How Much Debt Can a Government Handle?

Debt financing is a powerful tool for state and local governments, which often rely on borrowed funds to build or repair vital infrastructure. The need for these projects is beyond dispute: The American Society of Civil Engineers estimates that the roads, bridges, tunnels, schools, hospitals, and underground pipes that taxpayers use need $4.6 trillion worth of investment—only slightly more than half of which is currently funded. While there is much talk of a federal infrastructure bill, the cost of rebuilding is likely to be borne primarily by state and local governments, which historically have contributed about 75 percent of infrastructure-related spending.

But gauging whether a government can afford to take on new debt—and how much—can be difficult. Lawmakers must strike a tough balance between borrowing enough to build infrastructure and not letting interest payments squeeze out other needed expenditures. At the same time, the definition of affordability will vary among states, depending on needs, market conditions, fiscal constraints and attitudes toward borrowing. Amid this uncertainty, policymakers often lack the data they need to make informed decisions about debt—everything from appropriate borrowing levels to the way debt should be structured.

Debt-affordability studies can provide policymakers with the data-driven analysis they need to bring better management and oversight to the issuance of debt. Unfortunately, strong studies are still the exception. Recent research by The Pew Charitable Trusts found that while 29 states conduct debt-affordability studies, only nine produce reports that give policymakers the clearest understanding of their state’s obligations.

Affordability studies can differ from state to state—because of variations in tax structure, the type of borrowing used, the particular agencies authorized to issue debt and caps on debt service—but these different analyses share the goal of helping lawmakers and finance experts make borrowing decisions informed by the most relevant data.

States that use debt-affordability studies have learned valuable lessons. For example, in some cases, policymakers did not know the full extent of their state’s obligations because multiple offices—or separate legal entities, such as state universities—issue publicly supported debt and the data is not centralized. Rhode Island recently revised its debt-affordability study to address this problem. It now includes data on the debt of all state authorities and affordability guidelines for each entity.

A debt-affordability study needs to be forward looking, with current and anticipated obligations clearly analyzed against the expected resources available to repay outstanding debt. Doing so allows states to manage their budgets and borrowing in a way that anticipates—and prepares for—changes in revenue. This approach helped Nevada weather its housing crisis, when declining property-tax revenue left less money available to pay debt service. The state’s affordability model accounted for these declines and decreased the available borrowing capacity. And when property values began to climb, the affordability model remained conservative, not incorporating the revenue increases until the treasurer’s office was confident that they would remain stable.

Including a variety of assumptions about revenue performance, economic changes and the costs associated with borrowing in a debt-affordability study is key to helping policymakers assess risks and plan for a range of outcomes. Oregon relies on a volatile income-tax for the bulk of its revenue but still limits its debt service to 5 percent of revenue through robust and frequent projections that assess the impact of changing interest rates and revenue scenarios. This forward-looking analysis helped the state make prudent borrowing decisions when revenue dropped during the Great Recession.   

When states want to make major infrastructure investments using debt, an evidence-based debt study can establish a definition of affordability in an open and transparent process. Each year in Georgia, the state’s Financing and Investment Commission produces a study that it uses to recommend an amount of borrowing that keeps the state’s debt service under 7 percent of the prior year’s revenue. Even when the legislature and the executive branch disagree on the purposes of borrowing, they agree to stay under the specified amount each year, allowing the state to make important investments in infrastructure while staying within budget constraints.

While policymakers may disagree about how much to borrow, for what, and when, all policymakers can benefit from objective data, insights and analysis provided by an effective debt-affordability study.

Susan K. Urahn is executive vice president and chief program officer for The Pew Charitable Trusts.

Reposted with permission of e.Republic.