From the White House to state houses to city halls, policymakers agree the nation needs greater infrastructure investment. What’s less clear is the most strategic and cost-effective way to pay for these investments.
In many jurisdictions, debt is certain to play an important role in paying for capital improvements. According to the Securities Industry and Financial Markets Association, a membership organization for capital market participants, states and municipalities borrowed $204 billion in 2017 to pay for roads, bridges, state university buildings, and other infrastructure improvements—allowing vital projects to move forward with the costs spread over time and paid for by the taxpayers who will benefit.
Yet as state and local governments grapple with a growing need to pay for new projects and maintain their existing investments, gauging whether a state can afford to take on new debt—and how much—can be difficult. Policymakers don’t always have access to the data necessary to evaluate their state’s full portfolio of long-term obligations or the information they need to assess how financial commitments made in the current fiscal year will affect budgets down the road.
Twenty-nine states use debt affordability studies to manage long-term borrowing. These analyses vary across the states because debt portfolios differ substantially, too. But several elements are present in all of these studies, including data and analysis on outstanding debt, an analysis of obligations relative to the state’s capacity to support them, and projections to evaluate the state’s borrowing capacity in future budget years.
The core of an affordability study is its debt capacity model, which analyzes outstanding debt and debt service, anticipated future issuances, revenue and economic forecasts, and interest rates in order to project debt levels in future years.
In any forecast, actual outcomes may diverge from what the model predicts: revenues may be lower than expected, a state’s economy may grow faster than anticipated, or interest rates may unexpectedly rise. Varying the model’s assumptions—also known as performing a sensitivity analysis—can illustrate how the affordability of state obligations could change if future conditions differ from current expectations.
Sensitivity analysis is especially important in states that rely on volatile tax sources to pay down their debt. For example, Oregon’s revenues rely primarily on income taxes—a funding stream that can vary widely from year to year. That state’s debt capacity model incorporates regularly updated revenue forecasts and calculates changes to borrowing capacity based on both a 10 percent increase and a 10 percent decrease in general fund revenue. This forward-looking analysis helped the state make prudent borrowing decisions during the Great Recession. As revenues declined, the legislature delayed some projects to keep the state’s debt at an affordable level.
In addition to modeling general fund borrowing capacity, debt affordability studies can also help policymakers understand the full range of long-term liabilities for which public revenues are committed, such as borrowing by authorities and universities.
States take a variety of approaches to including these obligations in their affordability studies, often excluding them from the capacity model if the borrowing has no legal claim on state funds. In Rhode Island, the study includes an analysis of the debt burden of each authority, and uses credit rating criteria for similar entities to recommend non-binding, specifically tailored debt caps. Virginia takes a different approach: its debt affordability study examines the impact on the Commonwealth of assuming repayment for all outstanding “moral obligations.” These commitments are not legally binding on the state, but the state may appropriate funds and pay the debt service if necessary; for example, to protect the fiscal health of the issuing entity and its own credit rating. Other states simply report the obligations of other entities, such as local governments or independent public authorities, using the debt affordability study to convey this data in one place.
States can also use debt affordability studies to examine the combined claims on future revenue created by borrowing and unfunded pension and retiree health care liabilities. Unlike bonded debt, which typically carries a fixed payment schedule, retirement liabilities fluctuate based on investment performance and state contributions can vary from year to year. Despite these differences, retirement liabilities and debt both represent a claim on a state’s future revenue. Considering them together can inform decisions on debt capacity. In the last two years, North Carolina Treasurer Dale Folwell has recommended that the Tar Heel state raise its borrowing cap to free up cash to pay down retirement liabilities while allowing the state to continue investments in capital assets through prudent borrowing.
Incorporating robust data and forward-looking analysis helps policymakers establish evidence-based affordability policies—or borrowing caps. In some cases, like New Hampshire and Oklahoma, states use a debt affordability analysis to manage borrowing levels so they align with statutory or constitutional debt limits. In others, such as North Carolina and Rhode Island, the study is used to define the level of long-term debt deemed “affordable,” based on expected economic and fiscal outcomes. The affordability analysis can guide borrowing decisions made in the current fiscal year, and outline the expected levels of borrowing the state will be able to support in future budget years.
Because of variations in tax structure, the type of borrowing used, the particular agencies authorized to issue debt, and borrowing limitations across state lines, no two debt affordability studies will look the same. However, by providing information on a range of liabilities, strong debt affordability studies can help lawmakers and finance experts make borrowing decisions that are informed by the most relevant data—and help protect taxpayer dollars in the process.
Mary Murphy is a director and Frances McGaffey is a senior associate with The Pew Charitable Trusts’ project on state and local fiscal policy.
This column originally appeared in Capitol Ideas magazine.