The welfare-maximizing discount rate in a small open economy

The controversy about what approach is best for calculating the social discount rate for public investments is both long standing and heated. Two main approaches are the social time preference and the social opportunity cost approaches. Complicating issues are tax wedges, the question of whether public investments crowd out current private consumption or private saving, and the possibility of myopic behavior among individuals. This study uses a model that takes these issues into account to derive the discount rate that optimizes welfare in a small open economy. The result is that even if individuals have behavioral preferences differing from the normative preferences of the social planner and even if tax wedges exist, the optimal discount rate is the pre-tax market return on capital, as long as individuals are forward looking and consistent in their behavioral preferences, and their choices are not constrained by, for example, liquidity restrictions.