Overview

George Bugliarello

Polytechnic University

In the course of this colloquium, some clear messages have emerged about the future of financing infrastructure, both in this country and abroad. The realities of the straitened financial picture with regard to infrastructure were reflected in talks by all of the panelists about what is possible right now. Far from being pessimistic, however, the panelists presented some new information and profound insights detailing influences that will have a great impact in the future. These influences must be better understood to be managed effectively and enable us to respond to changing conditions.

Dr. Brennan discussed the key public policy issue in infrastructure investment, i.e., deciding to commit resources to a particular project or program rather than how to finance it. Dr. Brennan emphasized that resource flows are more important than money flows. On that basis, the present preoccupation with budget deficits (which relate to money flows) as a justification for reducing infrastructure investment (resource flows) may be misplaced. He presented a tutorial on the potential consequences of these decisions indicating that how infrastructure is financed, although not the most essential issue, may indeed matter a great deal.

Dr. Brennan presented two points of view on how to balance present value with future benefits, an "opportunity cost" and an "equal standing" approach, for deciding for whether or not to make investments. But he also pointed out that decisions also have an ethical, or even philosophical, basis. He pointed out that the dictates of the market, or what we actually do in markets, do not always reflect what we should do or what we might want to do. We may decide, for example, to intercede in the market for reasons of public interest or to prevent monopolies.

The complex relationship between economic and ethical considerations is underscored by Hume's Law—what "is" is not necessarily



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Financing Tomorrow's Infrastructure: Challenges and Issues Overview George Bugliarello Polytechnic University In the course of this colloquium, some clear messages have emerged about the future of financing infrastructure, both in this country and abroad. The realities of the straitened financial picture with regard to infrastructure were reflected in talks by all of the panelists about what is possible right now. Far from being pessimistic, however, the panelists presented some new information and profound insights detailing influences that will have a great impact in the future. These influences must be better understood to be managed effectively and enable us to respond to changing conditions. Dr. Brennan discussed the key public policy issue in infrastructure investment, i.e., deciding to commit resources to a particular project or program rather than how to finance it. Dr. Brennan emphasized that resource flows are more important than money flows. On that basis, the present preoccupation with budget deficits (which relate to money flows) as a justification for reducing infrastructure investment (resource flows) may be misplaced. He presented a tutorial on the potential consequences of these decisions indicating that how infrastructure is financed, although not the most essential issue, may indeed matter a great deal. Dr. Brennan presented two points of view on how to balance present value with future benefits, an "opportunity cost" and an "equal standing" approach, for deciding for whether or not to make investments. But he also pointed out that decisions also have an ethical, or even philosophical, basis. He pointed out that the dictates of the market, or what we actually do in markets, do not always reflect what we should do or what we might want to do. We may decide, for example, to intercede in the market for reasons of public interest or to prevent monopolies. The complex relationship between economic and ethical considerations is underscored by Hume's Law—what "is" is not necessarily

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Financing Tomorrow's Infrastructure: Challenges and Issues what "ought" to be. Dr. Brennan discussed various ways of assessing the interests of future generations—from discounting them entirely to arguing for equal justice in the distribution of resources, which would target the generation we think will be most in need of help. The issue of intergenerational equity is fundamental, he noted. The way we value the interests of future generations, typically through market rate discounting, has a profound impact on the equity of decisions we make today. In the ensuing discussion, it was pointed out that we had not addressed what could be called "intracontinental" equities. But the fact is that this country has been able to afford things that few other countries have been able to afford. Few other countries have been able, for example, to rebuild in a different area of the country, as we have essentially done by transferring people and resources from the east to the west. One could expand this principle to the problems of American cities, although the situation is, perhaps, not unique to the United States. Our cities have two distinct characters, daytime and nighttime. The question is whether or not our cities can become whole again. The answer may lie in telecommuting and other technological innovations. Another issue about urban centers mentioned in the discussion is that putting resources into highways takes resources away from city transit systems, making transportation for workers in the city less accessible. The morning panel on infrastructure challenges and issues, chaired by Ms. Connery, also raised a number of important points. Ms. Everett suggested that we consider new roles for the state, local, private, and federal sectors in the context of national strategies and objectives, a point that was reinforced by the keynote luncheon speaker, Ms. Wince-Smith. Ms. Everett cited three recent reports showing different approaches to defining infrastructure needs and ways to address them, depending on the perspective of the authoring body. However, taken together and interpreted in today's context, all three reports suggest that we should expect lower levels of support for infrastructure and changes in the traditional federal role in financing. Several speakers throughout the day reinforced this idea and offered evidence that a number of options are available, or can be made available, to augment or supplant federal funding. Dr. Humplick provided the assembly with an international perspective. She discussed nine financing alternatives that have been used throughout the world. These alternatives are not only technically elegant, but they also show how the public and private sectors can balance risk and return. Once the paradigm of public only financing is abandoned, services can be provided in areas where they otherwise would not be. Financing alternatives foster accountability and strengthen links between users and providers in different ways. Dr. Humplick pointed out that the critical factors for success or failure of a project are operating and maintenance costs. During the discussion, she

