ing this rate. We do, however, caution against the reliance on the observed rates of return in a limited subsector of the private economy as a normative guide to Federal Government interest rate policy. We agree with the Bureau of the Budget's reluctance to "adopt *** the rate of return on private investment foregone alone because government funds are drawn from both consumption and investment." 35 However, having advocated a conceptual basis for the public discount rate, the subcommittee notes that a number of subsidiary issues essential for sound discount rate policy remain unresolved. These concern matters such as the following:

1. The role of risk and uncertainty in public investment decisions and interest rate policy;

2. The appropriate interest rate for application to public investments which displace specific private investments; and

3. The treatment of inflationary influences on observed interest

rates.

The subcommittee does not presume to define a single correct approach to these issues. A number of suggestions presented to the subcommittee, however, do appear worthy of emphasis.

Nearly all of the witnesses appearing before the subcommittee noted that the estimation of the opportunity cost of displaced private spending by reference to realized private returns builds into the interest rate measurement an average allowance for risk and uncertainty present in the private sector.36 Use of this rate to evaluate public investments implies that they bear risk and uncertainty characteristics similar to those in the private sector. While this might be an acceptable practice, the subcommittee finds worthy of continued study the suggestion that a basic minimum-risk interest rate be used by the Federal Government and that explicit allowances be made for risk and uncertainty in the benefit and cost estimates of each public investment.37 The subcommittee notes that, in the judgment of nearly all of the witnesses, the "current yield on long-term Government securities" is the lowest reasonable estimate of this basic minimum-risk rate. We note further that it is on this basis that the Bureau of the Budget and other witnesses support the new interest rate formula proposed by the Water Resources Council. "A long-term riskless rate reflecting a private opportunity cost should not be less than the current yield on Treasury bonds with long terms to maturity."

38

In the testimony presented to the subcommittee, a number of witnesses addressed the question of the risk and uncertainty present in real investments. They agreed that, while the benefits and costs of all real investments are to some extent risky and uncertain, some undertakings are significantly more venturesome and hazardous than others. If, then, a basic, minimum-risk interest rate is applied to the investment, the estimated streams of benefits and costs should be adjusted to allow for risk and uncertainty. Further, the degree of adjustment should be related to the degree of hazardousness present in the investment. Hence, the benefits of an investment in a hydroelectric project would typically require less adjustment for risk and uncertainty than, say, an investment in an experimental, nuclear power generating facility.

Alternatively, the subcommittee visualizes that an allowance for risk and uncertainty could be incorporated into interest rates used for discounting public investments. The greater the degree of risk and uncertainty present in the project, the greater would be the adjustment made to the basic minimum-risk interest rate. Thus, starting from a given base rate, the interest rate used in discounting the benefits of low risk projects would require a minimum upward adjustment while the rate used to evaluate the output of a highly uncertain undertaking would be substantially above the base rate. The subcommittee realizes, however, that these adjustments for risk and uncertainty do not lend themselves to precise slide-rule evaluation.

In further analyzing the various types of investments undertaken by the public sector, witnesses distinguished between those investments that have no counterpart in the private sector and those investments which, when undertaken by the Federal Government, displace similar private investments." An example of the former would be the construction of a new weapons system; the public production of many research and development outputs exemplifies the latter. The suggestion was made that the analysis of those projects which displace no specific private sector alternative should be thought of as imposing a general opportunity cost over the economy as a whole equal to the value of private spending displaced. Projects which displace specific private investments should be evaluated by the rate of return prevailing in the sector from which the specific investment is displaced. The subcommittee finds this distinction to be a meaningful one and urges further study to refine this "two-part pricing" scheme.

42

The question of the influence of inflationary expectations on observed interest rates and the desirability of including this influence in the interest rate used to evaluate public projects is, in the subcommittee's view, one of the least settled technical issues pertaining to interest rate policy. This matter cannot be divorced from the question of which prices analysts of public investments employ in estimating future benefits and costs. While the current practice of using prices observed at the time the analysis is undertaken has substantial administrative merit, the subcommittee is aware of the position held by some that analysis should undertake the projection of future prices. This matter must be resolved prior to the development of sound and consistent evaluation policies. Again, further study seems in order.

40 Ibid.

41 Ibid., pp. 27-29, 177-178.

42 Ibid., pp. 28, 33-34, and 40-41.

VI

THE CURRENT MINIMUM-RISK INTEREST RATE WHICH SHOULD BE USED FOR EVALUATING PUBLIC INVESTMENTS IS AT LEAST 5 PERCENT

As outlined above, estimates of the interest rate for discounting public investments vary with the concept chosen as the appropriate basis for measurement. However, because the evaluation of public investments should accurately reflect the value of private sector alternatives foregone, the appropriate range of estimates is narrowed substantially. The consensus among the experts appearing before the subcommittee could be summarized as follows:

1. If explicit allowance for risk and uncertainty is made in the estimates of benefits and costs, a minimum-risk base interest rate can be used for discounting. In this case, the average current yield on Government securities with long terms remaining to maturity is an appropriate minimum estimate of the opportunity cost of dis placed private spending. This rate is currently about 5 percent. The new procedure proposed by the Water Resources Council is consistent with this basic minimum-risk concept and represents a major improvement over past interest rate policy.

