Saturday, November 7th, 2009

Principles of Privatization – Part 3: Uses of Funds

Continuing my look at privatization transactions, this installment focuses on appropriate uses of funds.

Some types of privatization involve paying a third party to deliver an outsourced service. If, by outsourcing, you are able to save money and get better service, great. If you are able to realize recurring savings from this, then you can put that money to use in many potential ways: special projects, new services, tax cuts, or making up for cost increases elsewhere.

I’m going to focus on non-recurring revenue, the type realized from transactions like the Indiana Toll Road and Chicago Skyway leases. Those leases generated multi-billion one time windfalls. What should governments do with one time lump sums?

My principle is that one time revenues should be spent on one time expenses.

So you are sitting on a big one time pile of money. What are some things you could do with that? Various good uses of the money would include:

  1. Paying Down Debt. If you can retire debt early, that’s good news. However, by paying off debt you are basically transforming a lump sum into a stream of future payments – namely the interest and principal on the debt you no longer have to pay. It’s sort of like a reverse capitalization. So now instead of figuring out what to do with a lump sum, you have to figure out what to do with a lesser sum of money each year for some fixed number of years. I won’t profess to have analyzed this completely, but if you are considering doing it, you should. One possible benefit of paying down debt is that it could improve your credit rating, lowering interest costs on all civic debts. One downside is that the annual savings might get frittered away on operating budget bloat and you end up with nothing to show for it.

  2. Establishing a Reserve. Another option is to simply put the money in the bank. This could be for a rainy day fund or some other purpose. Chicago established various reserve accounts during its privatizations that it is now tapping into during the recession. Indiana created a $500 million trust fund with a portion of the Toll Road lease that will generate income for future transportation projects, and could potentially be used for unexpected but important expenditures. For example, the state spent $60 million in road improvements to attract a Honda assembly plant to Greensburg. It is good to keep some powder dry to be able to move rapidly on opportunities like that. Reserve accounts can also raise your credit rating.
  3. Capital Projects. Indiana and Chicago both used the majority of their proceeds to fund capital projects. Chicago funded numerous streetscape improvements, for example. Indiana used its proceeds for the “Major Moves” highway plan. This is a huge benefit for the state since it is at least partially clearing a major transportation deficit for the state. The reality is, without the Toll Road money, many of the larger projects would never have gotten done. One gotcha with capital projects is that when you build a new piece of infrastructure, there is an operations and maintenance tail on it. If you don’t fund that properly, as Indiana did not fund the operations of a new Colts stadium in Indianapolis, then you end up with a major problem. So even one time spending can generate recurring costs as well. One benefit of financing infrastructure maintenance such as road reconstruction is that this can actually reduce the ongoing maintenance expense, since older pavement needs more repairs, etc.
  4. Rebate Checks. There’s no reason the government has to spend the proceeds at all. It could simply divide up the money and send out checks like Alaska does with its oil revenue. Spending privatization proceeds on anything is still a conscious decision to spend and should be treated as such. Of course, sending out checks from say the Indiana Toll Road lease would have been quite controversial, not least of which because the nakedness of the income transfer from one part of the state to another. And it would have left a transportation deficit. I happen to think the Major Moves program is a good one, but it is not automatic that proceeds from a highway have to be spent highway construction. The money could have been given back to the people in cash, or spent on other things such as transit systems or state parks. If the government did decide to give the cash back, then checks are much better than tax cuts. Tax cuts are permanent and should not be funded via one time chunks of cash.

In short, Indiana and Chicago used their proceeds wisely, to fund one time expenses and establish reserves. The money could have been used to paper over operating deficits or otherwise defer tough choices.

Now, Mayor Daley has utilized funds from the parking meter lease for the operating budget, including tapping some of the reserve funds it established. This has been controversial. And, as with all things involving that amount of money, it should be scrutinized. I think the real question is whether or not the money is being used to, again, defer tough choices and needed actions, or whether it is being used to weather the perfect storm. If this recession isn’t a rainy day, then what would be? Even a super fiscal hawk like Gov. Mitch Daniels tapped into $300 million of Indiana’s rainy day fund (which was carried over surpluses, not the Toll Road money). So in this environment I would not say tapping reserves from privatization proceeds is per se bad. With the word on the street being that Daley will run for re-election, any downstream fiscal problems created by this will land his own lap anyway, so presumably he’s motivated to make the right choice. But remember, once the money is gone, you can never get it back.

