Municipal bonds add fuel to the fire

It is well-known that the Federal government is amassing large amounts of debt, but state and local governments are piling it up as well. State and local debt soared from 1.19 trillion dollars in 2000 to 1.85 trillion dollars in 2005. About 39% of the total is state, while 61% is local, points out Chris Edwards, director of Tax Policy Studies at the Cato Institute, Washington, D.C.

Most state and local debt takes the form of long-term bonds. Issues of municipal bonds raised an average $230,000,000,000 annually in new funds between 2001-05, up from the $152,000,000,000 average between 1996-2000.

There are two main types of municipal bonds: general obligation (GO) and revenue. GO bonds are backed by general taxation and often are subject to constitutional limits. Issues of GO bonds usually need to be approved by voters. Revenue bonds are backed by particular sources of revenue and usually are subject to fewer restrictions. GO bonds are about 39% of long-term municipal debt and revenue bonds are 61%.

Revenue bonds are financed by receipts future taxes, fees, lease payments, Federal grants, lottery earnings, and tobacco settlement payments. The idea is to securitize expected streams of cash to allow state and local officials to spend now rather than later. A growing trend is to securitize future Federal aid for highways, housing, and other items in "grant anticipation" debt. Federal aid long has spurred overspending by the states, but such debt innovation is exacerbating the situation.

Recent Federal legislation has included new ways for states to go further into debt, such as the creation of three types of municipal "tax credit bonds" Interest payments on municipal bonds generally are exempt from Federal income tax. State and local debt thus is tax-favored over private debt, creating an economic distortion, Edwards maintains. Debt issued to finance government schools, airports, parking lots, and other facilities is favored over debt to finance similar private facilities. As a result, tax law encourages monopoly government ownership and is biased against private-sector competition and innovation.

Another problem with debt is that mixing big government with big finance often results in corruption, Edwards emphasizes. The municipal bond industry has had many scandals. In "pay-to-play" schemes, bond underwriters use bribes or campaign contributions to win bond business from state and local officials. There are Federal laws to prevent such abuses, but violations are common. Moreover, high levels of debt make government finances less transparent to citizens, charges Edwards. People do not appreciate the high costs of projects that officials are pursuing if they do not feel the bite of current taxes. The trouble is, if concerned citizens look into their government's debt situation, they may find it very difficult to understand. A recent "debt primer" by the state of California is 606 pages long.

Perhaps the best reason to start reducing debt is that large financial burdens are looming over the states, Edwards warns. Medicaid costs are growing rapidly and breaking state budgets. Pension plans for state and local employees have huge funding shortfalls that could total $700,000,000,000, according to Barclays Global Investors. Even more costly may be the generous retirement health care plans promised to state and local workers. An estimate by Mercer Human Resources put the unfunded costs of those plans at one trillion dollars.

State and local tax revenues currently are growing strongly, so now is a good time to start reducing debt loads, Edwards insists. There is no particular optimal level of government debt, but there should be a strong bias in favor of pay-as-you-go financing for infrastructure because it is cheaper, more transparent, and more prudent given the large costs that face the states in coming years, Edwards asserts.

Routine capital projects, such as school construction, should be financed on a pay-as-you-go basis. Debt financing is more appropriate for large and unforeseen needs, such as rebuilding after disasters, Edwards concludes. For their part, citizens need to remember that government debt simply represents deferred taxes and charges, and they will have to bear the burden sooner or later.

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