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Lecture Notes ECON 437/837: ECONOMIC COST-BENEFIT ANALYSIS Lecture Four. Economic Opportunity Cost of Capital. The economic opportunity cost of capital (EOCK) reflects the real rate of return forgone in the economy when resources are shifted out of the capital market.
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ECON 437/837: ECONOMIC COST-BENEFIT ANALYSIS
In a Closed Economy
The economic opportunity cost of capital (ie) is a weighted average of the rate of time preference for consumption (r) and the gross-of-tax rate of return on private investment ():
When the weights are expressed in terms of elasticities of demand and supply of funds with respect to changes in interest rates, the economic opportunity cost of capital ie can then be defined:
The above supply and demand elasticities can be considered as an aggregate elasticity that may be decomposed by the types of savers and by the groups of investors.
isis the supply elasticity of the ith group of savers, and (Si/ST) is the proportion of total savings supplied by this group;
jI is the demand elasticity for the jth group of investors, and (Ij/IT) is the proportion of the total investment demanded by this group.
To obtain the rate of return on private investment (), estimate the gross-of-tax return to the domestic investment from the national accounts or firm-level data.
In an Open Economy
So equation becomes:
is the required real net of withholding tax that foreign (international) investors require for investing in country i.
If tw increases, this will cause rf to increase not to fall.
The weights can be expressed in terms of elasticities of demand and supply:
sh is the supply elasticity of household savings, sf is the supply elasticity of foreign funds,
St is the total savings available in the economy, of which Sh is the contribution to the total savings by households, and Sf is the total contribution of net foreign capital inflows,
is the elasticity of demand for capital relative to changes in the interest rate.
in South Africa
Parameters for Estimating Return to Domestic Investment in South Africa (2001 prices)
Calculations of Gross of Tax Return to Domestic Investment for 2004
Return to Capital = GDP – Total Labor Income – VAT – (0.95*1/3*GVA in Agriculture) – ((Total Labor Income / (GDP – Taxes on Products + Subsidies)) * ((Taxes on Products – VAT) – Resource Rents – Depreciation)
Return to Capital = 1,374,476 – 676,231 – 80,682 – (0.95 * 1/3 * 41,323) – (676,231 / (1,374,476 – 146,738 + 2,671) )* (146,738 – 80,682) – 23,377 – 172,394 = 372,402
Real Return to Capital = Return to Capital * (GDP Def2000 / GDP Def2004)
= 372,402 * (100 / 131.39) = 283,428
Percentage Rate of Return = Real Return to Capital / Capital Stock
= 283, 428 / 1,656,231 = 17.11%
Parameters for Estimating Return to Domestic Savings in South Africa (2001 prices)
Calculations of Net of Tax Return to the Newly Stimulated Savings for 2004
Return to Domestic Savings = GDP – Total Labor Income – Taxes on Products – (0.95*1/3*GVA in Agriculture) – Resource Rents – Depreciations – Income & Wealth Taxes paid by Corp. – (Income & Wealth Taxes paid by Housholds) * (Property Income Received by Housholds) / (Wages & Salaries Received by Housholds + Property Income Received by Housholds) – (Value Added in FIs, Real Estates*0.5*0.5)
Return to Domestic Savings = 1,374,476 – 676,231 – 146,738 – (0.95*1/3*41,323) – 23,377 – 172,394 – 75,343 – (108,628 * ((305,088 / (618,215 + 305,088))) – 247,514 * 0.5 *0.5= 169,534
Real Return to Domestic Savings = Return to Domestic savings * (GDP Def2000 / GDP Def2004)
= 169,534 * (100 / 131.39) = 129,029
Percentage Rate of Return to Domestic Savings = Real Return to Domestic Savings / Capital Stock
= 129,029 / 1,656,231 = 7.79%
- Treasury Board, Benefit Cost Analysis Guide,1976
- Debates, Burgess vs Jenkins, Canadian Public Policy, 1981
- Treasury Board, Benefit Cost Analysis Guide,1998
- PCO, Social Discount Rates, 2007
- Queen’s University, JDI, 2010