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Financing Tomorrow's Infrastructure: Challenges and Issues suggested it would be useful if people paid as much attention to infrastructure investments as they do to their private investments. Ms. Cohen addressed the subject of demographic changes that affect infrastructure financing, including a sobering assessment of the implications of the Orange County, California, bankruptcy. She suggested that money will become increasingly tight as more and more social services are downloaded or devolved from the federal to the state and local level, as happened in the early years of the Reagan administration. The competition for local dollars will continue to increase, as taxpayers, who have greater control over local government, vote their frustrations with government budgets. Local governments concerned with keeping taxes low and containing service costs, partly because of reduced revenues from property taxes, are not likely to invest in infrastructure. The demographic trend toward significantly older property owners, who are traditionally reluctant to support public expenditures for schools and other improvements, provides an interesting counterpoint to the impetus toward intergenerational equity raised earlier by Dr. Brennan. Ms. Cohen noted that there are some bright spots in public spending, high growth areas like North Sioux City, South Dakota, and Rio Rancho, New Mexico, where infrastructure systems are being expanded to keep up with rapid growth. However, some questions were raised about the justification of displacing resources from developed areas to build new infrastructure in areas populated by people who have moved from somewhere else. This is a quasi-philosophical issue, but it shows, in a sense, how wasteful we sometimes are. The luncheon speaker, Ms. Wince-Smith, pointed out that new technologies represent from 30 to 50 percent of economic growth in an economy like ours and that the infrastructure is a very important element of that. Although we do not have figures showing the percentage of productivity from the infrastructure, she believes this might be useful information for the National Research Council to gather. The characteristics of a national infrastructure strategy that encourages innovation include the creation of new technologies, which are important to economic growth, and the means of applying them and translating their products into shares in a global marketplace. One suggested method for furthering this scenario was considering vertical, rather than horizontal, partnerships, i.e., users and producers from different industries pooling their resources. The idea is that companies from different industries are more willing to pool resources because they are not in direct competition with each other, and they do not have to worry about antitrust concerns. In the course of the discussion, the question arose of whether we can compete effectively with the Japanese to develop a sophisticated urban traffic control system, like the one already deployed in Tokyo. Clearly, congestion is a

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Financing Tomorrow's Infrastructure: Challenges and Issues visible problem in cities around the world, a potential market of 200 or more cities in need of traffic control systems. The afternoon panel, chaired by Dr. Bruce McDowell, discussed the future of infrastructure financing. As director of government policy research for the Advisory Commission on Intergovernmental Relations, Dr. McDowell brings together people from various government agencies to discuss federal infrastructure strategy and ways of financing projects and programs under straitened circumstances. The basic conclusion of the Advisory Commission on Intergovernmental Relations report, ''High Performance Public Works,'' is that financial planning should be included at the very beginning of planning infrastructure projects. Financial planning is fast becoming a standard part of infrastructure planning. The Intermodal Surface Transportation Efficiency Act (ISTEA) requires that transportation planning at the state and metropolitan levels be done in with financial constraints in mind. Many states and metropolitan planning organizations are hiring financial analysts as part of the planning process. As Dr. McDowell put it, in the past the challenge was to improve public works without new money. Today, we must find ways to improve public works with even less money than we thought we had. General Charles Williams, with the Greenway toll road project in Virginia, presented another aspect of the infrastructure issue—making money from public works. After his presentation, a question was raised about whether the Greenway project is an individual, isolated case or a project that could serve as a model for other projects. General Williams himself suggested that the Greenway was perhaps not an ideal model, because the cost of equity investment was too high and the public contribution too low—the price for being the first of its kind, he suggested. The project has reached a milestone by opening for operation ahead of schedule. Ms. Sowder also discussed reasons that the financing of the Greenway will probably not be duplicated. One of many unusual aspects of the financial arrangements for the Greenway is that the owner took on all collateral work associated with development of the road, making it easier for the contractor. What the Greenway can demonstrate, however, and what Ms. Cohen also suggested with some examples from Orange County, is that people are willing to pay user fees to make commuting smoother and faster even if they are not willing to pay higher taxes for government services in general. In his presentation, Dr. Mudge pointed out that infrastructure has direct benefits, for which people are willing to pay directly, and indirect benefits, such as productivity improvement, which may be greater by an order of magnitude but are difficult to demonstrate, for which people are reluctant to pay. He suggested that "thinking big" is good for the economy, particularly in the case of transportation, because the larger the network the bigger the returns.

