Michael Reddell: Really?

A few weeks ago an invitation dropped into my email inbox to attend a joint Treasury/Motu seminar on recent, rather major, changes that had apparently been made to the discount rates used by The Treasury to evaluate proposals from government agencies.

It was all news to me, but when I went over to The Treasury’s website I found that the new policy had come into effect on 1 October last year (relevant Treasury circular here) and that the work on this major policy change had apparently going on for a long time, dating back to the days of the previous government (the two consultant reports are both dated June 2023). All the papers Treasury has released are here (I have also now lodged an OIA request for other relevant papers, including advice etc to current or former Ministers of Finance).

The new discount rates are shown here

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This is a dramatically different model than what had been used until now, when all projects were required, as a starting point, to be evaluated using a 5 per cent real discount rate.

I have read all the papers The Treasury released and went along to the seminar on Monday, and came away even more troubled – about both the public policy and analytical dimensions – than I had been initially. Why, you might ask, should commercial projects be evaluated at dramatically different rates than non-commercial projects? Who is going to decide what counts as “commercial” and what as “non-commercial” (and should so much hang on what must, at the margin at least, be something of a line call)? And why would a change of this magnitude, which will materially affect advice going to ministers across the whole of government have been done with no public consultation whatever (and Treasury confirmed to me that this had indeed been the case, and that such consultation as there had been had only been with other government entities)?

But, first, those acronyms: SOC (social opportunity cost) and SRTP (social rate of time preference). Under certain restrictive conditions these two things should be the same, but estimates of them are rarely even close. There is a vast literature on this stuff, going back many decades.

Here is how The Treasury describes the two approaches

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There is quite a bit of (questionable) editorial in these descriptions, but the gist is fine: SOC is designed to capture the cost to “society” of funding some public sector proposal (funds could be used for other purposes and projects by firms or individuals), while SRTP attempts to capture how much current consumption “society” (however represented) is willing to give up in exchange for more future consumption.

For decades, Treasury has used a SOC-based approach here, and in my view were right to do so. Of the other countries shown in the various reports, it seems that a majority also use the SOC approach while a small group of European countries used a SRTP approach.

Treasury and their consultants all seem to agree that on straightforward commercial projects, the SOC approach is the only sensible one to take. To do anything else – to use a materially lower discount rate – would be to skew the playing field in favour of the government investing in commercial projects that the private sector could do just as well. In that sense, moving to an 8 per cent real discount rate for unquestionably commercial projects is a step in the right direction (although I suspect that even at 8 per cent, the discount rate is likely to be lower than the hurdle rates of return required by many/most private sector companies in deciding on investment proposals).

A common argument that claims this is okay is based on the fact that government bond yields are typically lower than those for corporate bonds. I’ve long thought (and written about here) that that is a deeply flawed argument, because a key reason government bond yields are lower than those of private sector securities (no matter how large the corporate) is that government’s ability to pay is secured on the coercive power to tax, and that risk (to us, as taxpayers) needs to be priced in evaluating proposals to spend public money. All the more so when one realises that the likelihood of draconian tax increases to meet government obligations is probably pretty strongly correlated with adverse economic circumstances in the wider economy (and thus for the ability of taxpayers to comfortably pay). I’ve also long been uneasy about the idea that public sector proposals should be evaluated at rates that are probably below private sector hurdle rates because of the utter absence of market disciplines government agencies and politicians as decisionmakers face. When people who face no market disciplines want to take our money – tax now, or via debt – and use it on long-term projects, it seems not unreasonable that their schemes should be evaluated on at least as demanding a basis (but ideally more demanding) as private commercial entities do. After all, it is a pretty widely-accepted stylised fact that cost over-runs and execution failures are more the norm than the exception in major public projects in New Zealand (not only New Zealand of course). Remarkably, in none of the Treasury papers nor in the seminar on Monday was there any mention of incentives and disciplines: government failure was all but unknown in a land of benevolent and wise social planners.

But commercial projects (ones that are clearly so) are the easy bit of all this. The latest change was at least a step in the right direction. And the Treasury circular is clear that

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The real problem arises in respect of the “non-commercial proposals”. You will look in vain in the Treasury Circular for any official justification for using such wildly different discount rates for the two types of proposals, with the far lower discount rates for those proposals that – almost by assumption – are subject to fewer market-type tests and greater uncertainty (including about specifying benefits and objectives). It will be interesting to see how The Treasury framed advice on this issue to the Minister of Finance. One hopes they mentioned that even so-called non-commercial projects have an opportunity cost – a real burden on taxpayers whose money could be used for other things.

Now, in fairness, the background papers briefly mentioned some arguments (including suggestions that future generations are not represented in today’s market prices, but may be represented by a benevolent government decisionmaker – although it is never clear why (eg) families are less likely to internalise interests of future generations than governments, the latter being individuals facing re-election every three years, and no effort is made to evaluate the actual demonstrated interest in or ability of past or present governments to effectively represent those interests). However, the main paper Treasury cites, that by academic economist Arthur Grimes, has just three recommendations at the end, and not one of them is for anything like this stark (although he notes that “long-term payoffs to projects for which the populace is likely to have a lower rate of pure time discount compared to that for generalised consumption could have a lower [social discount rate] than the default rate….This proposal…is one which warrants further investigation). Grimes was a little sharper in his slides on Monday, but even then his proposal was only for lower discount rates for “some non-market activities” (and quite whose preferences were to guide the choice of “some” wasn’t clear).

