Discounting in Cost-benefit Analysis

There is much disagreement about the discount rate. The prescriptive approach derives the discount rate from utility functions, growth models and ethical considerations. The descriptive approach stresses the opportunity cost of capital, but struggles to define which market rates to average. Both use social (shadow) discount rates to compensate for capital market distortions. Others propose discount rates declining through time. This paper argues that it is wrong to use shadow discount rates because they cannot ensure the efficient allocation of public funds nor correct for capital market distortions. Instead the marginal cost of public sector funds should be used for discounting and the shadow price of capital should be used to adjust for distortions. No other discount rate will lead to correct cost-benefit analysis results. This paper argues that discounting and inter-temporal distribution weighting are not equivalent, and that the former is required for correct cost-benefit analysis results. It argues further that discount rates should not be declining; and that the requirements for robustness of conclusions and the partial equilibrium nature of cost-benefit analysis limit the scope of its applicability.