Public accounting for public accountability

In a typical modern nation-state, the public sector accounts for a larger share of economic activity than any other economic actor.

In 2021, general government primary expenditure for the G7 member states ranged from 39.41% of GDP in the United States to 57.66% of GDP in France. Successful emerging-market economies – such as India (24.93% of GDP) and the People’s Republic of China (31.8% of GDP) – are set to follow the same pattern.

Given this, reliable and transparent public-sector accounting is essential to proper economic governance and management.

Governments impose rigorous demands on private entities to provide accrual-basis accounting, according to International Financial Reporting Standards (IFRS) or Generally Accepted Accounting Principles (GAAP). This includes the production of an audited balance sheet, which includes all financial and real assets and liabilities that define conventional net worth.

One might assume that governments hold themselves to similar standards, adhering to, say, the International Public Sector Accounting Standards (IPSAS), the obvious choice). But most governments fall far short of these standards, and only New Zealand uses the IPSAS as the basis for its financial-management system.

Instead, the accounts produced by the public sector focus on short- and medium-term cash flows – the general government budget deficit is a prime example – and on a subset of the public sector’s contractual liabilities, typically its gross or net financial debt. As my co-authors and I show in a forthcoming book, Public Net Worth: Accounting, Government, and Democracy, this approach is deeply flawed – with far-reaching implications for economic management.

For starters, governments often base their fiscal rules on narrow debt and deficit measures. In the European Union, for example, member states pledge to keep their debts below 60% of annual GDP, and their deficits below 3% of GDP.

This does not make economic sense. Debt measures typically ignore most assets – notably, the public sector’s real commercial assets – and some significant liabilities, including the present discounted value of public-sector pension entitlements. And deficit measures fail to distinguish between debt issuance that finances current expenditure, and deficits incurred to fund capital expenditure that yields future cash flows.

The figures associated with the missing assets and liabilities can be massive. In the 24 countries for which the International Monetary Fund provides updated databases for 2020-21, public-sector assets range from 88% of GDP to over 800%. (The latter figure reflects Mongolia’s mineral and energy resources.)

But these are statistical estimates, not the product of accrual-based accounting systems. Fixed assets – largely infrastructure – range from 23% to 188% of GDP. And financial assets can be significant, such as in Norway, where the government transformed much of its mineral and energy wealth into financial-asset holdings, now valued at around 450% of GDP.

Though Japan has the highest government-liability-to-GDP ratio in the IMF sample – 369.2% in 2020 – its assets are even higher, at 378.2% of GDP, leaving it with a positive public-sector net worth. The same cannot be said of the United Kingdom, the US, or any other G7 country except Canada.

Furthermore, the IMF data likely understate the value of land owned by the public sector. Property is usually the biggest single asset class in any economy and governments tend to be the largest property owners, often by an overwhelming margin. Yet many governments report small (or even zero) property holdings; among those that do report land holdings, the average value is only about 25% of GDP.

Public commercial assets (assets that can generate an income if professionally managed) are also frequently underreported, or not reported at all. And what is reported is likely to be undervalued because management is often far from professional.

In the US, the federal government owns almost a third of all land – some 640 million acres. The US Department of Defense, for example, administers 26 million acres, consisting of military bases, training ranges and more. The US Army Corps of Engineers manages a quarter of US hydropower capacity and more than 4,300 recreational areas, beaches, and local water and sewer systems. The US government’s balance sheet accounts for only a fraction of the land it owns.

Yet another example of hidden and undervalued public wealth is publicly owned urban real estate. The public sector is the dominant owner of real estate in every major US city, controlling at least half of the property market, which at a fair value is often equivalent to the city’s annual economic output. Failing to account for these assets, and managing them unprofessionally, can cause lasting damage to the state’s ability to meet its obligations to current and future generations, including by undermining climate action.

As for public-sector liabilities, they range from around 80% to 370% of GDP in the IMF sample. Debt securities account for some 60% of GDP – and about 34% of total liabilities – on average. Public-sector pension obligations average 40% of GDP. Eight of the 24 countries – including five G7 countries – recorded negative public-sector net worth for 2020-21.

Fiscal authorities must begin producing conventional balance sheets that offer more reliable estimates of conventional net worth, which may well be negative. In order to manage assets and liabilities effectively, they must also produce comprehensive balance sheets (or intertemporal budget constraints), which include the present discounted value of anticipated future non-contractual revenue streams, such as taxes (implicit assets), and outlays, such as social security benefits (implicit liabilities).

This would show the government’s comprehensive net worth – which, unlike conventional net worth, must not be negative, if equitable insolvency or cash-flow insolvency (the inability to meet contractual financial obligations when they come due) is to be avoided.

The risks are significant: as a 2021 IMF study showed, extrapolation of current policies for public expenditure and tax revenues often results in negative comprehensive net worth, frequently driven by population aging.

In other words, unless governments reconsider their accounting standards, they may end up paying a heavy price. 

© Copyright - Project Syndicate.

About the author

Willem H Buiter is the former chief economist at Citibank and former member of the Monetary Policy Committee of the Bank of England.

The views expressed in this article do not reflect the position of the IoD unless explicitly stated.

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