Governments Should Not Use Declining Discount Rates in Project Analysis

A number of governments have already adopted the policy of applying Declining Discount Rates (DDRs) to long lived projects, a move that could affect public sector investment decisions. Arguments for the use of Declining Discount Rates are based on the consideration of uncertainty, both for discount rates derived from social welfare functions, and for those derived from the characteristics of capital markets. The case for the latter is based on Martin L. Weitzman’s assertion that certainty equivalent discount rates are a declining function of time and tend to the lowest possible interest rate when interest rates are stochastic but perfectly auto-correlated. This paper finds that this conclusion is the consequence of Weitzman’s use of time reversed negative compounding, rather than of discounting, in the definition of net present value. When discounting is used instead, Weitzman’s conclusions are reversed, and do not support the use of Declining Discount Rates.