34: Closing the GAAP
Capital budgeting for governments
The problem: bad public accounts
Unlike businesses, governments do not commonly separate out their capital expenditures from their current expenditures. This means that the demands of current spending (eg on wages) often eclipse the need to replace or upgrade state assets and infrastructure - leading to crumbling roads, schools, and hospitals. At the same time, departments holding on to assets that are no longer needed face no budgetary pressure to sell them and find an alternative use for the money. And governments have some enormous liabilities - such as future state pension obligations - that never seem to show up in their accounts.
The idea: capital budgeting
Generally Accepted Accounting Principles (GAAP) are adopted by businesses worldwide. GAAP accounts include a balance sheet which reveals the size of the business's asset base, and changes in it. Governments sometimes insist on GAAP when business accounts are lodged for public inspection: why should they not require the same of themselves - adopting the same principles to give themselves a truer financial basis on which to make budget decisions?
Example: Kiwi accounting
New Zealand's 1989 Finance Act did exactly this, switching from cash accounting to accrual accounting, based on GAAP, for budgeting and management purposes. All government departments were required to produce annual accounts on GAAP principles, including statements of objectives, operations and performance, a balance sheet, and a cash flow statement - the first comprehensive accrual-based accounting system of any government in the world.
Accrual accounting is more complete than cash accounting because it tracks assets and liabilities and records changes in their value; it records non-cash expenses; it includes the value of debts outstanding and receivables yet to come in; it reports the value of assets such as offices and public infrastructure; and it records the value of non-cash liabilities like future pension benefits.
The 1989 Act also instituted a capital charge system. Twice yearly, a capital charge is levied on each department, based on the total value of departmental assets and the average interest rate on long-term government debt. This creates a strong incentive for departmental executives to reduce their unnecessary asset holdings. Should a ministry keep paying out each year for its expensive offices, for example, or should it move to a more modest location and use the money in better ways?
Selling the family silver?
The capital budgeting idea pioneered by New Zealand has now spread to many other countries.
In the mid-1980s, for example, managers in the United Kingdom's National Health Service were faced with capital charges for the clinics, hospitals, land and other assets which they use. Managers therefore had to start looking critically at their asset portfolios and try to see whether assets could be used with enough productivity to justify the annual charge, or whether they should be sold or rationalized. Some brought in professional estate-management consultancies to help them,or entered into joint-venture deals with private consortia to extract more value from their asset portfolios (see the chapter Prime Property).
This same principle has since been extended into other UK government bodies. A National Asset Register of all government assets has been compiled, and departments are penalized if they hold assets that do not produce a return.
Indeed, in October 2001 - despite press jibes that it was 'selling the family silver' - the UK Treasury itself decided to auction six lots of rare seventeenth-century silver candlesticks and snuffers, originally made for William of Orange's Privy Council members. A spokesperson explained: 'The object is to realize all assets that are locked away unproductively so that their value can be used for better purposes.' But this was a sale too far for public opinion, and eventually the Treasury decided to donate these important heritage assets to national museums.
Capital budgeting has also revealed the true and rather worrying size of the future pension liabilities that have been incurred by various European countries. While state pension costs are normally accounted as a historic annual outflow, the capital accounting techniques observes that future pension promises have their price. Calculating that future cost and bringing it home in capital accounts may make politicians less reckless when it comes to raising current benefits and hoping that some future generation will simply pay up, because the scale of the burden on future generations becomes clearer.
The results: firm basis for prosperity
The switch from cash to accrual accounting may sound only technical, but it is a necessary precondition for identifying inefficiencies, managing capital budgets properly, and ensuring that taxpayer-owned assets are put to their best use.
Thus the accounts for 1992/93 revealed the very disagreeable, but previously hidden fact, that the New Zealand government was literally bankrupt, with a negative net worth of nearly NZ$7 billion. This revelation helped to force policy changes to reverse the position.
Meanwhile the capital charge system has made department and agency chief executives much more critically aware of the value of the assets they use, and has produced some restructuring and much more careful appraisal of new capital projects.
This effect was summed up by New Zealand ambassador to the US, John Wood:
"At the Ambassador's residence, the foreign ministry owns a number of paintings by New Zealand painters which were purchased 20 years ago for a very modest sum. These have now appreciated to where their capital value is several hundred thousand dollars. Being faced with paying a twice-yearly capital charge on this capital value certainly sharpens my decision-making as to whether I would rather spend some thousands of dollars each year to have these works of art on the wall, or whether we might not be better off selling the paintings and using our resources elsewhere."
In the UK, the principle of capital accounting has produced the same, more focused, appraisal of assets by public-service managers as it has in New Zealand: and indeed this has led on to yet a further stage. Some government departments, including the work and welfare and taxing departments, have actually decided to outsource the management of their land and buildings portfolio to private companies which they believe can manage it more productively.
One mischievous economist, Gabriel Stein, has even used GAAP principles to show that, if the real liabilities of future state pension benefits were shown on government's books, most EU countries would be clearly bankrupt!
So first came the focus on how public assets are used: that led to an appreciation of the need to improve: which in turn led to this highly innovative approach to dealing with it. The result? Better-maintained and managed capital assets, and a better deal for the taxpayer.
For further information:
- O'Quinn, Robert and Ashford, Nigel (1996) The Kiwi Effect (download PDF 89kb): Adam Smith Institute (London) www.adamsmith.org.
- Stein, Gabriel (1997) Mounting Debts: The Coming European Pension Crisis: Politeia (London).
Copyright 2002: Adam Smith Institute
Created and Maintained by: Cyberpoint Limited