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Financing Tomorrow's Infrastructure: Challenges and Issues In his opinion, however, large networks cannot be financed privately. So the need for public financing remains. In the 1970s we completed the interstate highway system. In the last 20 years we have been looking for new financing mechanisms because the Highway Trust Fund is past its prime. New public mechanisms, like funds from Section 1012 of the Intermodal Surface Transportation Efficiency Act (ISTEA), have not been applied, however, for a variety of reasons, ranging from lack of imagination to the fact that they are complex and resemble derivatives. According to Dr. Mudge, there is nothing wrong with derivatives, but most people do not understand what they are and that they can be important innovations. New financing ideas may include infrastructure banks and other institutions or systems that would move us from relying on a single national model, like the Highway Trust Fund, to considering a variety of more flexible models. Dr. Mudge believes, however, that technical innovations have been much greater than financial innovations in the past two years. Ms. Sowder provided an overview of the private bond market, the primary agency for financing public works. She is optimistic about the strong interest on the part of the investment community in projects with the "right" characteristics, including public support. If there is a benefit, Ms. Sowder said, one probably can charge for it, and so, attract new money. There are two objectives in infrastructure finance, Ms. Sowder continued. One is using existing funds effectively, and the second is attracting new funds. In terms of using existing funds effectively, Ms. Sowder said, the focus should be on loans rather than grants. Loans not only provide fiscal responsibility, they also replenish themselves. Unlike grants, loans permit recycling of capital. A 3:1 leveraging ratio is appropriate, i.e., borrowing funds amounting to three times the seed money, which may be provided by the federal government. Mr. Tischler provided some insightful analysis about financial and infrastructure difficulties. Most local jurisdictions do not maintain depreciation accounts as revenue sources for replacing aging or failing infrastructure. He also noted the importance of accounting for operations and maintenance at the time a facility is proposed. Although over the life cycle of a facility these costs far exceed annualized capital costs, they are often ignored until they generate budget shortfalls or tax increases. The solution to this problem lies in better fiscal analysis coupled with public education and communication. Fiscal analysis can also clarify the levels of service provided by infrastructure. These levels tend to creep up where services have been expanded, increasing the level of expectation without a corresponding increase in financial support. Examples include special education classes, adding required courses, or reducing the number of students per classroom, which

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Financing Tomorrow's Infrastructure: Challenges and Issues translate into higher costs per student in infrastructure support. Unfunded federal mandates, such as bilingual education, are another cause of level of service creep. The financing equation has changed, partly because the public does not understand why infrastructure costs increase while the number of students decreases. Fiscal analysis may provide some solutions to these problems, but communicating results to the public is a major part of the solution. Mr. Tischler discussed the "cost of urban sprawl" and raised a very important, but counterintuitive, point that is often missed. Although infrastructure costs tend to be higher for lower density development, the tax revenue from higher value, low density housing can more than offset the higher cost of infrastructure. In the ensuing discussion, Dr. Humplick suggested that financing transportation infrastructure will remain in the public sector, the Greenway notwithstanding, but other infrastructure projects are likely to be privately financed. In any case, we need a new, more flexible financing model for transportation projects. Ray Sterling noted that the public may be reluctant to support projects where resources, particularly resources like water, are allocated to private, rather than public, utilities. Mr. Tischler concluded by suggesting that solutions are available, some of them quite simple. But they will not work unless there is public confidence in government. If people do not fully understand the issues, they tend to mistrust the government and are reluctant to support necessary projects and associated fiscal solutions.

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Financing Tomorrow's Infrastructure: Challenges and Issues Balancing Present Costs and Future Benefits Timothy J. Brennan University of Maryland, Baltimore County Resources for the Future I have been asked to talk about policy issues associated with finance, some of which may be connected to ethical issues involving what we do now for future generations. First, I need to set the stage by establishing some principles for thinking about the financing of infrastructure projects in particular and public budgeting and deficits in general. There are important differences between public and private finance in how one might balance present costs and future benefits. A key distinction, certainly with regard to policy decisions, is the distinction between "resource flows" (the actual movements of goods and services) and "money flows" (issues of how and by whom payments are made). Understanding this distinction has important implications for how we interpret budget deficits. As we will see, confusion between resource flows and money flows affects public opinion regarding deficits and decisions about which infrastructure investments are worth making and which are not. After discussing resource flows and money flows, I want to talk about future generations and the discount rates we use to evaluate infrastructure investments. Before doing so, some definitions may be in order. The idea of discounting future benefits with respect to present costs means, simply, that we require that every dollar of present investment has to generate more than a dollar in future benefits before we decide to invest it. The discount rate, like an interest rate, is a way of measuring how much future benefits should be discounted annually before we can see if they are great enough to warrant present investment. For example, if a one-dollar investment today has to generate two dollars in benefits 10 years from now, we would say that the discount rate applied to that investment is about 7 percent. This, not

