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Discount rates are widely used in the public sector to assess policy proposals where costs and benefits accrue over long time periods. Socially optimal policy choices require an appropriate choice of discount rate. This paper assesses the applicability of the two key theoretical approaches to selecting discount rates in the public sector. The two key theoretical approaches considered are the social rate of time preference and the social opportunity cost. Estimation issues in determining the rate using these two approaches are reviewed. The social rate of time preference is considered to be the appropriate approach. When estimates of the social rate of time preference are unavailable or clearly unreliable and the Government is considering financing a project, the social opportunity cost should be used. The social opportunity cost can be used as a proxy for the social rate of time preference. The paper presents an example using the capital asset pricing model in a weighted average cost of capital formula to determine a social opportunity cost.
Thanks to Felicity Barker for the suggestion to write a paper on this topic. Also I would like to acknowledge the time taken to discuss the issues and provide comments on the paper by Rienk Asscher, Felicity Barker, John Creedy, Andrew Thompson, Mark Fleming, Dieter Katz, Chris Pinfield, Peter Wilson, Iain Cossair, Len Staling, Inna Koning, Nick Mays, Catherine Rozendaal, and Frederic Sautet. I would like to thank Eithne Barry, Andrew Turner, Heather Kirkham and Matthew Bell for assistance in providing data.
The views expressed in this Working Paper are those of the author(s) and do not necessarily reflect the views of the New Zealand Treasury. The paper is presented not as policy, but with a view to inform and stimulate wider debate.