Do the States Have a Debt Problem?

States and localities have $3 trillion in debt, but the purpose and use of debt differs significantly from the federal government.
by | May 30, 2013

State and local governments have been on a borrowing binge. In 1980, they were carrying close to $400 billion in outstanding debt; by 2000, it was $1.2 trillion; today, it's $3 trillion, according to the Board of Governors of the Federal Reserve System.

Is that worrisome? Could states and localities find themselves over their head in debt and in danger of running out of money? How dangerous is the increase in debt and why is it happening? I put these questions to Merl Hackbart, professor of finance in public administration at the University of Kentucky and that state's former budget officer. An edited version of our conversation follows.

Is the increased level of debt a cause for concern?

Issuance of debt by states and localities has been done in a fairly sound and constructive manner. The purposes and use of that financing differs significantly from the federal government. Unfortunately, the two become confused in the popular press and the differentiation is not made. Whereas the federal government issues bonds and finances current operating programs through debt finance, state and local governments use the vast majority, if not all, of debt issues to finance infrastructure rather than current consumption. It's a significant and fundamental difference. States and localities are not having future generations finance current consumption. These are investments in the future because they are enhancing the capacity for economic growth and development. It's important to note that states differ from the federal government in that they have operating budgets and capital budgets, and the debt is issued through capital budgets.

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Why is the debt rising?

The issuance of bonds is an accumulation of debt in response to the fact that as the economy grows, there's an increased need for investment in infrastructure.

There are a number of other factors that account for the rise in debt as well. As the federal government cuts back on its funding of infrastructure and reduces its investment in capital facilities, state and local governments have had to fill that gap -- the need for maintaining existing transportation systems and other infrastructure components. [Based on the] current conversation about the federal government's deficit, it's likely [it will remain their responsibility well into] the future.

Another factor is that states and localities realize there are historically low interest rates available now. So that's a great opportunity to finance capital investments and reduce interest costs on into the future. In some states, a portion or all of those investments is usually financed from general sources of revenue. But state budgets are tight. Today, they might issue bonds for some capital investments that, under stronger economic conditions, they would have used a pay-as-you-go strategy.

What are state policies vis-a-vis debt limits?

A majority of states have constitutional or statutory limitations, particularly for general obligation bonds. Some states also establish limits on guaranteed revenue bonds. Many of the debt limits may be absolute numbers, which was more common decades ago. Recently, limits have been relative limits -- a percent of personal income or current revenues. The most common ones are a limit on debt service as a percent of the general fund or road funds or other earmarked funds. The limits have grown in popularity and provide guidelines to policymakers about the position the state or community might take regarding the financing of infrastructure through the sale of bonds.

These limits are not like the federal government's, where they are subject to renewal. They are more visionary in terms of debt capacity and trying to manage affordability. They eliminate the political considerations so popular in Washington.

Is there a "best way" to measure capacity for debt -- a measure that credit agencies or other third parties see as better than others?

In Kentucky, when we developed a debt policy, we looked at long-term trends and other states. There's a peer effect in the establishment of debt limits and guidelines. Debt limits tend to vary by source of support for the bonds being issued. If you look at long-term trends for transportation facilities, there's typically a dedicated revenue source to support [the bond]. A road fund is generally supported by a tax on gas, diesel fuels and other sources of that nature. Those tax revenues are dedicated for transportation only. [Bond repayments] are not in competition in the general fund with Medicaid or education, so there might be a higher ratio. It's the same with utilities. You might have a higher leverage ratio because there's a relatively fixed market.

Do you have any advice for governors, mayors and legislators, who might be looking at this issue this year?

Unlike the federal government, states and localities establish capital budgets. In doing so, they attempt to analyze needs for capital investments into the future. Certainly it's important to have established policies regarding the management of debt issuance and the overall level of debt. Once those policies are established, it's important to be consistent. Credit rating agencies are not as concerned about the specific metric; they're more concerned that debt policies and limits that are established be maintained consistently. Attempts to deviate from policies may suggest that the long-term commitment to debt outstanding may be wavering.

A strong capital management budgeting process is important. Maintaining infrastructure is important so you don't run into a bump where you need significant investment and there's a testing of debt capacity. It's also important for state and local governments to monitor or watch federal government policies. While states and localities finance the bulk of public infrastructure, the federal government is still a partner. Those trends about what the feds might do will have implications for needs that will have to be met by state and local governments.

That's not necessarily good news, is it?

No, it isn't.

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