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Financing Tomorrow's Infrastructure: Challenges and Issues coincidentally, is the amount that a one-dollar investment has to earn per year to be worth two dollars 10 years from now. The questions raised by discounting are numerous and highly controversial. Should we use discount rates from private financial markets to tell public policymakers how much the interests of future generations should count? We will see that it is at least questionable whether what we actually do in markets tells us what we should do in policy settings. To understand how to approach the issue, we will look at a couple of potentially conflicting views on whether, in making investment decisions, we discount the interests of future generations or not. The "opportunity cost" way of looking at investments insists that we compare infrastructure investments to what we could have earned in the future if we had put the money elsewhere. The "equal standing" approach denies that interests should be treated preferentially just because they happen to belong to present individuals rather than individuals living in the future. After examining and comparing these approaches to evaluating infrastructure investments, I will turn to ethical (as opposed to narrowly economic) arguments for why we might want to discount benefits to future generations when deciding which infrastructure investments are worth making and which are not. PUBLIC POLICY TOWARD PRIVATE INFRASTRUCTURE INVESTMENTS What makes financing a policy issue? I assume we are not worried here about evaluating privately financed investments. What General Motors decides to do with money in building factories is up to the company because GM reaps the benefits and GM bears the costs. Applying principles of private financing may not be enough to arrive at the right decisions, however, when there are different kinds of market failures. One such context involves monopolies. Experience with infrastructure investments in the telecommunications and electric utility industries indicates that the absence of competition or the regulatory mechanisms we have put in place to replace competition may lead firms to invest too little or too much. Public policies involving government mandates, public financing, or subsidy programs may be necessary to ensure that monopolies do not withhold investments in order to keep supplies low and prices high or overinvest to exploit regulatory commitments to cover costs. A second category of market failure warranting public concern with private investments involves what economists call "externalities." These arise when private investments generate costs and benefits that accrue to third parties beyond their markets. Businesses will be less willing to invest in infrastructure

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Financing Tomorrow's Infrastructure: Challenges and Issues or anything else if they cannot capitalize on costs and benefits by charging whoever benefits. If benefits cannot be captured in markets, the public may have to make the investment. This principle applies not just to physical infrastructures; it is the primary argument for public funding of basic scientific research that is not protected by patents and copyrights. A third source of public concern with private investments is "asymmetric information." There may be situations where someone who is thinking about undertaking an infrastructure investment knows something that buyers on the other side of the market do not, or vice versa. This can cause markets to fall apart because the buyers without the crucial information stay away to avoid being exploited by buyers who have it. Asymmetric information is a very important concern in health insurance—which, in the eyes of some, is as much a part of the nation's infrastructure as highways, power lines, and telephone networks. PUBLIC PROJECTS: RESOURCE FLOWS AND MONEY FLOWS Although market failures are important—but not sufficient—conditions for justifying public intervention, my main purpose is to talk about issues posed by public financing, either through state or federal governments. There are two questions here that are inseparable. One is the decision to spend in the first place. Do we take public resources and use them to create, expand, or augment the infrastructure in some way? The second question is how we fund this spending. Do we tax? Do we borrow? Do we rely on user fees, if that option is available and feasible? The main point is that resource flows, not money flows, are what matter. The real cost of the infrastructure is not money we take away from the future but resources not devoted to consumption or to building things today. If our choice is, say, between installing fiber-optic networks and expanding hospitals, then the cost of doing the former is that we strip resources from the latter. This is an example of what economists call "opportunity cost." This sort of choice arises whether the funding comes through borrowing, taxation, or some other source. But if resource flows are what matter, then what is the importance, if any, of budget deficits, i.e., financing public expenditures via borrowing rather than taxation? This is a money flow rather than a resource flow question. We should look at some arguments about why budget deficits, as a money flow issue, may not matter very much and then turn to some responses to those arguments.

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Financing Tomorrow's Infrastructure: Challenges and Issues BORROWING FROM OURSELVES The first thing to notice is that public budget deficits have no direct effect on resource flow. One cannot move production and resources from the future to the present simply by changing how one finances things. The idea that when we run deficits we are somehow robbing the future to pay for the present, therefore, cannot be right, at least not in simple terms. Quite literally, the future is not here for us to rob now! If 25 or 50 years from now, someone's labor is going to go into building a car, we cannot take that car, hence that labor, from the future and put it into the present to be used today. There may be implications for the future from our present investment decisions and perhaps from our financing decisions, but it is impossible to take wealth yet to be generated and transfer it, as if by time machine, into the present. If financing has an effect on resource flows, it has to be fairly subtle. Deficit-financed infrastructure does not come from future taxpayers but from reduced consumption or reduced alternative investment from present bondholders. To be sure, future taxpayers will end up with fewer resources—i.e., poorer—to pay off the debt. But those payments do not go to us in the present. They go to other people in the future who hold the government bonds that are being paid off. This is basically a long way of restating the familiar argument that deficits are not important because we "owe the money to ourselves." For every future dollar paid by taxpayers because of deficit financing, a dollar will be paid to a bondholder. One could as easily say that deficit financing creates a windfall for some future persons (the bondholders), as we frequently say that such financing robs other future persons (the taxpayers). By paying attention to how dollars are moved around, we can see that deficit financing does not move resources from future taxpayers to present consumers. A somewhat more sophisticated way of viewing this is what economists call the "Ricardian Equivalence Theorem." On that account, deficit financing does not matter because, if the government borrows now, it creates a future tax liability because of the need to pay off the bondholders from which it borrowed. If governments and individuals can borrow at the same rate, people will view that future tax liability as a financial burden equivalent to what they would have borne if they paid taxes today rather than let the government borrow. In that sense, deficits do not matter. This is the public finance analog to the "Modigliani-Miller Theorem" in corporate finance, which says that financing private capital through debt or equity does not matter because it ends up having no effect on the individuals who end up putting up the money. If the

