_..---- -.. -....-. 1\
Selecting an Interest Rate 495
cost to a government agency or other governing body, this interest rate is known as gov-
ernment opportunity cost. In this case the interest rate is set at that of the best prospective
project for which funding is not available.One disadvantageof the government opportunity
cost concept is that different agencies and subdivisions of government will have different
opportunities. Therefore, political units could potentially set different interest rates for use
in economic analysis, and a project that may be rejected in one branch owing to an inade-
quate rate of return may be accepted in another.Differing interest rates lead to inconsistent
evaluation and decision making across government.
Dollars used for public investments are generally gathered through taxation of the
citizenry. The concept of taxpayer opportunity cost suggests that a correct interest rate
to use in evaluating public investments is that which thetaxpayercould have received if
the government had not collected those dollars through taxation. This philosophy holds
that through taxation the government is takingawaythe taxpayers'opportunityto use the
same dollars for investment."The interest rate that the government requires should not be
less than what the taxpayer would have received. This compelling argument is supported
in general by the Office of Management and Budget (OMB) A94 directive that stipulates
a 7% interest rate be used in economic analysis for a wide range of federal projects. It is
not economically desirable to take money from a taxpayer with a 12%opportunity cost, for
example, and invest it in a governmentproject yielding 4%.
Recommended Concept
The general rule of thumb in setting an interest rate for government investments has been
to select thelargestof the cost of capital, the government opportunity cost, or the taxpayer
opportunity cost interest rates. However, as is the case in the private sector, there is no
hard and fast rule universally applied in all decision circumstances. Setting an interest rate
for use in economic analysis is at the discretion of the government entity performing the
analysis. Consider the sevengovernmententitiesgiven in Table 16-1.The interest rates used
by these decision-making bodies for evaluatinginvestments could all potentially be set at
different levels. Setting these interest rates would involve a management decision based on
both objective (cost of capital, etc.) and subjective (risk attitudes, etc.) factors considered
by each unit.
TABLE16-1 Examples of Interest Rates Used in Government
Economic Analysis
Government Entity
U.S. armed services
State agency
Federal agency for highway transportation safety
City port authority
City school board
State waterway commission
City of Any town
Interest Rate Used (%)
4
6
3
5
6.5
5
8
