Opinion: Public capital is not as cheap as we think
Canadians need to understand that public capital is every bit as costly as private capital.
A common fallacy in policy discussion is to assume that because private companies usually pay more to borrow than public-sector companies do, the cost of carrying out any activity will necessarily be lower, everything else equal, in the public sector than the private.
Governments do generally pay lower interest rates but there is more to the cost of government borrowing than simply the interest rate. Why do public companies obtain lower-cost finance even when their activities and production methods are identical to those of a private company and are therefore exposed to the same risks? Because governments can levy taxes to repay their lenders if, for instance, their activities or projects fail to meet expectations. Private companies can’t do that, which is why investors or lenders require a higher rate of interest or return from them.
For taxpayers, the government’s power to cover any financial difficulties its projects may run into has a very real cost — the possibility of higher taxes or fewer or lower-quality public services. In the accounting for public projects, however, that cost is simply swept under the rug. If taxpayers were competitively paid for the risks they bear, the all-inclusive cost of capital would be the same in both the public and private sectors for similar activities and projects.
The idea that governments can run huge deficits because their financing costs are lower than the private sector’s is also an error. In a recent article in the journal Canadian Public Policy I discuss several important cases where this error has been made.
The first is Québec’s Generations Fund, which is a sovereign fund earmarked to repay the province’s debt. The comparison between the cost of Quebec’s debt and the return on the fund that the Caisse de dépôt management of it produces is flawed: the cost of the debt is grossly undervalued. Moreover, when the Fund was created in 2006 the Québec budget was balanced and the contributions to the Fund were indeed a form of debt repayment. But with the significant deficits the province is running such contributions simply raise the debt … to repay the debt!
In the case of the Caisse’s and the government’s investment in Montreal’s light-rail project, currently under construction, the Caisse will receive an eight per cent return on its investment before the government is paid a return equal to the interest paid on its debt. Not one, but two errors are made here: the return on the debt is too low to begin with and some portion of it may get no return at all.
Similarly, Infrastructure Ontario’s approach to assessing the riskiness of project costs is in many ways fundamentally flawed. According to the methodological guide prepared for IO by Deloitte, “As the public sector financing rate reflects the virtually unlimited taxing power of the crown to repay its debts, crown borrowings are viewed as being risk-free. (Accordingly,) … the appropriate rate to use for discounting project costs is the public sector financing rate.” Same error, same potential damage to citizen-taxpayers.
Finally, B.C. Hydro’s Site C hydroelectric megaproject is evaluated on the basis of a cost of capital given by the low interest rates paid on the public capital raised for it by the B.C. government. If a more realistic social cost of public capital were used, the project may well not generate a return sufficient to pay its costs.
I could also have looked at a more recent example of this major error: calculation of the financial performance of Investissement Québec (IQ), the powerful investment fund of the Government of Québec. In its 2021-2022 annual report, IQ writes (my translation): “Investissement Québec aims for a long-term average return on equity threshold equivalent to at least the borrowing rate of the Government of Québec … The Company recorded a three-year adjusted return on equity of 9.3 per cent for fiscal year 2021-2022 … The comparable borrowing rate for the Government of Québec is 1.9 per cent per year. The adjusted return on equity for the past three years exceeded the set target by 7.4 percentage points.”
The error is glaring. If the real cost of the capital invested were used, not just the interest rate the government paid for it, IQ’s performance would certainly be much lower — and the significant performance bonuses for IQ staff and managers likely much smaller.
Business assistance, loans, guarantees, subsidies and so on are often justified by this same fallacious argument that the cost of financing them is lower for the public than for the private sector. The result is a bottomless pit of crony capitalism.
If we are ever to get public finances under control and stop misallocating capital between the public and private sectors, Canadians need to understand that public capital is every bit as costly as private capital.
Marcel Boyer is a TSE associate member and emeritus professor of economics at the University of Montreal.
Article published in the Financial Post, on September 13, 2022