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Financing Tomorrow's Infrastructure: Challenges and Issues company itself does not borrow, individuals could borrow to finance stock purchases. Returning to the government deficit context, if we were to eliminate the budget deficit tomorrow by raising taxes, people could borrow to pay their taxes and maintain current consumption levels. From the point of view of the bondholder and the macroeconomy, it would not make any difference whether the government or individuals issued the bonds. In fact, if there would be a market where some want to borrow and some want to lend, and if the government has capital market advantages that other borrowers lack, it is probably better for the government than for individuals to run a deficit. This is an example of the degree of detail necessary to come up with a real effect of money flows. WHY FINANCING MATTERS Like a lot of arguments in economics, the "borrowing from ourselves" and Ricardian Equivalence arguments are caricatures. Nonetheless, they show that money flows may not be very important compared to resource flows. However, there is a lot of concern regarding financing, and some of it is justified. Let me take a brief look at some of the criticisms of these caricatures. Importing Investment Capital A first reason why financing might matter to us as a nation is that the resource flows may not be just among ourselves. They may be coming from or going to someplace else, and we may care about that. Resources used to build the infrastructure today may be coming from foreign investors willing to defer consumption now in exchange for greater consumption later. By borrowing in this way, we are obliging future U.S. taxpayers to send resources abroad. In this sense, we do not simply owe ourselves. This is obviously a major concern among state project financiers, who have no reason to think bonds are going to be held by people who live in state. (This may explain why many states have balanced budget laws, while the federal government does not.) On the other side of the coin, perhaps we should be more ethical or broad-minded about the issue. Is it merely parochial to care if we deprive future U.S. taxpayers and benefit foreign bondholders?

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Financing Tomorrow's Infrastructure: Challenges and Issues Tax Avoidance Strategies A second reason why financing might matter involves economic distortions associated with collecting taxes. Moving money around is not as simple as it may look. There are real economic costs to redistributing purchasing power, including shifting purchasing power from taxpayers to bondholders. If we have to raise taxes in the future to raise the funds to pay off bondholders, people will start doing things to avoid paying those taxes—working less, investing less, looking for shelters. These avoidance tactics make the economy less productive. If, because of a deficit, we are going to have to raise future taxes to pay off future bondholders, there will be deleterious effects in the future. Of course, if the alternative is financing by increasing taxes now, we will create similar effects in the present. Ascertaining which is worse or when these effects balance involves subtle, complex estimates of discount rates and marginal tax burdens. Shifting Productivity to Present A third point is that if you know taxes are going to go up in the future because of debt financing, you might have an incentive to work harder now and avoid working later or to consume now rather than invest, shifting income to the present to avoid paying future taxes. You would be reallocating your effort to generating wealth in the present rather than in the future. This reduces savings, the rate of resource accumulation, and bequests to future generations. I do not know how large the effect of the shift is. An interesting aspect of it is that one argument against the idea (from the "Ricardian Equivalence Theorem") that future tax payments create a present liability is that people are too myopic to think that way. However, they must be farsighted to engage in income-shifting behavior. Thus, these two criticisms rely on contradictory assumptions. Lax Fiscal Discipline The myopia argument brings us to the last, and perhaps most important, point about the importance of financing related to fiscal discipline. This may be what underlies a lot of concern with and opposition to the deficit. The goal of many deficit opponents is to reduce excessive government spending by limiting borrowing. Their premise is that control over money flows (bondholders to taxpayers today, taxpayers to bondholders tomorrow) would control resource flows (public investment rather than private investment or

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Financing Tomorrow's Infrastructure: Challenges and Issues consumption). The underlying idea might be that in a democracy, a myopic or present-oriented majority might believe that they are getting something for nothing when the government borrows. If so, this creates a bias toward public investment and away from private investment, which may not be in our economic interest. SHOULD WE BUILD AND FOR WHOM? Whether these financing effects are major first-order effects or minor second-order effects is something about which economists argue a great deal. The answer is likely to vary from context to context. The reason I offer this short review on the basic economics of deficit spending is to indicate why I believe financial issues are second order. Ultimately, we should be talking more about whether or not an investment should be made and not so much about how it should be financed—recognizing, of course, that it should be financed as efficiently as possible. This brings us to the generational issue. The decision to make a public investment in infrastructure is a decision to direct resources away from current consumption and private investments to benefit people in the future. The first-order question is whether or not to build. Do we construct new highways? Do we expand the water system? Do we invest hundreds of billions of dollars in a fiber-optic broadband telecommunications network? These concerns are similar to concerns that arise when considering investing in ecological conservation and environmental protection. One might break the to-build-or-not-to-build question down by looking first at whether we are talking about shorter term investments for shorter term payoffs. To borrow an observation from Professor Thomas Schelling of the University of Maryland, decisions about investments with benefits that fall within our lifetimes are essentially decisions we make for ourselves and do not raise a profound ethical or policy issue involving future generations. If the payoffs come in 5, 10, or 20 years, we can say with some confidence that we do not have to worry about whether we are properly taking into account the interests of future generations in the cost-benefit calculation. Investments in infrastructure or the environment that will last for decades raise harder, long-term generational issues. In telecommunications, for example, there are significant questions about whether or not to build a fiber-optic infrastructure that could be in place for half a century. Nuclear power plant construction and waste disposal effects may span centuries. Debates over reducing industrial growth to lessen the "greenhouse effect" or to protect endangered species raise deep concerns about whether markets reflect the

