Until about the mid-1980's, when total state expenditures on prisons and related activities were $9.6 billion, about 40 percent of all state prison construction was financed by the pay-as-you- go method and 50 percent by general obligation bonds. The remaining 10 percent was financed using lease revenue bonds and other revenue streams.¹

• In the pay-as-you-go method, total capital projects are fully paid for in cash at the time of construction from current revenues or accumulated cash. Its obvious advantage is that it does not involve interest payments or other expenses associated with debt as no money is borrowed.
   
• With general obligation bonds, projects are paid out of tax revenues and backed by the full faith and credit of the government. Many states have statutory and constitutional limits on both the total amount as well as the amount of new debt that they can issue. General obligation bonds also require voter approval.
   
• In the case of lease revenue bonds, an entity or agency is specifically created to build the project, which then leases the right to use it to the government. The bonds are repaid by rent or lease payments that are appropriated by the legislature and paid for by taxpayers.

STATE AND FEDERAL EXPENDITURES ON CORRECTIONAL FACILITIES

Total Expenditures and Capital Expenditures³ 

• State expenditures (including the District of Columbia) for adult prisons were estimated to be $22 billion for 1996, the most recent data available from the Bureau of Justice Statistics. Overall, between 1990 and 1996, state prison expenditures increased 83 percent from $12 billion to $22 billion.
   
• Of these, capital expenditures (on construction, land and equipment) were 6 percent of total expenditures, i.e., a total of $1.3 billion. Construction costs at $0.8 billion represented 4 percent, while equipment and land at $0.3 and $0.2 billion each represented about 1 percent of total expenditures.
   
• Federal prison expenditures increased 160 percent, from $946 million to $2.5 billion, during the same period.  

In 1996 the following states had the highest prison expenditures:

For a breakdown of total and capital expenditures for all states and regions, see <http://www.ojp.usdoj.gov/bjs/pub/pdf/spe96.pdf>

NUMBER OF FACILITIES AND SECURITY LEVELS 

According to the 2000 edition of the Census of State and Federal Correctional Facilities, there were a total of 1,668 state, federal and privately operated correctional facilities in 2000, or 204 more than in 1995.⁴ These included prisons, boot camps, prison hospitals, centers for substance abuse, community-based facilities and other places of confinement. 

• Of the total 1,668 correctional facilities in the country in 2000, 1,320 were state facilities, 264 were private and the remaining 84 were federal facilities.
   
• Of the 204 new facilities built between 1995 and 2000, 154 or three quarters were private facilities, an increase of 140 percent in the number of such facilities from 1995.
   
• About half of all facilities were minimum or low security prisons, a third were medium security and a fifth were maximum security. The proportional share of each security level of prisons was unchanged from 1995.
   
• Of the total 332 maximum-security facilities, 317 were state operated, 11 were federal and four were private. Maximum security prisons are the most expensive and thus come at a maximum price to taxpayers.

FINANCING PUBLIC PRISONS

State spending on prisons and other correctional facilities has historically constituted the lion's share of total prison expenditures combined for all levels of government.

Until the 1980s, state public prisons, as noted above, were usually financed using the pay-as-you-go method or by taking on debt through issuing general obligation bonds.

The use of general obligation bonds, however, started to become increasingly unpopular during the 1980s as states faced increasing budget deficits and other fiscal problems. For example, in 1981, New Yorkers rejected a $500 million bond issue for financing prisons. Faced with a soaring prison population and a budget crunch, New York, under Governor Mario Cuomo, began to finance prison construction through the Urban Development Corporation (UDC). Tax activists, however, challenged the use of UDC, which was originally a government agency responsible for oversight of low-income housing. The suit prevailed at the trial court level, but eventually lost at the state supreme court.

Unable to meet voter approval for general obligation bonds for prison construction and expansion, a number of state and local governments also began to use lease revenue bonds, which also allowed them to circumvent constitutional and statutory limits on debt. California led the trend and financed a large number of public prisons in the 1980s with lease revenue bonds when taxpayers started to refuse to pay for the increasing cost of building prisons for the state's exploding prison population.

