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Policy Basics: State and Local Borrowing

January 15, 2015

State and local investments in schools, roads, hospitals, and other infrastructure provide the foundation for a vibrant economy and high quality of life.  Borrowing — by issuing bonds — is a tried-and-true way to finance the cost of building and maintaining this infrastructure.  Projects financed with bonds can give a state’s economy both a short- and long-term boost.

There are sound reasons that states and localities borrow to pay for infrastructure, rather than use annual tax collections and other revenues.  Public buildings, roads, and bridges are used for decades but entail large upfront costs; borrowing enables the state to spread out those costs.  As a result, taxpayers who will use the infrastructure in the future help pay for it, which promotes intergenerational equity.  Borrowing also makes infrastructure projects more affordable by reducing the pressure on a state’s budget in any given year.

Most State Debt Used for Long-Term Infrastructure Investments

Almost all state and local bond debt is long-term debt incurred to pay for capital expenditures — primarily infrastructure projects such as roads and bridges, schools, water systems, and hospitals — not to cover operating expenses.[1]  (See figure.)

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States typically prohibit the use of bond proceeds to fund operating expenses, although that has occurred in a few instances.  The vast majority (99 percent) of state and local debt is long-term, but a few states also issue short-term “revenue anticipation notes” to help them manage their cash flow.  This type of debt must be repaid within the fiscal year.

How much a state or locality borrows should reflect local infrastructure needs, the current cost of debt, and expected revenue growth.  With the memory of the Great Recession still fresh, some states and localities are hesitant to take on more debt.  Conditions for borrowing have rarely been better, however, and needs are great.

  • States’ and localities’ current interest costs are low.  Interest payments on debt averaged just 4 percent of current spending in 2011, the lowest level since Census began tracking this data in 1977.  Interest payments made up less than 5 percent of state and local spending in all but nine states.
  • Total state and local debt is below pre-recession levels. Measured as a share of the economy, state and local debt has fallen since 2010 and is below pre-recession levels.  If borrowing returned to pre-recession levels as a share of the economy, an additional $400 billion would be available to address infrastructure needs.  (For comparison, the aggregate value of all bonds issued for school construction and rehabilitation between 2003 and 2012 was $514 billion.)
  • Interest rates are low, which means borrowing is inexpensive.  In order to promote economic growth after the recession, the Federal Reserve has kept the short-term interest rate that banks charge to borrow from each other very low.  This, in turn, reduces the interest rates charged for other types of loans, including bonds purchased from state and local governments.  The Fed is not expected to begin raising short-term interest rates until the middle of 2015, so the Congressional Budget Office projects that interest rates in general will remain low until then and increase only slowly after that.
  • New infrastructure projects can boost the economy by creating short-term construction jobs.  This could improve the slow job growth many regions have faced as the country recovers from the recession.
  • New schools and better roads and bridges are investments in a state’s future.  Businesses rely on an educated workforce, and a well-functioning transportation system allows industry to bring products to customers.  Infrastructure improvements will make a state more attractive to businesses and residents.
  • Maintaining existing infrastructure is also critical.  Roads, bridges, water treatment facilities, and schools are in dire need of repair or replacement in most states, according to the Society of Civil Engineers.  Crumbling infrastructure hinders economic growth.

Safeguards Can Lessen Risk of Taking on Too Much Debt   

States and localities rarely fail to repay bondholders, but there is some risk that they might borrow so heavily that their debt obligations begin to crowd out other parts of the budget.  Because each decision to issue a bond will affect the state for decades, guidelines are needed to prevent one generation’s decisions from pre-empting those of the next. 

States use several methods to limit their indebtedness, usually by setting a cap on total debt as a share of the state’s economy or a cap on annual interest payments as a share of state revenues.  (Some states, however, have no such limits; on the other hand, a few states are prohibited from issuing general obligation debt.)  Because policymakers need flexibility if the state faces unusual capital needs resulting from natural disasters, aging infrastructure, or other challenges, these limits should be guidelines rather than rigid caps.  States and localities should also regularly perform a formal debt affordability analysis and make this information public.

End notes:

[1] This paper focuses on bonded debt — borrowed funds used mainly for capital needs. States also incur other long-term obligations that are sometimes considered debt, such as pensions, “other post-employment benefits” (OPEBs) such as health benefits for retirees, and federal loans to help cover unemployment insurance benefits.