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Financing Tomorrow's Infrastructure: Challenges and Issues interests of future generations in terms of resource conservation and environmental protection. How should we take the interests of future generations into account in making these decisions? Should we do what markets tell us to do in terms of how future benefits translate into money and how much future money is worth today, after discounting? Should we discount future benefits at all? These questions, which are already difficult, become even more difficult because of the uncertainty about the future benefits of ecological policies. In the eyes of many, that uncertainty colors the decision about how much we should take future interests into account. DISCOUNTING Sound policymaking requires that we review our tools for deciding if capital market discount rates should measure if long-term future benefits are worth present costs. There is a great deal of controversy about how discount rates figure in cost-benefit tests. Some of the controversy, I believe, rests on conceptual confusion. To understand that confusion and, I hope, to get past it, we should focus on one particular factor that goes into the determination of market discount rates—''pure time preference.'' We can look at what determines market discount rates in a very general sense. Many of you know more about the specific determinants than I, but a simple, gut-level analysis can make the point. On the demand side, the level of economic activity affects how much entrepreneurs and corporate managers are willing to borrow at given interest rates. In terms of the cost of supplying capital, you have to compensate people for expected inflation and for risk. Most important for the generational policy question, markets compensate those who supply capital for what economists call "pure time preference," a term that refers to how much people have to be paid in added future consumption to get them to defer the chance to consume now. In other words, how much do you have to be paid for deferral, over and above compensation for inflationary declines in the value of money and for the risk that you may not get your principal back? The pure time preference part of the discount rate raises the most serious ethical questions. Accepting market-based discount rates as the standard for weighing future benefits against present costs implies accepting whatever pure time preferences we happen to have—how we choose the present over the future in our private saving and investment decisions—as appropriate. Accordingly, this leads us to the opportunity cost standard for evaluating infrastructure investments by requiring that investments produce a stream of

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Financing Tomorrow's Infrastructure: Challenges and Issues benefits at least as great as could be obtained by taking those funds and investing them elsewhere, e.g., in the stock market. The problem with holding future benefits to an opportunity cost standard is that it can trivialize them over the very long term. At a 6 percent discount rate, it takes a $340 return one hundred years from now to be worth a dollar today. If investing that dollar paid only $339, it wouldn't be worth it. To take a fairly well known example, it does not take a large discount rate for the $24 paid for Manhattan Island in the early seventeenth century to have been a good deal for the Indians. At 6 percent, that investment would be worth about $40 billion today, a figure comparable to the aggregate earnings of the current residents in Manhattan. We do need to remember that market interest rates include more than pure time preference. They also reflect inflationary expectations and compensation for bearing risks, neither of which is particularly problematic. The 6 percent figure chosen here is rigged on the high side, perhaps by quite a bit. Many estimates of the pure time preference component of the interest rate are lower, some as low as 2 percent. If the interest rate is 3 percent, the hundred-year rate of return ratio falls from 340 to 1 to only 19 to 1. Still, at 19 to 1, it would not appear that we are treating benefits a hundred years from now equally in an ethically acceptable sense of evaluating infrastructure investments. EQUAL STANDING: ADDING ETHICS TO ECONOMICS The 19 to 1 ratio remains a rather gross violation of what, from a legal or philosophical perspective, we might think of as an "equal standing" principle. Why should present generations get to count 19 (or 340) times as much as generations a hundred years hence? The conflict between equal standing and opportunity cost principles, because both are plausible, is undeniable. Public finance textbooks contain a variety of attempts to rig market rates to conform better to ethical viewpoints. For example, a great deal of attention is devoted to whether we should use pre-tax market rates or post-tax returns as measures of the discount rate. There is not enough time to delve into the fine points of this discussion except to observe that it is born, in part, out of the hope of finding an opportunity cost measure more in line with equal standing principles. I think this hope is misbegotten because it tries to force a round, descriptive economic concept into a square, ethical hole. The confusion arises because too little attention is paid to methodology. One has to separate the normative question, "should we assist future generations," from the empirical

