The Choice of Discount Rate Applicable to Government Resource Use

Theory and Limitations

by James P. Quirk, Katsuaki Terasawa

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This report presents a review of theories of the social discount rate, identifying the sources of divergent views and limitations of the theories in actual application. The question of the optimal discount rate to use in evaluating government projects has been debated in the economic literature since the late 1950s. The authors suggest that the discount rate be used as a filter rather than a device to achieve the desired level of government spending. Adopting this approach implies the choice of a discount rate that is in principle computable from existing data, with government budget limits acting as an effective constraint on government investment spending. Risk, flexibility, and data manipulability are considered. The approach is based purely on efficiency grounds and thus does not require information on the social rate of time preference. It does not address important equity issues, which the authors believe can be better resolved outside the framework of cost-benefit analysis.

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