A New Model for Governmental Finance
Why do state and local governments finance their capital improvements by issuing bonds? Instead of borrowing, why don’t they pay as they go?
In large part, it’s a matter of tradition. Much of the pertinent legal authority dates from the 1800s, when capital improvements were seen as intermittent events. Many frontier communities were boomtowns, growing from nothing to a significant size in just a few years. They needed schoolhouses and waterworks right away, and the only way to finance those needs in short order was by borrowing. Moreover, once the initial improvements were made, it might be many years before a replacement or an expansion was required. Taxpayers would have had no interest in savings being accumulated for unspecified future capital projects.
However, once a public entity reaches a certain size, its infrastructure needs become constant, rather than intermittent. Local governments like the City of Albuquerque and Albuquerque Public Schools, which own hundreds of properties of different ages and conditions, must each year devote significant resources to restoration or replacement of their existing plant, in addition to new infrastructure to serve a growing population. These entities accordingly hold bond elections every few years. The bond maturities are carefully adjusted, however, so that the new debt service will be balanced by bonds that are being retired. That way, the voters can be informed that a “yes” vote will not raise their taxes.
But if all that voters are approving is a constant levy, so that the benefitting entity is receiving a more or less steady stream of revenue to fund its annual capital improvements plan, then why not cut out the bonds altogether, and dispense with the interest expense? The interest burden, after all, is not small.
Consider the following illustration. City A keeps an average of $100 million of bond principal outstanding, with an average bond term of 20 years. In general, $5 million of new bond principal is issued every year, and $5 million of old bond principal is paid off. If we assume a historical interest rate of 5% (rates have been lower recently, but they were higher during the 1970s and 1980s), then City A needs average annual property tax revenues of $10 million to service its bonds: $5 million to pay interest, and $5 million to pay off maturing principal. In other words, half of the tax levy goes to pay interest alone.
One important way to control interest expense is to gradually reduce the average maturity of the governmental entity’s bonds. All other things being equal, the shorter the bond term, the less the total interest. But the key means of breaking the debt habit would require a change in law. Right now, the New Mexico statutes offer the state and its local governments many dozens of ways to incur debt for capital expenses. However, with one limited exception for school districts, there is no statutory authority for levying property taxes for public improvements on a pay-as-you-go basis.
The legislature ought to furnish such authority, but it is very important that the legislation include three features.
First, all pay-as-you-go levies should require voter approval and be time-limited, just as voter approval is required for the issuance of bonds and the associated debt service levies, which expire when the bonds are paid. A pay-as-you-go reform cannot succeed if it is seen as a governmental power grab.
Second, governmental entities should be allowed to finance a given capital project by a combination of bonds and pay-as-you-go levies, presented as a single ballot question. It will take many years for most governments to gradually reduce their debt burdens, and that will inevitably require the continued issuance of bonds. It would be impracticable to propose a project financing in two questions, pay-as-you-go and bonds, only to have the voters approve the pay-as-you-go part and reject the bonds.
Third, if the purpose of pay-as-you-go authority is to reduce reliance on debt, voters need information to gauge their progress. All capital improvement ballot questions, whether purely bonds, purely pay-as-you-go, or any combination of the two, should be required to show the estimated percentage of the total levy that will be used for interest expense. Voters will be far more inclined to support a debt reduction program --- requiring considerable discipline over a period of years, or decades --- if they can see a steady decrease in interest expense from one election cycle to the next. And governmental officials, of course, would be motivated to structure financings accordingly.