Introduction

The concept of the shadow price of capital was developed in the context of the debate over the appropriate rate of discount for use in the economic evaluation of public projects and programs. However, the concept and the magnitude of the shadow price of capital have important implications not only for evaluating the cost and benefits of public investments but also for evaluating the opportunity cost of any public expenditure whether it be for public investment, public consumption of goods and services, publicly financed transfer payments, or programs in the private sector mandated by the government, such as pollution control. Furthermore, using the concept of the shadow price of capital, it can easily be shown that the opportunity cost of these programs depends critically on how they are financed and on the nature and rate structure of the tax system. Similarly, the concept of the shadow price of capital can be used to provide a first-order estimate of the burden of the debt and has important implications for tax policy and tax reform.

In this chapter, we develop the concept of the shadow price of capital and compute its values under varying assumptions about tax and savings rates. We then use these results to analyze the opportunity cost of public programs and the cost of “crowding out” private investment, to analyze the burden of the debt, and finally, to explore some implications for tax reform.