Date created: 28 November 1996
Last modified: 18 November 1997

Maintained by: John Quiggin
John Quiggin

Why selling assets will not pay

Australian Financial Review

Aug 29, 1994

Recent comments by members of the ALP Left have reopened an issue that has been debated in various forms, at every level of government in Australia. Should new government expenditure be financed by higher taxes or by the sale of assets ?

This apparent choice is illusory. Selling assets may reduce the measured budget deficit and the level of gross public debt, but it does not, in general, yield any net income to the government. This is because the savings in public debt interest is offset by the loss of the earnings that would have accrued from the asset. In present value terms we would normally expect the two to roughly cancel out. This means that if the government used the asset sale to pay off debt, the interest savings would be about equal to the earnings foregone. Hence, from an economic viewpoint, the sale makes no difference. However, the government can report an improvement in the budget deficit in the year of sale.

If the asset to be sold lies outside the Budget sector there is another illusory source of benefit. Government business enterprises (GBEs) normally remit only part of their profits as dividends, retaining the rest to finance new investment. The standard rule is that 50 per cent of profits should be remitted. Hence, an asset sale represents a transfer from the GBE sector to the budget sector. As long as the sale price is more than 50 per cent of the present value of the flow of profits, the budget deficit will show a permanent improvement. Not only will the asset value be added to revenue in the year of sale, but the savings in public debt interest will be greater than the flow of dividends foregone. However, assuming that the asset is sold for a price equal to the present value of future earnings, correct accounting on a whole-of-government basis would show no net effect.

In fact, the assumption that the asset sale will return a price equal to the present value of future earnings is over-optimistic for two reasons. First, for reasons that are not entirely clear, the rate of return required by holders of equity has historically been far above the rate of return required by holders of high-quality debt. (Economists refer to this as the 'equity premium puzzle'). The result is that the discount rate used by stockmarkets in evaluating the expected flow of returns from a privatised asset may be much higher than the government's cost of funds. So the interest savings gained from the asset sale may be less than the value of earnings foregone.

The second problem relates to the political incentives involved in pricing an enterprise for flotation (or, in the case of sale by tender, in deciding whether to accept the best offer). Particularly in situations where privatisation is a controversial policy, there are substantial political costs in a float that is undersubscribed or a tender process that ends in failure. In a situation where the market value of the enterprise is unclear, the political calculus favors underpricing.

Evidence from the UK suggests that underpricing has been the rule, particularly in the case of public floats. The majority of issues were oversubscribed (sometimes 20 or 30-fold), with prices on the first day of trading exceeding the offer price by as much as 85 per cent. Similarly, the initial float of shares in the Commonwealth bank was at a price that yielded substantial gains to purchasers. When the second tranche of shares was sold, the market price was observable and the offer price was very close to the market price (since the shares subsequently declined in value, purchasers made substantial capital losses).

The question of asset sales is a diversion from the real issues relating to the balance between private and public sectors. Currently the government is responsible for the provision of services in precisely those areas of the economy where demand can be expected to grow most strongly in the future - health, education, law and order, the environment and other directly provided services. Over the past ten years, it has tried its best to squeeze funding in these areas. Although there are no doubt some efficiencies remaining to be realised, the ultimate bankruptcy of this policy is evident. The inadequacy of current public provision in these areas is now, along with unemployment, the major political concern of the Australian public.

If public provision is not to be expanded, the only alternative is a move to individual purchase of health, education and other services. The government has made some limited steps in this direction in regard to education, such as the introduction of HECS, but there does not appear to much scope for further movement in this direction. In the case of health care, the difficulties the government has encountered in even holding the private contribution constant, and the dreadful example of the US, suggest that large-scale privatisation is unlikely to be a sustainable option. With the abandonment of the Opposition's commitment to scrap Medicare, neither party has a plausible program to generate substantial private contributions to the funding of community services. At the same time, the bipartisan commitment to ever lower tax scales means that neither party can explain how to fund the necessary increase in services.

In the long term, there are only two alternatives if the demand for services is to be met. Either taxes must be raised, or the private contribution to the provision of services must be drastically increased. This, and not the question of who should own our airports, is the real issue facing the Australian public.

John Quiggin is Professor of Economics at James Cook University and author of Great Expectations: Microeconomic reform and Australia, published by Allen & Unwin.

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