Government variations on Enron accounting

Kash returns tomorrow so I thought I’d have my last post cover another one of my pet peeves that covers public finance concerns and a twist on how financial economics impacts tax contorversies.

Janet Yellin’s “The Bringe Mentality in the Federal Deficit” drew a parallel to what Wall Street has come to know as Enron accounting:

The budget binge is supported by the same kinds of unrealistic projections of future revenues, low-balling of spending and obfuscatory accounting that are now the focus of the Wall Street scandals…The perpetrators of the budget binge – President Bush and Congress – are sacrificing the public’s long-term welfare for their own short-term political gains. In the case of Enron, the company’s long-run stability was sacrificed for inflated stock prices in the short run. In the case of the federal budget, the health of Social Security and other programs is being sacrificed for unaffordable tax cuts.

Dr. Yellen focused on the Social Security accounting issues, which certainly dominate the debate over our long-term fiscal future. I wish to draw attention to two other forms of possible Enron accounting – one at the Federal level and one at the state level. One draws from (but should not be blamed on) chapter 5 of the Economic Report of the President 2003, where Glenn Hubbard makes his case for two means of reducing the tax burden on capital income: (a) a proposal to not tax capital income (akin to a Roth IRA), or (b) a proposal to switch from income taxation to consumption taxation (akin to tradtional IRAs). Box 5-3 notes:

For an investment with expected normal returns, the tax payment due upon distribution under a deductible IRA is equivalent to the prepayment of tax under a Roth IRA. If the government could reinvest the tax received from prepayment under a Roth IRA in an equivalent investment, the value of its investment would be exactly equal to the tax payment due upon distribution under the deductible IRA.

In other words, the present value of tax revenues is the same. However, note that the Roth IRA would have the government receiving its revenues earlier than would the tradtional IRA. Hubbard’s argument that changing the way we collect taxes would induce more savings and investment assumes that government spending is not affected by the timing of taxes. But if there is any validity to the alleged “starve the beast” view of political decision making, would not such the acceleration of tax revenues under a Roth IRA approach induce more government spending now and hence less investment with the debt implications deferred for future generations?

Californians may be concerned that our replacement governor is also deferring the issue of the deficit problem that drove Gray Davis out of office. Other states are also facing deficit issues and may be tempted to sell some of its assets to private entities and then lease back the proceeds. This editorial criticizes these sale in-lease out (SILO) transactions noting how there is a bipartisan consensus in the Senate to eliminate this tax planning on the premise that the Federal government loses an estimated $11 billion in present value terms from the timing of tax deductions (there is a growing literature on this issue, but I thought this editorial captured the essence of the public concern quite simply). The defenders of SILOs would argue that only about half of this Federal loss is reaped by the private owners of property the local government lease with the local governments allegedly reaping the other half. Their analysis that claims that the private sector only gets half of the benefit rests on economic assumptions that are controversial, but then those who put forth the models that suggest such a split ask why would a local government ever engage in a SILO that does not yield it a positive net present value? This argument presumes that government decision makers engage in SILO transactions considering the long-term budgetary implications as opposed to short-term appearances and are not constrained by borrowing restrictions. In many cases, however, neither assumption is true. State and local governments are often faced with self-imposed borrowing restrictions and if national politicians are guilty of Enron accounting as Dr. Yellen suggests, why should be assume state and local government officials are not?