Ghana: Saving the State from the scourge of compound interest
On March 8, 2024, an amendment to the Contracts Act, 1960 (the Contracts (Amendment) Act, 2023) took effect. A new section (section 17) provides that:
“Where a person specified under subsection (2) enters into a contract or transaction *on behalf of the Republic (of Ghana)*, the payment of interest on any sum of money due under the contract or transaction *shall be calculated at simple interest*.
(4) A person *shall* not enter into a contract or a transaction on behalf of the Republic in which the payment of interest on a sum of money due to a party to the contract or transaction is *calculated at compound interest*.
(5) A contract entered into contrary to subsection (4) is null and void.” (Parenthesis mine)
According to the Attorney-General, “the law seeks to curb the inimical tendency on the part of public officers to enter into contracts with … compound interest, which result in huge financial loss to the state.” (https://www.ghanaiantimes.com.gh/parliament-passes-law-to-prohibit-payment-of-compound-interest-by-state/#:~:text=The%20law%2C%20the%20contracts%20(Amendment,to%20it%20March%208%2C%202024.).
If the Republic of Ghana believes that compounding interest rate is unfair when it is the payer (debtor), then it should also be fair and consistent by not applying it in its dealings with its citizens or residents when Ghana is the payee. Yet, section 71 (late payment of taxes) of the Revenue Administration Act, 2016 provides that:
“71. (1) A person who fails to pay tax by the date on which the tax is payable is liable to pay interest for each month or part of a month for which any part of the tax is outstanding. (2) The interest is calculated as one hundred and twenty-five percent of the statutory rate, *compounded monthly*, applied to the amount outstanding at the start of the period.” (https://gra.gov.gh/wp-content/uploads/2023/01/Revenue-Administration-Act-2016-.pdf)
And, in the case of tax evasion, section 70 (titled “Interest for under-estimating income tax payable”) provides that “The amount of interest that a taxpayer is required to pay for each period under subsection (2) is calculated as one hundred and twenty five per cent of the statutory rate, *compounded monthly*.”
Government contractors borrow from banks at interest rates that are compounded. When the government owes (i.e., arrears) these contractors for several months and years, shouldn’t the delayed payments include interest that is compounded? If the government makes timely payments to contractors, the compounding of interest will not be necessary. Is it fair that when Ghana owes a contractor (a company), a simple interest is applied to the arrears but when that contractor owes (i.e., taxes) Ghana, the interest on its tax arrears is compounded (monthly ooo)?
Ghana issues foreign (Eurobonds) and domestic bonds. It can be shown (the proof is available on request) that these bonds implicitly have a compound interest. Suppose Ghana issues a ten-year $1000 bond with an annual interest (coupon) rate of 10%. The typical payment structure (a bullet bond) takes the following form: Ghana pays 10% of $1000 (equal $100) each year for 10 years and pays the principal of $1000 in the tenth year. This is equivalent to a loan with an interest rate of 10% (*compounded annually*) that is paid off in 10 years by making annual payments of $167.75 for 10 years. Note that, unlike the bond, the principal of $1000 is not paid in the tenth year. This is because a part of the annual payment of $167.75 (greater than $100) goes towards the payment of the principal. In both cases, the present value of the stream of payments is the *same*.
Why at all is interest compounded? Why is it a ubiquitous practice? I can think of two reasons:
(1) in an inflationary environment, prices rise at a compounding (exponential) rate. To compensate investors or creditors by protecting their purchasing power, interest rates must be compounded, and
(2) compounding interest is actually the application of simple interest. Suppose Kofi owes Ama $100 at a simple (annual) interest rate of 10%. Kofi (the borrower) has to compensate Ama for the loan of $100. The compensation is the interest rate. An interest rate is the price of credit (loan) just as a loaf of bread has a price. Note that the interest rate is defined for a year (i.e., an annual interest rate). If Kofi pays Ama the interest of $10 and the principal of $100 after twelve 12 months, no compounding is necessary. Suppose instead that Kofi did not pay the $100 after a year and also did not pay the interest of $10. *Then Kofi now owes Ama $110 (not $100)*.
At the end of the second year, the simple (annual) interest of 10% is applied to the outstanding balance (loan) of $110. It turns out that (1 + 10%) times 110 = (1 + 10%)^2 times 100. Raising (1 + 10%) to the power 2 (i.e., (1 + 10%)^2) is what creates the compounding effect. But if we take note of the fact that by not paying off the loan and not paying the interest as well, Kofi’s debt obligation has increased from $100 to $110 after two years, then we are still in a world of applying simple interest to $110 (not $100).
Some people describe “compound interest” as “interest on interest.” It is important to pay attention to the principle of interest rates (even simple interest rates) because the “on interest” part includes a financial obligation that was not met. To reiterate, if after a year, the borrower fails to pay the interest (fails to compensate the borrower) and also fails to pay the principal amount, this increases his total financial obligation to the borrower. That obligation is the payment of $110, not $100.
In accordance with Sharia law, Islamic banks do not charge interest on loans. However, there are financial and non-financial obligations on the part of the borrower because, in return for its loan, the bank becomes a shareholder in the borrower’s business. There is no free lunch. This is the classic debt-vs-equity debate/trade-off in corporate finance.
Is section 17 of the amended Contract Act just? Is it fair? You be the judge.
