Balanced budgets and present values

Public debt levels and balanced budgets have never been more in the media and the minds of politicians and economists around the world. The question of whether and when a budget should be balanced is fundamental to how governments are reacting to the struggling economy, high unemployment and increasing government borrowing in developed countries around the world.

Much of the conversation ignores some pretty fundamental points about the present value of future taxes and the present value of future payments arising out of current obligations. If a nation’s social security system is not funded or “pay as you go”, one might argue that there is a significant additional liability not being reflected in the national accounts. The size of some of these numbers is sufficiently large to swamp the current conversation about debt levels.

Equally, though, we can’t take into account the present value of all future social security payments for the next hundred years without considering the taxes that will be raised over that same period. This future stream of cash inflows to government treasuries could be considered an asset.

Now the possibility of calculating the present value of cash outflows and inflows and the measurement of these “liabilities” and “assets” doesn’t necessarily mean doing so is the most useful way of understanding the problem. Pension valuations often use “projected unit credit methods” and others of determine an appropriate net liability at a particular point without explicitly considering the future contributions that will be required to fund the liability over time.

The relevance of present values and the budget is fairly well understood when it comes to social security, but the same principles should inform nationalization and privatization debates. Selling a national asset only changes the net position of national finances if the receipts received from the market are higher than the present value of future profits to the treasury from the company.

On the other side, borrowing to finance a productive capital project doesn’t change the net balance sheet position, although it does increase gearing – just like for any organisation.

The point of this slightly rambling post is that budget deficits and the demand to balance budgets are usually based on incredibly short-sighted measurements of national finances. If we don’t consider the impact on economic growth and therefore future tax receipts when making decisions, we are bound to get it wrong more often than right.

Published by David Kirk

The opinions expressed on this site are those of the author and other commenters and are not necessarily those of his employer or any other organisation. David Kirk runs Milliman’s actuarial consulting practice in Africa. He is an actuary and is the creator of New Business Margin on Revenue. He specialises in risk and capital management, regulatory change and insurance strategy . He also has extensive experience in embedded value reporting, insurance-related IFRS and share option valuation.

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