Unfounded liability

by Stubborn Mule on 20 May 2013 · 6 comments

Today a tweet from “Australia’s most idiosyncratic economist” Christopher Joye caught my eye. I followed the link and found a scaremongering article trying to whip up concerns about Australia’s levels of government debt.

cjoye tweet

A key part of Joye’s argument is to accuse the government of creative accounting by including Future Fund assets in the calculation of net debt. Carving out these assets, along with some other tactics, leads him to assert that the true size of the government’s debt is around 40% not 11% of GDP. But it is Joye’s accounting that is flawed, not the government’s.

Joye’s argument centres on the notion that government pension obligations to public sector employees constitute an “unfunded liability”. Unlike other liabilities, i.e. government bonds, this liability is not included in the calculation of the government’s debt, thereby understating it. To remedy this, Joye argues that the calculation can be corrected by noting that the Future Fund was created with the precise purpose of funding these liabilities, so excluding them from the net debt calculation addresses the omission of the unfunded pension liabilities.

Superficially, this argument can sound plausible. But, closer scrutiny shows that Joye is cherry-picking to distort the numbers.

Analogies between government and household finances can be dangerous, but I will cautiously draw one here to illustrate the point. Imagine a family with a $300,000 house financed with a $200,000 mortgage, a net asset position of $100,000. Over time, the family works to save and pay down the mortgage. But they also want their daughter to attend a private high school and have been putting money aside into a saving fund to be able to afford the fees. A few years later, the debt has been paid down to $175,000 and they have put $25,000 into the school fund. So how does the family balance sheet look now? Assuming that property prices are unchanged, the family has assets of $325,000 (house and saving fund) and a debt of $175,00, so net assets of $150,000.

Not so fast, Christopher would argue! Those school fees are an unfunded liability! Since the school fund is there solely to fund that liability, it should be excluded, so the family only has assets of $125,000.

It’s nonsense of course. A commitment to pay pensions (or school fees) is a liability of sorts, in that in entails a commitment to making payments in the future. But why stop there? The government is also committed to making welfare payments, so there’s another unfunded liability. We can ignore the baby bonus, as that’s likely to be eliminated, but the government has a whole range of commitments for future payments.

But that ignores all the sources of future receipts for the government. If public pensions are an unfunded liability, what about the unfunded asset represented by all future income tax receipts? Corporate taxes provide another solid income stream, not factored into the governments assets.

The family’s school fees are a liability of sorts, but their capacity to earn income into the future effectively provides an even greater asset. Both are uncertain, which is why accountants stick to financial assets, like loans, bonds and deposits or even stocks, land or houses, all of which have a relatively clear value today and, more importantly, can be bought or sold for figures very close to those assessed values.

Christopher Joye drastically overstated the government’s net debt position by factoring in future government payments and ignoring future government receipts. As the less “idiosyncratic” economist Stephen Koukoulas eloquently put it:

This is like painting a red dot on a daddy long legs and telling people it is a redback spider.

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{ 6 comments… read them below or add one }

1 Whatsinitforme? May 21, 2013 at 1:09 pm

Not sure i agree with your analogies as I think the issue is a little trickier.

The liability arises when I work, not when I receive the benefit – it is an unconditional entitlement of mine s the employee.

Welfare payments are subject to an “eligibility” test – thus there is no commitment.

Mule – being the securitisation expert that you once were, I would suggest that if you can securitise then you should account. That is to say if someone is willing to buy a future commitment today it should be treated as an asset/ liability in present value terms.

2 Ken May 21, 2013 at 6:32 pm

Eventually we will pay more tax, public servants will have lower incomes, and have the pleasure of watching retired public servants have a good time. One of the problems is that in the past there was a new group of public servants to fund the unfunded liabilities. Now they have funded super schemes. Like most things we will solve it by borrowing more.

3 Stubborn Mule May 21, 2013 at 9:00 pm

@Whatsinitforme? I am not denying that the pensions are a stronger commitment (albeit one that a future government has the power to alter) than the school fees, but on the asset side, tax is a binding legal commitment too (again one that the government could alter). Just because there is an obligation does not automatically mean it should be accounted for as a on balance sheet asset/liability (although Enron tried it). But even if one does want to go down that route, a consistent approach should be adopted, looking at both payment and receipt commitments.

The securitisation point is an interesting one, although generally I think that there has been far less securitisation of liabilities than of assets (catastrophe bonds being the only example that I can think of fitting into the former). In fact, I suspect it would be easier for the government to securitise some of its unrecognised assets (think selling taxation rights to the Sheriff of Nottingham) than it would be to securitise pension liabilities.

4 Peter Whitteford May 22, 2013 at 1:09 pm

Just about everything the government does is unfunded (Defence forces, education, health etc), so the reason for picking out public servant’s pensions are not clear to me. There would be a lot of angst, but the government can change these pensions in exactly the same way that it changes the age pension, e.g. by increasing the pension age, changing indexation etc.

I agree with the post that if you want to account for future liabilities, you also need to consider future income streams.

5 zebra May 30, 2013 at 2:57 pm

I got the impression, from your analogy, that what he was saying was not so much to add in the unfunded liabilities that the future fund is set up for but not to offset other sorts of debt by the assets already in the future fund. So if the expected cost of paying for their daughters education is say $100k there are 4 possibilities.
1. ignore the education fund, assets and liabilities, and just say the family has (house) asset=$300k and (mortgage) liability = $175k so net assets = $125k (Joye’s position)
2. include the assets in the education fund but ignore unfunded liabilities so assets (house+fund) = $325k and liabilities=$175k so net assets = $150k (Govt’s position)
3. estimate the education liabilities as $100k. So net asset position =$325k and liabilites=$275k so net assets = $50k.
4. not set up an education fund but pay an extra $20k off the mortgage, so assets = $300k, liabilities=$150k so net position=$150k, same as in scenario 2.

I suspect the equivalence of (2) and (4) is why the government (or in reality Treasury) treats the assets of the future fund, but not the liabilities, the way they do. Otherwise they would be penalised for setting up the future fund, in terms of reported Debt/GDP ratio, and unfunded pension liabilities would only be considered for inclusion if some swivel-eyed loon suggested all future Government liabilities be accounted for.

6 zebra May 30, 2013 at 3:13 pm

@whatsinitforgary – unlike the legal obligation of a company to pay pension liabilities , the government has no legal obligation to provide pensions, or, at what level. If the government decided to scrap pensions altogether nobody can sue them for breach of promise (imagine if people could sue governments for breach of promise, hah!!!!). They are also subject to a means test.
But on the issue of securitisation, future tax payments are a government asset so I can’t see why either:
(i) companies can buy their future tax liability (in part or whole) essentially prepaying tax with the government wearing the payment risk (actual vs expected payments) so that companies would pay a premium to do this.
(ii) the government doesn’t securitise its future tax income.

Either of these would immediately solve all the current governments budget “black hole”, after all it’s is not that different than issuing government debt is it?

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