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Financing Tomorrow's Infrastructure: Challenges and Issues question, "if yes, than how." Philosophers refer to this kind of error as a "category mistake." Empirical and normative issues belong in two different categories. In the eighteenth century, British philosopher David Hume propounded the idea that what "is" does not imply what "ought" to be. Despite how something is, we need to come up with an independent ethical justification before we conclude that this "is'' tells us what we ought to do. Merely looking at how something is currently done does not solve the problem. I am suggesting that when it comes to infrastructure investments, the opportunity costs are important, but they are only the "is" part of the story. They do not necessarily play a role in deciding the ''ought" question. It is important to keep these concepts separate. An example may clarify why markets do not tell us what to do regarding future generations and why we need an ethical premise of some kind to get at the question. The example is unrealistic, but its extreme nature makes the difference between the "is" and the "ought" easy to remember. Assume for the moment that generations of people do not overlap. Everyone lives for 75 years, and then they all die at once. Out of the ground comes the next generation of people, like tulips. Assume also that there are no cross-generational connections or families, i.e., that no one today knows that a particular person 75 years in the future happens to be a "descendant" in some genetic or functional way. Let us suppose one generation of these tulip-people faces an issue of long-term infrastructure investment, e.g., whether or not to build an elaborate highway system that will last into the next generation—the members of which the present generation will never know, see, or experience in any specific way. One might expect that the present generation would forego the investment and consume very quickly. Beyond their own lifetimes, the discount rate would be infinite—subsequent generations would count for naught. Future persons would simply not matter. Even in this setting, I think it would be hard to argue that future generations "ought" to have no claim on present resources, despite the fact that the discount rate "is" infinite. The tulip-people's attitudes that future tulip-people do not count does not mean they ought not count. In our own world, our ethical obligations and duties to make investments or conserve resources for the future are not just by-products of the happenstance that generations really do overlap. The tulip-people example illustrates how there can be a difference between what markets tell us to do and the right thing to do. We cannot decide if future benefits of infrastructure investment or environmental protection are worth present costs simply by looking at market rates of return. The distinction between opportunity cost market measures of investment worth and equal standing appraisals would not matter if investments that ranked higher on one scale necessarily ranked higher on the

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Financing Tomorrow's Infrastructure: Challenges and Issues other. This issue would lose most of its force if investments earned a higher rate of return if and only if they yielded more benefits overall, counting future recipients equal to present recipients. Unfortunately, things do not work that way. Consider two investments. One involves giving up $100 billion today in consumption benefits to put in a high-speed communications network that will last for 20 years. A second involves putting that $100 billion sacrifice into new technologies that produce less carbon dioxide, leading to a meaningful reduction of mean global temperatures, but only after 100 years. The first investment may pass an opportunity cost test, while the second one fails, at prevailing market rates. However, if benefits in 20 years and benefits in 100 years are given equal weight, the carbon dioxide abatement investment might win out over the communications network. EQUAL STANDING: ADDING ETHICS TO ECONOMICS The contrast so far between the economic and ethical perspectives on discounting is extreme, largely because a meaningful discount rate eventually means that, at some point, future generations count for very little in current policy calculations. However, the discipline of ethics is not quite so simple. There are some philosophical appeals one could make to support some degree of discounting. Some of these appeals hinge on future generations being much wealthier than the present generation. A number of economists expect future generations to be wealthier, in keeping with historical trends up to the present, because of the greater knowledge that will be available to them. There is speculation on the other side as well, focusing on material resource constraints. If future generations are wealthier, then there is a justification for discounting, according to Professor (and recent Nobel Prize winner) John Harsanyi of the University of California. He offers an ethical theory grounded in the obligation to maximize aggregate utility over time. This framework can support discounting. If people in the future will be wealthier than we are today, a dollar will give them less utility than we get from that dollar. To compensate, we should not give up dollars unless they produce more dollars for them, i.e., we should apply a positive discount rate. Conversely, if one believes that people in the future will be poorer than we are today, a dollar to them is already worth more than a dollar is worth to us. In that case, a negative discount rate would apply, i.e., we should invest on their behalf even if they get less in dollars than we give up. A different and more stark perspective comes from Harvard philosopher John Rawls. His "theory of justice" is derived from a hypothetical

