THE DISCOUNT RATE
8.3 Criticism of the Use of the Interest Rate as the Discount Rate
The first type of criticism focusses on the existence of the conditions required for the market to reveal rate d. Not only are future prices and incomes not even known as random variables, they are also subject to uncertainty.
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CRITIQUE OF THE INTEREST RATE
Figure 8.3 Positions of Intel-temporal Equilibrium of Mr. P
over, the market interest rates are expressed in nominal terms so that any intertemporal consumption plan requires the future inflation rate to be known.1 In addition, the existence of income tax introduces special complica-tions. In this case, person j will equal his individual discount rate di with the rate of interest after taxes z (1 — tj) in which tj is the marginal income tax rate corresponding to that person. Consequently, unless tJ is the only rate for all persons, a single interest rate will correspond to various individual discount rates and there will be a different "average" discount rate for each project, which will depend on the interpersonal and intertemporal distribution of costs and benefits.2 Finally, application of the compensation criterion to the inter-temporal allocation described in Section 8,2 requires both individuals to par-ticipate in the "savings market." Let us consider for example the case shown in Figure 8.3, in which the future income of P is less than or equal to the minimum acceptable consumption in this period, while his present income is somewhat higher than the respective minimum consumption. In such a situa-tion, P does not want to borrow since this would mean an unacceptable reduction in his future consumption. At the same time, the prevailing rate of interest i is less than his time-preference rate d so that
the increase in future consumption possible at rate i (Cl,—F, in Figure 8.3) is less than the minimum required to persuade him to save (Cld—YT). In this
1. See Section 9.3 below.
2. Cf. Mishan (1982, Chapter 35). The author wishes to thank Professor Mishan for an exchange of correspondence on this point.
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THE DISCOUNT RATE
case, the compensation criteria cannot be implemented by using a single rate i since this rate is different from the time-preference rate of Mr. P. A change in the distribution of present or future income in favor of P could take him to a point such as A at which he would participate in the savings market. However, a generalized redistribution would affect the savings market and would give rise to a different interest rate than that which would have prevailed without redistribution. As a consequence, even if a perfect market existed, the result-ing rate of interest might not be the appropriate one for implementresult-ing the compensation criterion if one or more individuals did not participate in the market. It should also be noted that the interest rate is not independent of (present or future) income distribution between individuals.
The second type of criticism is based on the impossibility, in the field of intertemporal decisions, of complying with the principle that it is those who are affected who determine the nature of effects, since these extend beyond the life of the present generation. Mishan (1981a, 1981c, and 1982) has put this in terms of the impossibility of applying the criterion of the potential Pareto improvement when gainers and losers do not co-exist in time. Let us suppose that project Pr, which costs the Government 100, will show bene-fits the following year of 100(1 + qr) received entirely by Mr. R, and that qr > d. Alternative project P?, which also costs 100, will provide benefits 100(1 + qf)m received entirely by Mr. F in year 100, in which qf = rf.3 Obviously,
and application of the present value criterion would result in Pr being selected.
However, as Mr. R would not be alive in year 100, it would not be possible to effect compensation unless a mechanism existed for transfers between genera-tions that could potentially take compensation 100(1 + d) in year 1, and reinvest it at rate d for 99 years in order to compensate Mr. F. Given that this mechanism depends not only on the possibility of transfers between members of the same generation, but in addition on the possibility of transfers between generations, Mishan has called it "potential potential Pareto improvements"
and expressed objections to the use of the present value criterion without explicit consideration of the intergenerational problem.4
Other economists have questioned acceptance of the interest rate of a per-fect market on the basis of denying the ability or even possibility of individ-uals of the present generation to make intertemporal comparisons that affect
3. The assumption should be noted that d today is equal to d in 100 years.
4. In this regard, see also Pearce and Nash (1981).
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members of future generations. Even in the (unrealistic) case of perfect cer-tainty about future prices and incomes, there would be no cercer-tainty about the date of death, and this uncertainty of the present generation, which would be expressed through higher discount rates, is not a defensible argument for discounting the benefits of future generations.
The criticism would be equally strong if the claim were made to use a
"pure" time-preference rate. In the words of Sen (1961):
A distant object "looks" smaller, and we tend to value, it is claimed, a unit of consumption in the future less than we value the same now... If the difference is only due to distance in time, then the position is symmetrical. A future object looks less important now, and similarly, a present object will look less impor-tant in the future. While it is true that the decision has to be taken now, there is no necessary reason why today's discount of tomorrow should be used, and not tomorrow's discount of today.
These concisely put criticisms are by no means exhaustive. However, they do illustrate the difficulties in accepting even the interest rate of a reasonably competitive market as the discount rate.5