<p>For instance, does the compiler know to translate</p>

<pre><code>string s = "test " + "this " + "function";
</code></pre>

<p>to</p>

<pre><code>string s = "test this function";
</code></pre>

<p>and thus avoid the performance hit with the string concatenation?</p>

Yes. This is guaranteed by the C# specification. It's in section 7.18 (of the C# 3.0 spec):
Whenever an expression fulfills the
  requirements listed above, the
  expression is evaluated at
  compile-time. This is true even if the
  expression is a sub-expression of a
  larger expression that contains
  non-constant constructs.
(The "requirements listed above" include the + operator applied to two constant expressions.)
See also
this question
.