What that 2 per cent discount rate for non-commercial proposal does is to ignore the actual opportunity cost of funds (that 8 per cent, or more) and preference – in ranking possible proposals for using scarce societal resources – non-commercial proposals (that generally won’t cover the social cost of capital) over commercial ones. And that is quite regardless of the character of the individual non-commercial proposal, a category that even in concept covers a vast array of possibilities. It is really quite extraordinary, and perhaps all the more so to see it adopted by this government, which came into office focused (at least rhetorically) on low quality government spending, the rapid run-up in debt under the previous government. (I had been unsure until Monday whether these policies had simply been adopted by Treasury, but I was assured by Treasury officials that they had in fact been signed off by the current Minister of Finance).

Now, to be clear, there are some caveats. First, discount rates aren’t everything. All too often cost-benefit analyses have simply been ignored, even when done. And if one looked at the table of discount rates used in other countries that was presented on Monday, the only country using a lower discount rate than the New Zealand 2 per cent is Germany – a country that many of the great and good think does far too little government capital spending (their debt brake – a very sensible initiative in my view – acts as a constraint presumably). In a New Zealand context, simply changing discount rates won’t of itself get more projects off the ground.

But both operating and capital allowances are fluid over time – they are no sort of anchor – and there is no real debt constraint at all. What the change to discount rates will do is make many more non-commercial projects look to pass a cost-benefit assessment, creating pressure from interested parties on governments to raise taxes or take on more debt “because, you can see, so many good projects just aren’t being funded”. And going by the mood of the room on Monday – most attendees seemed to be public service affiliated – many officials will think that just a fine thing indeed (there were people getting up and thanking Treasury for making this change, which would make such a difference to their preferred types of schemes). What was the Minister of Finance thinking when she signed this off?

Especially as the entire thing seems like an indeterminate muddle.

First, there is this table from the Treasury circular, designed to assist agency CEs and CFOs in doing their cost-benefit analyses.

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So things that politicians or officials happen to think are good for people (“merit goods”) – whether we value them or not – get evaluated at a much more favourable (lower) discount rate than other stuff. But even setting points like that aside, one is left with more questions than answers. Take schools for instance. Most are provided directly by the state with no charge at point of use, but not all are, and there is no technical reason why a quite different operating model couldn’t be chosen. Same goes for health and hospitals. Are they “commercial” or “non-commercial”? How will Dunedin hospital – a long-lived capital project – be evaluated (if at all)? Does a different discount rate get used if a PPP is involved (see final item in the “commercial” column), than if the government provides the finance directly? And if so, why? And “social housing” is in the right hand column, even though housebuilding and rental operations are directly amenable to commercial models (perhaps with income subsidies to poor users). One could go on.

I asked about some of these specifics at the seminar on Monday, and got no better than handwaving answers, along the lines of “well, we don’t really know, but time and experience will tell”. It was pretty breathtaking really, but then I came home and reread the official circular and that was more or less exactly what they’d told agencies too. It was there in the text above that table, and also in this “The Treasury may publish further guidance as we gain experience with the new PSDRs.”. May…..how helpful.

Now again, to be fair, the circular notes that agencies will be required to stress test proposals by presenting evaluations done at both high and low discount rates. And there will be plenty of public sector proposals where it may not make much difference (where the costs and benefits are both substantially spread through time), but for anything with a major long-lasting capital commitment (think infrastructure) the difference will be enormous. And there is just no guidance, either to agencies, or to enable the public to have a sense of how proposals are likely to be evaluated by officials.

But in case you were thinking that surely not too much would be done at 2 per cent, there was this final guidance to agencies

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That is pretty much everything central government actually does.

The whole thing is rendered even more unsatisfactory by this note at the end of the Treasury Circular


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If the social cost of capital estimate is 8 per cent real – per this new guidance – it is hard to see any decent basis for keeping the capital charge rate, which incentivises agencies to use scarce capital prudently, at 5 per cent. And whatever the capital charge rate is set at – 5 or 8 per cent, or something higher still – our Minister of Finance and Treasury are happy to evaluate almost all central government department proposals at a discount rate of 2 per cent, far below our cost of capital to enable and fund such activities. I’m happy to agree that there are probably a handful of things that might appropriately be evaluated at below the cost of capital, but….they are few indeed (and probably contentious across different groups in society). And the approach Treasury and the Minister have taken just increases the risk of more uneconomic proposals being adopted over time, with more of a bias towards proposals where there are fewer solid external benchmarks. That seems less than ideal, especially in a government that touts its commitment to “turbocharging” economic growth and productivity.

(I’m also not really persuaded by the case for generally declining discount rates on all non-commercial projects, especially beginning at such a short horizon (30 years, which seems to be shorter than those other countries that adopt this approach), but it would be largely irrelevant if these projects were being evaluated at discount rates nearer the cost of capital.)

Finally, in a country where so much is subject to public consultation, what possible grounds were there for moving ahead on a change of such (potential) magnitude with no wider consultation whatever?

Michael Reddell spent most of his career at the Reserve Bank of New Zealand, where he was heavily involved with monetary policy formulation, and in financial markets and financial regulatory policy, serving for a time as Head of Financial Markets. Michael blogs at Croaking Cassandra - where this article was sourced.