Tyler Cowen:
Debt-financed government spending must eventually be paid off and the estimated deadweight loss of taxation is at least twenty percent. That immediately puts a hurdle rate of twenty percent or more on projects, even when real borrowing rates are very low….
Private companies, when making investment decisions, often use hurdle rates as high as twenty or thirty percent… to constrain overeager empire builders, or “cowboys”… there should be a “cowboy premium” for the public sector as well, even if that premium should be lower for the public sector.
The real risk of public sector investment is not measured by the borrowing rate, but rather by the covariance of the value of public sector outputs with a very broad notion of the market portfolio. I call this the Jensen premium, since Michael Jensen first outlined this argument clearly.
This is all standard stuff, none of it is like reading the “he said, she said” debates over the proper size of the fiscal policy multiplier.
Nope. It is not standard stuff. The standard stuff is:
The effect of taxation deadweight losses is to increase the hurdle rate not by 20% but by 20%/duration of the debt undertaken to finance the spending. That is a very different thing from 20%.
The right way to do benefit-cost calculations is to get the benefits and costs and discount rate right, not to overestimate the benefits and then screw up the discount rate by overstating it. Cowen's proposal creates a systematic bias against thinking about the long run--a pronounced myopia.
Since the residual risk from public investments is borne by the taxpayer, the right cost is the risk-free real rate plus (coefficient of risk aversion) x (covariance of public output with wealth as a whole). The covariance of public output with a market portfolio when the equity premium tells us that the market does a really lousy job of mobilizing societal risk-bearing capacity is neither here nor there.
It's not the Jensen premium, it's the Marglin premium. Stephen Marglin is much clearer on this stuff then Jensen...
We're talking about an adjustment to the real risk-free rate of less than 50 basis points here…
