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This version 25 February 1997
Privatisation: what to count?
Department of Economics
James Cook University
Published as: Quiggin, J. (1997), 'Privatisation: what to count?', Australian Accountant 18-9 April.
Accounting for privatisation
The policy of privatisation has been very popular with Australian governments in recent years. Privatisation may be undertaken for a number of reasons. Some governments, have an ideological preference for private ownership. Privatisation may be undertaken to remove particular areas of service provision, such as water supply, from the political responsibilities of governments. In some instances, privatisation has been seen as a way of weakening the power of public sector unions. In the Australian case, however, policies of privatisation have been adopted primarily on the basis of accounting considerations.
Initially, governments saw privatisation as a method of raising revenue without the pain of increasing taxes. This naive approach appears to have been the main basis on which the Hawke government adopted policies of privatisation. Hawke (1994, p. 391) says:
When it came to privatisation, Brian [Howe] was able to argue that one dollar simply could not do two jobs. Putting a dollar of equity into the running of an airline was paid at the expense of programs for the unemployed or the single mother.
A second case for privatisation has been based on the use of the sale proceeds arising from privatisation to reduce public debt. A common practice in accounting for the costs and benefits of privatisation has been to compare the interest savings arising from debt repayments with the flow of dividends foregone as a result of privatisation. This approach was used by the Department of Finance in its analysis of the proposed partial privatisation of Telstra.
A third accounting motive arises from a view that public sector enterprises should have a capital structure similar to that of private enterprises and should be valued in the same way. Typically this implies that privatisation neither increases nor reduces the net wealth of the public sector. Under this view, the benefit of privatisation is the elimination of unnecessary public exposure to the risk associated with equity holdings.
In this paper, it will be argued that the first and second cases for privatisation are based on simple accounting fallacies. Analysis of the third case for privatisation depends on whether risk is best handled in the public or the private sector. There is no simple answer to this question. Some risks are best handled by government and others by private firms and individuals. Hence, privatisation will be beneficial in some cases and not in others.
The current and capital accounts
In terms of the standard budgetary accounting conventions, the case for privatisation of government business enterprises appears unanswerable. The whole of the sale price of the asset concerned is recorded as an offset against outlays (or, in some jurisdictions as revenue). This analysis reflects the generally defective nature of the budget deficit as a measure of public saving. The budget deficit is simply a measure of cash flow and is confined to the 'budget sector'.
The fact that the budget is a cash flow measure means that capital and current expenditures are lumped together. Similarly asset sales from within the budget sector are treated as current income (or, in some budget systems, as an offset against current expenditure). Thus, the budget deficit is useful as a measure of public saving only if the level of net public investment (new investment less asset sales) is essentially constant.
Further difficulties arise from the division of the public sector into budget and non-budget components. Government business enterprises lie outside the budget sector, and are disregarded altogether in the budget statement unless they are sold or remit dividend payments to the government. Transfers between the budget and nonbudget sectors are essentially irrelevant in measuring public savings. Thus, for example, the claim that an equity injection into Qantas is made at the expense of current expenditure on programs for the unemployed reflects a confusion of categories.
The fallacy of treating the proceeds of asset sales as current income has now been widely recognised. One response has been a focus on 'underlying' measures of the budget deficit or surplus, which exclude the effects of asset sales. A more comprehensive response has been the move in some jurisdictions to accrual accounting. Accrual accounting solves the problem of the confusion between current and capital expenditure, but raises new conceptual and practical difficulties, some of which were discussed in the report of the Commonwealth Commission of Audit.
Public debt interest, dividend income and reinvested profits
The confusion between current and capital income may be avoided by comparing the flow of interest savings arising from privatisation with the flow of earnings the enterprise would have generated if retained in public ownership. Unfortunately, confusion arises from the distinction in public accounts between the budget and non-budget sectors. Interest on public debt is regarded as part of general government expenditure and therefore appears in the budget. By contrast, the earnings of government business enterprises accrue to the non-budget sector. Only the component of earnings paid out as dividends appears in the budget. As a result, many analysts have compared the flow of interest savings arising from privatisation with the flow of dividends flowing to the Budget sector. This would be an error in the valuation of a privately owned enterprise and, for just the same reason, it is an error in the valuation of a government business enterprise.
A fundamental proposition in the theory of finance is the proposition, due to Modigliani and Miller, that, apart from tax considerations, the value of a company depends only on its current and future earnings and not on its dividend policy. Giving evidence on the proposed sale of Telstra, the Department of Finance witness professed ignorance of this proposition, and implied that it had little relevance to the real world. The Department's position is defended on the basis of fallacies that were refuted decades ago, such as the view that retained earnings are 'locked up' and therefore of no value. This claim is erroneous since reinvested earnings will generate a higher stream of income in the future, and are just as valuable as dividends.
A further difficulty arises in the presence of inflation. In most cases, the earnings of government business enterprises can be expected to grow at least in line with inflation. It is therefore inappropriate to compare current earnings with the saving in nominal interest payments associated with repayment of debt. More appropriate procedures are to compute a present value of a projected stream of earnings or to exclude the nominal component of interest in a comparison with current earnings.
The treatment of risk
A comparison between the expected flow of earnings from a government business enterprise and the interest saving that could be achieved through privatisation is based on the implicit assumption that governments are, or should be, in a position to disregard the fact that flows of earnings are risky and variable. There are strong reasons for arguing that this should be the case. The taxing power of government and the fact that all Australian governments have high credit ratings mean that governments are in a strong position to deal with fluctuations in income over time and to spread risk across the entire community. Calculations based on standard economic assumptions suggest that any premium for the pure risk associated with government holdings of equity should be very small.
However, in the presence of perfectly efficient capital markets, the same calculations should apply to the valuation of private enterprise by the stock market, whereas in reality, the risk premium associated with privately held equity is quite large. The gap between theoretical estimates and the observed premium is referred to by economists as the 'equity premium puzzle'.
Advocates of privatisation have normally disregarded these issues and have argued that the risk associated with publicly owned enterprises should be valued in the same way as if the enterprises were privately owned. In this case, if efficiency is unchanged, privatisation makes no difference to the value of the enterprise. An alternative view is that the equity premium reflects the costs of financial market transactions and is not applicable to publicly owned enterprises. On this view, privatisation will result in a loss of public sector net worth, unless the new owners are able to achieve efficiency gains impossible under public ownership, and these gains are sufficient to offset the higher risk premium required under private ownership.
The relative efficiency of public and private ownership will also depend, in large measure, on the allocation of risk. If the risks faced by an enterprise relate primarily to possible changes in public policy, efficiency will be best served by retaining the enterprise in public ownership. If the risks are mainly to do with operational costs, private ownership will normally generate efficiency gains that may be sufficient to offset the higher private costs of capital.
The case for privatisation in Australia has been based, in large measure, on accounting fallacies. Advocates of privatisation have confused capital and current income and have focused on flows of dividends rather than flows of earnings. When these errors are corrected, the analysis of privatisation depends in large measure on the appropriate way of accounting for risk. The general issue of how to interpret the high risk premium for private equity remains unresolved. In specific enterprises, the efficiency or otherwise of privatisation will depend on the appropriate allocation of risk between the public and private sectors, and this will depend on the sources of risk faced by the enterprise. Privatisation must, therefore, be assessed on a case by case basis.
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