In the case of lease revenue bonds, an entity or agency is specifically created to build the project, which then leases the right to use it to the government. The bonds are repaid by rent or lease payments that are appropriated by the legislature and paid for by taxpayers (but without the requirement of voter approval as in the case of general obligation bonds). Also called a lease-purchase financing arrangement, under this arrangement, the entity or developer that builds the project agrees to give ownership of the project to the state (or the relevant jurisdiction leasing the facility) at the end of the lease period.

Lease revenue bonds have not gone unchallenged by taxpayers. Opponents have asserted that lease-backed bonds should be treated as debt. Technically, they are not considered debt because the leasing party, usually a municipality, can stop making payments for the leased asset. But in practice, it is almost impossible for a municipality to exercise that option without serious negative consequences such as a downgrading of its credit rating.

FINANCING PRIVATE PRISONS

The number of state facilities has been and continues to be much higher compared to the number of federal and private facilities. But as noted above, of the 204 new facilities built between 1995 and 2000, 154 or three quarters were private. Though the private prison industry has raised significant amounts of capital through private capital markets since its inception in the 1980s, its rapid growth in the 1990s was largely facilitated by the use of lease revenue bonds and certificates of participation, as well as the use of government subsidies.

Private Capital

Construction of capital projects like prisons requires significant capital investments. While many of the new fledgling companies that entered the private prison business had limited access to capital, industry leaders like Corrections Corporation of America (CCA) and Wackenhut Corrections (now called The Geo Group, Inc.) were not subject to the same resource constraints. Wackenhut Corrections was part of the Wackenhut Corp., an established participant in the security business, and CCA, through its founders, was well connected in its home state of Tennessee.  

The new prison companies managed to raise substantial amounts of capital fairly quickly and got venture financing from private investment companies, in addition to financing from commercial banks. The interest in the industry was so strong that CCA was able to go public in 1986, just three years after being formed. The other major players at the time, Wackenhut Corrections, Esmor Correctional Services Inc., Cornell Corrections and Avalon Enterprises were also successful in raising significant amounts of capital in both the equity and the debt markets and went public in the 1990s. 

CCA and Wackenhut also formed REITs or real estate investment trusts, which are publicly traded entities that manage and own real estate but do not pay corporate income taxes. REITs must redistribute 95 percent of their profits as dividends to shareholder. These special attributes make REIT shares attractive to investors who are willing to pay a relatively higher price for them. Companies like CCA and Wackenhut that used REITs were able to raise more capital in this manner. 

Other Sources of Capital

Pivate prison companies also received millions of dollars in government subsidies. These included various kinds of tax abatements and infrastructure assistance in addition to low-cost financing through several types of bonds .⁵

Industrial Revenue Bonds 

In the early years of the industry, private prison companies used traditional industrial revenue bonds (also called industrial development bonds) that were issued by local governments. Industrial revenue bonds or IRBs are a subset of private activity bonds, which typically include all municipal bonds whose proceeds are used to finance infrastructure that are used by private businesses.

IRBs constitute a subsidy because the interest paid for the borrowing is well below market rates for corporate bonds or bank loans. This is possible because the interest earned on these bonds is exempt from federal taxation. IRBs end up subsidizing upper income groups as they are typically purchased by affluent investors.  

Lease Revenue Bonds

While some private prisons have been financed using IRBs, a relatively larger number have used lease revenue bonds and certificates of participation (COPs). In fact, IRBs were almost completely replaced by lease-backed securities as the preferred mode of financing by private prison companies during the 1990s. 

Traditional revenue bonds back repayment of interest and principal with revenue generated by a project, such as tolls, stadiums and parking garages. But projects financed with lease revenue bonds do not generate revenue in the same direct way.