2. If specific allowance for risk and uncertainty is not made in the benefit and cost estimates, an average allowance can be incorporated in the base interest rate. In this case, the opportunity cost of displaced private spending, as observed in private capital markets, should be accepted as the base interest rate. As stated above, this rate is estimated as a weighted average of the observed rates of return over the private consumption and investment sectors. Depending on the system of weights adopted, this rate is currently in the 8-10 percent range.

VII

ALL FEDERAL AGENCIES SHOULD ESTABLISH CONSISTENT AND APPROPRIATE DISCOUNTING PROCEDURES UTILIZING AN APPROPRIATE BASE INTEREST RATE COMPUTED AND PUBLISHED ON A CONTINUING BASIS

The subcommittee believes that substantial gains have been made in the application of economic criteria to proposed Federal expenditures. It wishes to commend the Bureau of the Budget and the agencies for the progress made in this area. We wish to emphasize the importance of this kind of analysis in guiding the decisions of the executive agencies and the Congress. While recognizing that decisions cannot be made on the basis of economic considerations alone, we believe that the explicit statement of the economic impacts of expenditures is extremely useful. At the least, this kind of analysis will enable decisionmakers to recognize the economic costs incurred to undertake investments which satisfy other noneconomic, yet worthy, objectives.

Notwithstanding the progress which has been made, the subcommittee is greatly concerned about some notable problem areas in the implementation of economic analysis and appropriate discounting procedures. Among these are:

1. The failure of some agency personnel to stress the importance of effective discounting analysis in their agencies;

2. The sizable range of inconsistency in the evaluation procedures applied by agencies, especially in the discounting process; 3. The inappropriately low-interest rate applied by a number of agencies in evaluating investment alternatives;

4. The existence of significant legal and institutional constraints which inhibit the effective implementation of analysis in the agencies;

5. The current lack of the knowledge and data necessary for sound analysis of the economic benefits and costs of certain public investments, especially in the human resource areas. The concerns of the Public Works and Appropriations Committees of the House and Senate, and the Senate Committee on Interior and Insular Affairs regarding the need for improved benefit-and-cost evaluation procedures is noted by the subcommittee;

6. The potential for the misallocation of funds inherent in most grant-in-aid type support programs which funnel investment funds from the Federal Government where a commitment to the economic analysis of alternatives exists to State and local governments where no such consistent system or commitment exists;

7. The current inability and unwillingness of the Congress to make consistent use of the objective evidence on the benefit-andcost impacts of its spending decisions and to search consciously for superior means of accomplishing its objectives.

Based upon the testimony presented to it, and reflecting the abovestated concerns, the Subcommittee on Economy in Government offers the following recommendations:

1. The Bureau of the Budget should undertake to require all agencies to develop and implement consistent and appropriate discounting procedures on all Federal investments entailing future costs or benefits. The subcommittee, however, recognizes that procedures among investment areas may legitimately vary depending on the measurability of benefits and other factors. 43

2. The Bureau of the Budget should, in conjunction with other appropriate Government agencies, immediately undertake a study to estimate the weighted-average opportunity cost of private spending which is displaced when the Federal Government finances its expenditures. This study should

(a) Be guided by an advisory panel of experts to consult with the study personnel on the development of an appropriate methodology and submit an evaluation of the report's conclusions. The panel should be composed of recognized experts in the field of public expenditure analysis without ties to any particular agency or expenditure program;

(b) Make appropriate assumptions about the sources of the funds which finance public investments; calculate the observed before-tax rates of return prevailing in these sectors, and estimate the opportunity cost prevailing over the economy as a whole, giving appropriate weight to both the private consumption and investment which is foregone; and

(c) Culminate in a report proposing the methodology and preferred arrangements for the continuing computation and publication of an interest rate representing the opportunity cost of displaced private spending.

44

3. Some appropriate Federal Government agency, perhaps the Office of Business Economics, should estimate and publish on a continuing basis the weighted-average opportunity cost interest rate defined in point 2 above for guidance to all Federal agencies in undertaking the analysis of public investments. This published rate should be adopted by the Bureau of the Budget and specified by the Bureau as a guideline for agencies on budget and program submissions.45

4. The Water Resources Council should adopt its proposed interest rate procedure as stated in the announcement of July 22, 1968. The subcommittee believes that this proposal is a significant improvement over the current practice and that it is not inconsistent with though the lowest reasonable estimate of-the cur rent minimum-risk opportunity cost of displaced private spending. Given that this interest rate is a minimum-risk rate under current capital market conditions, it should be noted that explicit allow. ances for elements of risk and uncertainty should be made when passim., "Economic Analysis of Public Investment

43 "Interest Rate Guidelines Decisions *

pp. 22, 28-29, 34-35, and 137.

44 "Economic Analysis of Public Investment Decisions * * pp. 41, 45, 56, 57-65, 143144, and 179-181.

45 Ibid., pp. 45, 78, and 179-186.