Tax

Just as investors require a return that compensates for inflationary effects, they also require a return that compensates for any tax payable on the return. At the investor level, there is an extensive array of taxes on investments with different marginal tax rates and structures for different investors, different investments and different countries. The return observed in the marketplace therefore must represent an aggregate after-tax rate required by investors on average.

At a corporate level, some forms of capital are tax deductible to some investors. For example, franking credits are available to Australian resident investors under a regime that takes into account company tax paid on profits so as to avoid double taxation

For public sector projects, exactly the opposite approach is taken. Applying pre-tax discount rates to public sector cash flows (which are also tax-free) ensures that public sector projects are assessed on a neutral basis relative to private sector projects.

Government projects usurp capital that would otherwise be available to private sector projects upon which corporate taxes would have to be paid. Therefore, to ensure efficient allocation of resources between the public and private sectors, the appropriate public sector discount rate must incorporate the same tax wedge as would apply to the marginal private sector project.

This is achieved by valuing pre-tax cash flows at a pre-tax discount rate. The use of a pre-tax discount rate with pre-tax cash flows automatically removes any advantage the Government may have from being tax-exempt. This ensures that projects are assessed in a manner that does not distort investment decisions between public sector and private sector projects. The same methodology applies to the PSC as a reference project.