Typically, the government enters into a lease purchase agreement with a non-profit corporation or authority that will build the project. The non-profit corporation or authority, called the lessor, will issue tax-exempt lease revenue bonds. The project or facility that is built or acquired with the bonds is leased to a municipality (in the case of prisons it is often a correctional agency), called the lessee, under a lease agreement. The lease payments by the lessee (i.e., correctional agency) to the lessor (i.e., the non-profit corporation) form the basis of the security of the repayment of the bonds. Funds for the lease payments made by the correctional agency come from state or local government appropriations. When both the interest and the principal on the bonds are fully repaid, the government obtains title to the facility. The terms of the debt are tied to the useful life of the project under this arrangement.

A lessee's source of funds for its lease payments, however, can vary from state to state. For example, in California, the source of funding for the lease payments is any legally available funds appropriated by the Legislature on an annual basis. In other states, the lessee can use its full taxing powers to raise the required revenues to fulfill its lease payment obligations. 

Certificates of Participation

In the case of private prisons, lease revenue bonds often take on a specific form, called certificates of participation or COPs, though these are not exclusively used for prisons. COPs were widely used for financing speculative private prisons, i.e., facilities that are built in anticipation of future demand and do not have an operating contract for actual prisoners ahead of time. These certificates were considered to be the riskiest type of lease-backed securities. In the 1990s, prisons financed with COPs constituted more than one third of all lease-backed defaults nationwide. Many of them were not insured or rated. CCA's financial problems were largely a part of its over-investment in speculative prisons. The company borrowed about $1 billion to support speculative construction and almost went bankrupt in the late 1990s.

With COPs, the bond issuance is structured so that investors buy certificates that entitle them to receive a share or participation in the lease payments for the prison. The lease payments by the lessee or renter (i.e., the correctional agency) are passed through the lessor or the landlord (i.e., the non-profit corporation/building authority) to the certificate holder, including the tax advantages. The lessor or landlord usually assigns the lease and lease payments to a trustee, who in turn distributes the lease payments to the certificate holders.

In the case of COPs, the government lessee or renter commits to making future payments and, in theory, does not incur debt. This is done by using a lease that is contingent on the appropriation of public funds and that includes a rent abatement clause. The abatement clause stipulates that the renter or lessee is not obliged to make lease payments if a property is not utilized because of construction delays or damage caused by natural disasters. This makes the lease payments "fees for service" rather than debt. However, the lease payments or rent are considered long-term payment obligations. Protection against abatement risks is supposed to be covered by insurance provisions in a lease agreement. A government may terminate a lease if it cannot appropriate the necessary funds for the project. A non-appropriation clause allows a government to terminate a lease.

In spite of their growing use, lease revenue bonds can be problematic for a number of reasons. First, they are more expensive than general obligation bonds because their interest rate is higher. The interest rate is higher because lease revenue bonds are not backed by a state's General Fund, but by lease payment debt obligations subject to appropriations. Lease payment debt appropriations are also not as secure and have lower credit ratings compared to general obligation bonds. They require property and liability insurance, which, in addition to driving up costs, also makes them more complicated to manage.

In most cases, the sale of lease revenue bonds is negotiated privately between bidders and the government because competitive bidding is not required, losing the advantages of transactions conducted in the open, competitive market. The non-profit corporations or authorities created to build the projects may be quasi-public and the agencies that bid for the lease are often "shadow agencies" created within another government body, thus eliminating competition. Finally, there is the issue of circumventing voter approval and statutory debt limits, which makes this form of debt issuance undemocratic and less accountable.

For a list of private prisons financed with lease revenue bonds and COPs, see <http://www.goodjobsfirst.org/jbstudy.htm>

CONCLUSION

The use of lease revenue bonds and certificates of participation has grown rapidly since the 1980s to finance prisons. At the same time, they have come under increasing scrutiny because of their inherent disadvantages. In particular, many private prison financing arrangements have been extremely controversial, leading to litigation, risks of default, credit downgrades and higher borrowing costs for taxpayers.

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