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Financing Tomorrow's Infrastructure: Challenges and Issues scenario in which persons collectively decide, behind a "veil of ignorance," how resources should be allocated over time. The linchpin of his argument is that the individuals making allocations do not know in advance in which generation they will live. Rawls contends that if people do not know where they will end up, they will be averse to risk. Consequently, they will adopt a "maximin" rule to maximize the welfare of the generation least well off. According to the "maximin" rule, we would always adopt investment policies that would make poorer generations better off, regardless of the sacrifice from other generations. If future generations are expected to be poorer than we are, sacrifices may be warranted even if the gains to them are far outweighed by the losses to us. If they are richer, however, we need not give their interests any weight, i.e., we could justifiably adopt an infinite discount rate. A third approach, recognizing perspectives from feminist philosophy, is offered by philosophers Susan Wolf and Martha Nussbaum, who point out that equal standing, however noble in theory, is extreme in practice. Equal standing denies fundamental aspects of what it means to be a person. It is an integral part of our humanity to put our families and friends ahead of strangers. We may put our nation ahead of other nations. We may put generations we know—our children and grandchildren—ahead of generations far enough in the future to be strangers. To deny ourselves the moral right to favor some generations over others undercuts the validity of the specific connections that form our lives, and would turn us into rationalizing machines instead of people. FINAL WORD TO THE PRESENT I would like to close with another observation from Professor Schelling. In talking about discounting, he has noted that we worry a great deal about what we should do for people in the future, but, in the meantime, we do not seem to be worrying nearly as much about poor people in the world today. The conclusion I draw is that we ought to think about our current spatial discount factors—how much we count benefits to people elsewhere in the world, elsewhere in our country, elsewhere in our communities—as opposed to worrying about the huge ethical problem of comparing claims over time. The debate about how to judge the benefits of future infrastructure investment against present costs is important, but it ought not to keep us from recognizing serious problems in the here and now that we should, perhaps, invest in solving as well.

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Financing Tomorrow's Infrastructure: Challenges and Issues DISCUSSION Dr. Bugliarello: This last example from Professor Schelling shows the drift from economics to philosophy because it is basically philosophical. In many cases infrastructure is planned and built with the expectation that demand will increase over time. How does that play into the setting of discounting and ethical considerations? Dr. Brennan: Off the top of my head, that would play in a couple of ways. One, if you think the reason demand is increasing over time is because economies are developing over time, that is an argument for positive discounting because it shows that people will be wealthier. On the other hand, if you think the reason demand for infrastructure is increasing over time is that alternatives are becoming more expensive, then people will be effectively less wealthy without the investment, arguing for a lower discount rate. In either case, an equal standing or an opportunity cost perspective is obviously going to tilt the balance in favor of making the future investment. The mystery about a lot of investments I am familiar with, particularly telecommunications, is that they are so speculative it is hard to know what the costs and benefits will be. This is the fiber-optic argument. I remember a year or so ago hearing a talk endorsing spending the hundreds of billions it would take to put in a fiber-optic telecommunications infrastructure. The speaker, Henry Geller, quite self-consciously gave the field of dreams argument for it, "If you build it, they will come." At lease Henry was honest, and I give him credit for that. Some people make grand claims about what people are going to do when, in fact, they do not know. He said, "Look, I don't know what they are going to do, but I think it is worth building anyhow." How you defend that judgment to the taxpayers, rate payers, or whoever is picking up the tab, I am not exactly sure, but I admire his candor. Participant: We all assume that in the future telecommunications will have a significant impact on the way we live and where we live, which in turn may have some impact on the kind of support infrastructure we need to provide for the future population. Do you have any observations on the economics of that scenario? Dr. Brennan: I do not have any profound factual observations, but there are two arguments, one inside and one outside economics, that deal with it. The one within economics is that it is like boosting demand, and if you happen to have information to make judgments about the costs, you can at least conceptualize it.

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Financing Tomorrow's Infrastructure: Challenges and Issues The harder argument is that economic arguments and, to a large extent, philosophical arguments take people as a given. When that assumption is not true, economic arguments fall apart because things are judged against the demands of people. If you think something is going to change, not just in the sense of being more valuable but actually changing what people want and, in a very real sense, who they are, as economists define identity, then you are trying to measure benefits and costs with an elastic yard-stick. You have to look outside economics to make those kinds of judgments. What do you do if a decision affects who people are, their numbers, and so on? Are we better off in a world with fewer people who are wealthier, on average, or more people, who are poorer? The frameworks we are most comfortable with talk about fixed sets of people. When we're dealing with things that have effects on population patterns, for example, fundamental questions or conceptions we use to address them do not seem to work very well. How would you evaluate building an infrastructure one way if it means one set of people is going to be alive and reap the benefits and that they would not be the same people who would exist if we built it another way? As a result of infrastructures, people move, people meet each other, people are born. In what sense would we be depriving one set of people who are not very well off by building one way when they might not be around at all if we built another way? How do we make those kinds of comparisons? I could go into some of the very thorny examples and paradoxes philosophers have identified in thinking about these questions, but it would not really tell you a whole lot about how to solve these puzzles. Participant: How would changing governmental accounting affect this argument? Dr. Brennan: Do you mean whether or not we count capital expenditure as part of the deficit? I do not think it would affect my overall argument, other than in the indirect feedback effects on resource flows, primarily through fiscal discipline. If you think that, for a variety of reasons, it would make sense to have fairly substantial budget deficits or that we should not shrink them very much, then changing to an accounting system where deficits are viewed as less threatening than they are now, by and large, would be a good idea. I am not sure that it has a direct real effect, however, because the important factors are not money flows but resource flows. To get a real effect, you have to trace the accounting effect to a resource flow. The main response I want to leave you with is that accounting practice is not likely to have an instantaneous, simple, breakthrough effect on infrastructure investment and budgeting policy.