the real rate of interest which was the real cost to the government of borrowing. Somewhere in the ensuing years, some smart people in the Congress or out in the public came along and said the government is saying that they are borrowing money at 2.25 percent, when we know they have to pay much more than that. So they would require the Corps to jack up that side of the equation, all the while leaving the benefits unadjusted. Am I correctly describing that? If that is so, why doesn't the Corps suggest to us a new way to calculate benefit-cost ratio that accurately reflects what is happening-I would suggest that they use the actual rates of interest, and use the consequent actual rates of inflation that are reflected by whatever rates of interest you use, in other words, adjust both sides of the equation. Would you speak to that issue? General HEIBERG. Yes, sir. We talked about that a bit last year, and you quickly noticed that I passed the question on to others. I have found, over the years, that if you ask three economists to answer the question, you get at least four answers back. However, let me try to answer the question then see where we go from there. I am sure my colleagues might want to help me with this. PROJECT DISCOUNT RATE You are correct that we do evaluate our projects benefits and costs in real terms. And, I might add, there is no jacking up of costs to reflect inflation. The discount rate which is applied to both benefits and costs is based on government securities. And that rate does include an inflation factor. I have for a long time, long years before I came to this job, been concerned personally with the question is the resulting discount rate too high? I have kicked this around. I have kicked this around inside the Corps, with my colleagues in Mr. Page's office, and several economists outside the Corps of Engineers. Let me give you some of the views that I have gotten back, and then tell you what I think. One yew of at least two economists that are today in academia, who are prestigious economists, is that if you have a measure of the benefits and costs from a project that are both inflation-free and risk-free, then the current rate of $ ́ ́s that we use by law is indeed, too high. On de ochter side, others have argued that inflation-free opportunity cost of capital is a proper standard for water resource projects. The Ofe of Magement and Budget today, which is the spokesman for President in is a mers that to be 10 percent. Im a 's wordwde to revisit the me SZIBIROR JOHNSTOa corde opportunity cost of capital is 10 percent. Ceneral Hamere. Dat is OMS's en resting panget yes, St. Sawr CHNEN IST DA PAZEN A Cereri Esme que goren OWN ROZY V General HEIBERG. That is why I had a problem with it, sir. APPLICATION OF DISCOUNT RATE General HEIBERG. What I think you need to do is balance the benefits and the costs using a discount rate that gives you an equal measure. Our problem has been explaining why the 10 percent, or even the 85% rate which we are now using permits an inflation-free comparison. I think there is a way to obey the law-in other words, go along with the formula that the Congress and the administration both recognize now, which is the basis for deriving the 85% rate-and still apply some other factors to provide another test for the projects. I can't tell you what the procedure is, but I think one could be developed. I am prepared to work with your staff, with Mr. Page's permission, and take a more in-depth look at this question and see if we can't, without promising anything for the future, come up with some other ways to test a project. Senator JOHNSTON. Do we have that permission, Mr. Page? Mr. PAGE. Yes, sir; if you do that right away, maybe we will find out something. CURRENT PROCEDURES Mr. DOYLE. Senator, with your permission, we will, for the record, provide the best defense we can for the current procedure so that that is on the record as well. Senator JOHNSTON. The best defense for it? Mr. DOYLE. Yes; the best explanation for it, as we understand it. Senator JOHNSTON. If, in fact, what I said initially was correct that, in effect, you are supposed to consider benefits as inflation free-when we get a weapon system, we always talk about constant dollars-so we are talking about constant benefits. Then on the interest side, it was supposed to be the real cost of capital, or the opportunity cost, which is, I think, another way of saying the same thing, in effect, the difference between interest rate and inflation rate. If that was the theory, then you cannot defend using an artificially and statutorily imposed figure which exceeds that, can you? Mr. DOYLE. The current procedures were developed after a great deal of debate, public comment, discussion, and criticism, and have been in place for many years. Senator JOHNSTON. The 85/8 percent? General HEIBERG. The formula for the rate; the rate has varied, but it is currently 858 percent. Mr. DOYLE. The 1974 Act tells us how to adjust the discount rate. Senator JOHNSTON. I know, but that wasn't arrived at by a lot of economists figuring out what the opportunity cost of capital or the real rate of interest was. That was imposed politically by a bunch of people in my position who didn't have the foggiest notion of what the formula was all about. Mr. DOYLE. Not having been here then, you are in a better position to answer that. Senator JOHNSTON. It is not unusual that people don't have the foggiest notion what the formula is all about. Mr. DOYLE. There is a body of economists that does believe that the current practice is defensible. I think, in order for you to be able to have the complete picture, what we need to do, as part of your consideration, is get you a definitive explanation of the current procedures, as well as whatever additional information you may want on other alternatives. [The information follows:] EXPLANATION OF DISCOUNT RATE When the Corps of Engineers undertakes an economic analysis of a water resource project, it evaluates both costs and benefits in "constant dollars"; estimates of costs and benefits are not tied to a factor which accounts for future inflation. This procedure is used as a basis for determining the value of a project in terms of the flows of goods and services it produces relative to its cost. Normally, prices of goods and services used to evaluate the benefit-cost ratio for a water resource project are those prevailing during the period of planning. These are taken to represent the real value relationships expected over the life of the project unless some specific evidence indicates that the real exchange values are expected to change. Expected changes in economic activity, e.g. changes in structures on a flood plain, or level of traffic on a waterway, are included in the analysis, but without projection of relative price shifts. Because of the use of inflation free estimates, the discount rate (which permits comparison of costs and benefits occurring at different points in time) should also be inflation free. The discount rate formula currently used in the formulation and evaluation of Federal water resource projects is provided for in the Water Resources Development Act of 1974. Section 80(a) of this act states that the formula shall be the one approved by the President on May 15, 1962, published as Senate Document 97 on May 29, 1962, as amended by the regulation issued by the Water Resources Council and published in the Federal Register on December 24, 1968. This formula provides that the discount rate shall be based upon the average yield during the preceding fiscal year on interest-bearing marketable securities of the United States which, at the time the computation is made, have terms of 15 years or more remaining to maturity. Provided, however, that in no event shall the rate be raised or lowered more than one quarter of 1 percent for any year. For fiscal year 1988, this rate is 8 5/8 percent. The yield on long term government bonds is a "nominal rate", that is, it includes an inflation premium. On this basis, some have argued that the current formula results in too high an estimate of a "proper" discount rate. On the other hand, unlike a water resource project, a government bond is a no risk, highly liquid asset. The current procedure may therefore result in an understatement of the most appropriate discount rate. On balance, while the current rate is tied to an arbitrary formula, it is within the range of estimates of real returns on private sector investments in new plant and equipment. In fact, the current rate is less than the estimate of 10 percent, made by the Office of Management and Budget (OMB) to be used in evaluating Federal projects that do not involve water resources. In our view, the discount rate should reflect the opportunity cost of land, labor, and capital resources diverted from private to public investment. This should be the normal rate of return expected from capital investments in the private sector which would enhance the national income, as measured by the flow of goods and services produced in the economy. OMB's estimate of 10 percent, published in Circular A-94, is intended to be a measure of the real return on capital investments. It is based on empirical data from economic studies conducted at the time the circular was written. More recent data confirm this estimate. For example, Standard & Poor's Compustat Services Inc. provides estimates of the industry composite nominal rate of return on invested capital. For 1983-86, the industry composite return averaged 15.6 percent. The difference of 5.6 percent between Compustat's nominal return and OMB's estimated real rate of return can be interpreted as a measure of expected inflation. |