The Public Discount Rate and the Uncertain Budgetary Flows

Public investment in infrastructure and the like do not usually yield direct pecuniary returns to the public exchequer. Instead public capital leads to increases in factor productivity in the private economy. This paper argues that government typically shares in the latter gains via the tax-expenditure policies. Consequently the discount rate relevant for the investment is ultimately the same rate, as that required for valuing the future gains. However, it is important to note that these productivity gains are subject to aggregate economic shocks. From the perspectives of a counter factual experiment whereby the risky revenue flows serve as collateral for public borrowing, one may derive the risk discount rate that the capital market would set. This paper applies the above methodology to the United States, uses budget data for the period, 1950-1995, and shows that while the risk discount would typically exceed the risk free rate, it remains well below that facing a private investor. The intuition here is that the portfolio of assets embedded in the state's revenue claims provides additional diversification than is available through financial markets. Consequently even investors holding well-diversified stock portfolios may legitimately view claims on state revenue as vehicles for further risk shifting