PUBLIC GOODS, INFRASTRUCTURE, CAPITAL SPENDING AND PUBLIC SECTOR BORROWING

PUBLIC GOODS

 

Public goods include parks and bridges and usually involve low operating costs and significant capital investment costs. Public goods are characterized by non-excludability, that is, it is impossible to exclude anyone from enjoying their benefits, or from defraying its costs; and non-rivalry, that is, the cost of extending the service or providing the good to another person is (close to) zero.

INFRASTRUCTURE AND PRINCIPLES OF EQUITY AND EFFICIENCY

In public sector economics, the term infrastructure refers to public sector physical capital such as water and sewer systems, roads and highways, school buildings and prisons. These may be provided by a variety of institutional arrangements, including fully public, fully private (for-profit or non-profit), and public-private partnerships. In the United States, public infrastructure as a share of total physical capital declined from 50 percent in the 1970s to 40 percent in the 1990s.

 

Public sector capital often has some of the attributes of public goods. It usually involves low operating costs (exceptions include prisons) and significant capital investment costs. Public sector financing for public infrastructure may also be necessary because private or other forms of financing may be unavailable or because of the failure of the market to provide such goods and services.

 

The role of the public sector in providing and paying for infrastructure reflects both efficiency and equity concerns. When the public sector finances infrastructure, issues of intergenerational (present versus future users) and interpersonal (users versus non-users) equity considerations arise. As a result, public sector capital often is financed over its useful lifetime (the pay-as-you-use concept) rather than on a pay-as-you-go basis, so that all users, including future users, will also have some responsibility for paying it. Increasingly, for infrastructure projects, the trend is to identify beneficiaries and make them pay a reasonable share of the cost instead of using general tax financing. Recent financing arrangements have included public-private partnerships, creation of special districts (i.e., water and sewer districts) and impact fees.

 

GOVERNMENT BORROWING FOR PUBLIC CAPITAL AND DEFERRED TAXATION

 

Rather than being financed by current taxes, public sector capital is often financed by borrowing through capital markets. The most common means of borrowing for the government is by issuing bonds that are sold to the public (individuals and institutions). General obligation bonds are backed by the full faith and credit of the government, require voter approval and are subject to statutory debt limits. The other widely used bonds for public capital are lease-revenue bonds, which are payable exclusively from the revenues generated by the project and are an extension of the pay-as-you-use philosophy. Lease-revenue bonds do not require voter approval and are not subject to statutory debt limits.

 

When a government borrows money from the public by selling bonds, the government makes a commitment to repay the principal and the interest accrued over the life of the bond. In order to fulfill its obligation of repayment, the government will need future sources of revenues. This could come from future taxes or additional borrowing. But eventually some taxes or fees will have to generate the needed revenue for repaying the bond debt. In this sense, bond financing for public capital or other forms of public spending is actually deferred taxation, which shifts the burden of taxation for financing public goods to future taxpayers. The level of government debt is particularly important because interest payments on debt constitute a significant share of total expenditures at all levels of government.

 

In other words, expenditures in a government budget arising from bond debt repayment (both principal and interest) are obligations on present taxpayers that were decided in the past. If a government decides to renege on its payment obligations for debts incurred by a previous government or defaults on its payment for some other reason, the public project would continue to provide public benefits to all current and future generations. Because of these equity and efficiency concerns, bond financing is politically sensitive.

 

The question, under such a scenario, then is whether it matters if government uses taxes or borrows to finance public spending. The answer depends on who eventually repays the debt. If the same individual bears the burden, regardless of whether the repayment is in the form of current taxes or future interest payments, then it does not matter. If, on the other hand, government borrowing is used to finance public spending so that payment of the interest and future repayment of the bond can be shifted to future generations, then the form of repayment does matter, as it has direct equity implications.

 

FISCAL ILLUSION

The failure of people to recognize that government bonds are future tax obligations is called a form of fiscal illusion. If borrowing is not recognized as deferred taxes, then a government may use this type of fiscal illusion to increase its revenue beyond what taxpayers may prefer. In such a situation, public spending may exceed what voters would actually want in the absence of fiscal illusion.  

 

PUBLIC BORROWING AND DEBT MANAGEMENT

The consequences of borrowing or issuing debt is critical on several fronts - from the burden on taxpayers to the fiscal health and state of public infrastructure. Since borrowing is almost unavoidable, it is important that government borrowing is based on some fundamental principles that create conditions for effective financial management.
 

The Government Finance Officers' Association (GFOA) defines debt management policies "as written guidelines and restrictions that affect the amount and type of debt issued by a state or local government, the issuance process and the management of a debt portfolio." (See GFOA's recommended practices.)

 

A formal debt policy is considered integral to effective financial management and provides guidelines for a government to manage its debt within available resources. A good debt policy should have clear policy goals, result in better decisions, and be able to justify the structure of the debt issuance. In other words, it should demonstrate a commitment to long-term financial planning, including capital planning.

 

An October 1997 article in the Government Finance Review summarizing a 1995 survey across a large number of GFOA cities concluded that less than 20 percent of GFOA municipalities had debt management policies. The 97 policies covered in the survey varied substantially in scope and content as well.
 

The GFOA recommends that a debt policy should include the following elements:

• Purposes for which debt may be issued
• Legal limitations on debt
• Use of moral obligation pledges (when a debt is backed by moral obligation, not legal obligation)
• Types of debt that may be issued and criteria for issuance
• Structural features that should be considered in an issuance
• Credit objectives
• Methods of sale
• Selection of financial professionals involved at any point of the debt issuance
• Refunding of debt
• Primary and secondary market disclosure practices, including annual certification as required
• Compliance with federal tax law provisions, including arbitrage provisions
• Integration of capital financing and debt financing activities
• Investment of bond proceeds