iity. )T Bo 2=7.7AK Nes
*an Die!o. I6 Bo 2.220.=C7 Nes
*an /rancisco. I6 Nes 82A.7=7 Nes
*an Jose. I6 Bo 8:2.2C: B6
*anta 6na. I6 Bo 27A.8C2 Nes
*eattle. +6 Nes =2K.2=7 Nes
*po(ane. +6 Nes 288.27K Nes
*toc(ton. I6 Bo 220.7CA Nes
*yracse. BN Bo 2KA.:K0 B6
Tcson. 6Z Nes C0=.A70 Nes
Tlsa. OQ Nes AK8.A02 Nes
+inston>*alem. BI Bo 2CA.C:= Bo
Non(ers. BN Nes 2::.0:2 Bo
2. /orrester. John -. EHnicipal Iapital Dd!etin!% 6n ;'aminationF. Jornal of -bic
Dd!etin! and /inance. 2A. 124 *mmer 277A
2. Havriles(y. Thomas. GBe" ;vidence on ;'pected Lon! Term Real ,nterest RatesG.
Journal of )orensic Economics" *mmer. 27::
A. Jd!e. Jeor!e J. R. Iarter Hill. +illiam ;. Jriffiths. Helmt Lt(epohl and Tson!>
Ihao Lee. n $ntroduction to t(e '(eor! and P+ractice of Econometrics" ,econd
Editon" Be" Nor(% John +iley T *ons. 27::
C. Lind. R. I.. GReassessin! the Jovernment9s Discont Rate -olicy in Li!ht of Be"
Theory and Data in a +orld ;conomy +ith ,nte!rated Iapital Har(ets.G Journal of
Environmental Economics and Management 2:%*>: > *>2: 127704.
=. Lyons. Randolph. G/ederal Discont Rate -olicy. The *hado" -rice of Iapital and
Ihallen!es for ReformsG. 2: Journal of Environmental Economics and Management
*27>*=0 127704.
K. Zerbe. Richard O. Jr. GRecommendations for Jovernment Discont Rate -olicyG. Bo.
72>2. +or(in! -apers in -blic -olicy 6nalysis and Hana!ement. Jradate *chool of
-blic 6ffairs. 127724
8. Zerbe. Richard O. Jr. and D"i!ht Dively. Benefit Cost nal!sis in '(eor! and
Practice" Harper Iollins 1277C4.
:. Zerbe. Richard O. Jr. and Jonathan Lesser. GDiscontin! -rocedres for
;nvironmental and Other -ro#ects% 6 Iomment on Qolb and *chera!eG. JPM. +inter.
6--;BD,X% LOJ,T T6DL;*
The follo"in! three tables sho" the coefficients for the t"o variable lo!it rns. The
sample si$es are C=. CC. and C= for the three cases.

Mariable Deta 1coefficient4 *tandard ;rror *i!nificance
;lected Officials
2.K: 0.7280 K.8?
Iity 6!e >0.02A .0077 2:.8?
Ionstant 2C.22 2:.72 20.2?
Mariable Deta 1coefficient4 *tandard ;rror *i!nificance
,ndependently ;lected
2.87 0.72 C.7?
-ercent Jro"th Rate >A.72 2.CA 20.:?
Ionstant >0.=8 0.A7 2=.0
Mariable Deta 1coefficient4 *tandard ;rror *i!nificance
,ndependently ;lected
2.:C 0.72 C.C?
-oplation 2770 .000C .0008 =8?
Ionstant >0.=8 0.A7 A.7
Bominal or real interest rates and are sed to discont economic loss to present
vale in tort cases. Bominal discont rates are mar(et rates in crrent dollars. that is.
nad#sted for inflation. Real rates are nominal rates ad#sted for inflation. *imilar
definitions apply to nominal and real "a!e !ro"th. The relationships are appro'imately
as follo"s%
Har(et Rate 1Bominal Rate4 0 Real Rate 3 ,nflation 124
Real Rate 0 Bominal Rate > ,nflation. 124
6s lon! as the mar(et discont rate is sed "ith nominal "a!es and the real discont rate
is sed "ith real "a!es. the se of the nominal and real rates "ill !ive the same ans"er as
lon! as the inflation component is the same. This may be seen by "ritin! ot the
e'pression for the net present vale of a "a!e stream%
o o o
g -
g -
g -
4 2 1
4 2 1
4 2 1
4 2 1
4 2 1
4 2 1
! is the nominal or mar(et !ro"th "a!es in "a!es.
is the "a!e one period before the initial period. and
r is the nominal or mar(et discont rate.
The nominal !ro"th rate. J. "ill e5al O12 3 ,412 3 !4P>2 "here

, is the ,nflation rate and
! is the real 1inflation ad#sted4 !ro"th rate.
*imilarly. the nominal discont rate. r. "ill e5al O12 3 ,4 123 r4P>2
"here r is the real 1inflation ad#sted4 discont rate.
The e'pression containin! the inflation components "ill then divide ot as lon! as
the inflation components are the same in the denominator and nmerator so that e5ation
1C4 may be "ritten as%
The e'act definitions are. BR 0 O12 3r4123,4P>2. and r 0 O12 3 R4<12 3 ,P >2."here BR is the nominal rate.
R is the nominal rate. r is the real rate of interest .and , is inflation.
Bote that this e5als , 3 ! 3 ,! or appro'imately #st , 3 !.
N PV =
( 1 + g )
( 1 + r )
( 1 + g )
( 1 + r )
+ . . . . .
1 + g
( 1 + r )
That is. e5ations 1A4 and 1C4 sho"s that the B-M can e5ivalently be e'pressed in real or
nominal terms.