A businessman’s ascendance to the presidency earlier this year gave rise to many discussions about the operating practices of businesses vis-à-vis those of government entities. While a variety of similarities and differences exist, perhaps the most notable one is that of financing methods; while public and private corporations can raise capital via debt or equity offerings, government entities’ financing efforts are entirely limited to the debt sphere.
While this has become a sine qua non of municipal, state and federal finance, it is worth discussing whether it is truly the best practice. State and local governments pay hundreds of billions of dollars in debt service costs annually for debt issued for the construction of capital projects, to provide for maintenance of our infrastructure, and to fund municipal deficits.
It is a truism that some of the few certainties in life are death and taxes. The tax burden on our citizenry would certainly be optimized and potentially even reduced if our elected officials sold equity in the government, rather than issuing bonds. However, any proposal of this type would have to account for the overall ramifications of this change, which would be quite significant.
Benefits of Equity Issuance
Should governments begin issuing equity, or surplus-linked instruments (SLIs), the government would enjoy the same favorable pay-out structure as do firms in the private sector: When the government earned a profit or had a surplus, the shareholders would be entitled to a dividend. On the other hand, when times are bad and the government is running a deficit, payments would halt. This would increase the government’s flexibility to solve problems in the short term, enabling a troubled government to put money toward solving its fiscal problems (rather than spending any available cash on funding debt service payments).
As a further benefit, governments that issue SLIs would become the recipients of the best advice Wall Street and locals could offer. SLIs would only pay dividends when a government generated a surplus, so investors would have every incentive to help the government do well financially. For citizens, this would encompass looking out for the government’s best interest as opposed to their own, encouraging sound fiscal policy, and voting for fiscally responsible candidates. Institutional investors would also do their part, by providing budgetary and economic analysis, and by encouraging governments to consider the long-term implications of more risky decisions.
Challenges of Equity Issuance
The most glaring issue with states or municipalities issuing equity is that SLI holders would "own" or control government decisions. No reasonable mind wants to see to the wealthy "buying" the government or its power — this would likely devolve into a moral perversion worse than the 19th-century voting laws that limited suffrage to wealthy landowners. Certainly, the question of what control SLI holders would exert over government decision making is one of significant concern.
Another major issue with SLIs relates to the payment terms to which an equity-like instrument would be subject. Could shareholders vote to pay out all surplus funds as “dividends?" Could shareholders raise taxes indiscriminately and empty the pockets of taxpayers? Could a distressed government sell SLIs? How would an SLI program be structured so that investors would be encouraged to purchase equity but would not be given carte blanche to take advantage of taxpayers?
A Reasonable Plan for SLIs
The best method for governments to issue SLIs is to structure the securities with a final maturity date and a maximum rate of return. For a relatively stable government, like the State of Delaware, that rate would be only slightly higher than the coupon rate of a bond with a comparable maturity date. The terms would clearly have to be set in advance, and would permit dividends of up to a fixed amount of GAAP surplus, perhaps 50 percent, to be paid to SLI holders. Government officials would operate independently (i.e. without shareholder control) and equity holders would simply retain a claim on some portion of the surplus. SLI holders would never be entitled to more than their fixed portion of the annually adjusting surplus.
As SLI holders are repaid, the government would have the option to sell more shares at the prevailing market rate or to retain the freed-up "surplus," previously allocable to the retired shares.
As an example, if a town with a $100,000,000 budget, average annual surplus of 1 percent, and an AA rating issued $10 million of 30-year SLI at with a 5-percent “coupon,” they would be subject to maximum dividends or distributions of $500,000 annually or 50 percent of the annual surplus, whichever is less. This payout compares to a long-term borrowing rate of approximately 3 percent, so SLIs would cost the town at most an extra $200,000 annually. If the town produced a surplus of just 0.7 percent ($700,000), the town would pay out just $350,000. When a town that has historically paid 3.5 percent or less has half of its shares amortize, and then decides to issue new shares, investors that require the full 5-percent coupon may elect not to purchase new shares without a discount to face value, due to the reduced payment prospects of these securities.
Food for thought
While state and local governments would be eager to raise capital and only pay dividends during a booming economy, any such issuance would have to be considered with a heaping measure of prudence and judiciousness. The proposal outlined above addressed many potential concerns, but even in this program, government-issued SLIs would only be viable for strong municipalities; cities and states with chronic financial issues would likely have no market for these securities. Of course, the all-important questions of how investors perceive the risk of these instruments -- not to mention how government watchdogs would react -- still remains to be seen.