More in This Series

Topics: Public Policy

9 Responses to “Principles of Privatization – Part 3: Uses of Funds”

  1. Sid Burgess says:

    Great post. I love your last idea. I have been working with a community that was contemplating selling of their gas system. The offer they had received was no small sum of money. I wish I had your post a couple months ago. You did a great job of explaining the options.

    (in the end they decided to raise rates and keep the system)


  2. the urban politician says:

    Good post.

    I would say spending it on paying down debt, rainy day funds, and public goods (ie infrastructure) are the best use of money.

    Actually using the money to send out cash to taxpayers? It sounds attractive, but in the end I think that would be the worst use of such monies because you’re potentially 1) diverting money away from the city’s economy (ie a guy gets a $1,000 check and spends it on a Caribbean cruise) instead of spending it on the direct betterment of the city itself, and 2) cashing out on an asset that could accumulate value much better in a giant growth fund.

    Selling off assets should be for the surface of the public good, not personal profit. Americans as a whole have no sense what’s good for them, and putting cash directly in their hands is quite possibly the worst thing you could ever do for your city when it comes to the sale of public assets.

  3. the urban politician says:

    ^ Edit: last paragraph I meant “purpose”, not “surface”

  4. Sid Burgess says:

    Urban Politician,

    I would agree for the most part, however, that is a cynical position that doesn’t always play out that way. Many communities enjoy a great deal of retail sales. Also, as in the case of Oklahoma, retail sales tax is the largest contributor of revenue. Property taxes go the county or state. So dumping a large sum of money into a small economy can be a great way to build up a small economy and return a small portion of those funds directly back to the municipality.

    I did though recommend quality of life improvements in this specific instance because there was too much leakage for the rebate option to make as much fiscal sense.

    Great topic though. In general I believe our communities spend far too little so I would tend to agree with you because of the current crisis our cities face. In a more perfect world, returning the money to the local people should stabilize and build local markets.

  5. Thanks for the comments.

    TUP, I think that public assets belong to the public, so it is ultimately the people’s money. While I’d generally support infrastructure projects or generally back into the public sector rather than rebate checks, I certainly have a higher opinion of the public’s ability to spend their own money than you do. One man’s trash is another man’s treasure. What’s valuable is mostly a matter of personal taste in my view.

  6. the urban politician says:

    Aaron, what makes urban cities like San Francisco, NY, Chicago etc so great (as compared to all the suburban sprawl out there not worth defending) is the collective pooling of resources that both made these built environments possible and continue to sustain them.

    While I don’t completely disagree with you that a check to taxpayers would at least in part be beneficial to the local economy, at large I think the money would be far better used to benefit the public good in the form of paying down the city’s debt, infrastructure, preventing tax increases during a rainy day, etc

  7. Alon Levy says:

    The public’s ability to spend money depends on circumstances. In general, the public knows how to spend money better than the government. In times of growth, this creates a crowding out effect for extra spending. But in times of recession, people hoard money, so spending provides an extra stimulus. Both rebate checks and public spending will give the money back to the city, but spending will create a multiplier effect, whereas tax cuts will largely be saved. Of those, rebate checks are the worst – in 2008, most Americans just saved the entire rebate check they got. Tax cuts that are less visible, such as the current stimulus’s payroll tax reductions, generate some multiplier, though still a lower one than spending.

  8. AmericanDirt says:

    Why is the suburban sprawl so indefensible? San Francisco, NYC, Chicago may be great cities for people who read this blog regularly, but they aren’t usually among the fastest growing–and they are out of the question for people who are seeking a certain way of life that can only be fulfilled in suburbs. Is the problem that what those suburbanites value is indefensible? Why can a metropolitan region be great for offering outstanding urbanism as well as outstanding sprawl? I largely agree with Aaron’s point–which is why we continue to see people flock to anti-urban cities (you know which ones I mean) that have a financing scheme that completely devalues or inverts public assets; they move there because that’s the way they like it.

  9. Alon Levy says:

    New York has outstanding sprawl, if you go to North Jersey or Staten Island; San Francisco has outstanding sprawl on the Peninsula and in Contra Costa County. This sprawl is already full so you can’t build a house there, but if you can buy existing houses. You’ll get your minority-free, poverty-free enclave, while still living close to a good city. The problem is that those characteristics together make an area fairly desirable, and then zoning restrictions reduce housing supply, which interact to make housing unaffordable.

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