Most people know that the federal government is amassing large debts and unfunded liabilities. But they may not know that state and local governments are doing the same. The latest data from the Federal Reserve Board show that total state and local debt jumped from $1.19 trillion in 2000 to $1.85 trillion by 2005, an increase of 55 percent.
Part of the increase is in traditional “general obligation” debt, but there is also rapidly rising issuance of “revenue bonds.” These bonds, which account for 61 percent of state and local debt, securitize future streams of taxes, fees, leases, lottery earnings, and tobacco settlement payments. State budget officials call their rush to securitize and spend “innovative finance.”
The eagerness to spend is even spurring officials to securitize future federal aid payments in the form of “grant anticipation” debt. Why wait for future federal housing or highway aid when you can go to Wall Street and turn promised aid into cash to spend right now? The problem is that when the future arrives and federal aid is consumed by debt servicing, politicians will likely declare a “budget crisis” and demand tax increases.
The federal government is fostering the debt addiction by providing incentives for states to borrow. The main incentive is the income tax exemption on state and local (“municipal”) bond interest, which distorts the economy by favoring government infrastructure over private infrastructure. Essentially, federal tax law favors the financing of monopoly government schools, highways, and airports over the financing of competitive private alternatives.
The tax advantage for municipal bonds also creates an incentive for special interests to lobby state officials to issue debt on their behalf. Dozens of major sports stadiums have been built with tax-exempt municipal debt. There is no reason to favor projects like these over private investments, such as oil refineries, that are the real backbone of the economy.
Congress imposed limits on the issuance of tax-exempt bonds for private activities in 1986, but since then, it has reversed course and embraced economic micromanagement by creating many new types of tax-exempt debt. Bureau of Census data show that 23 percent of all municipal debt is for “private purposes.”
Recent federal legislation has also promoted new ways for states to go into debt. For example, Congress has created three types of municipal “tax credit bond,” which have even larger tax advantages than regular municipal bonds.
Rising levels of state and local debt might not be so troublesome if it weren’t for all the other fiscal pressures facing the states. State and local governments have also built up large unfunded retirement liabilities for their 16 million employees. Pension plans for state and local employees are underfunded by about $700 billion, according to Barclays Global Investors. Health plans for employees are underfunded by about $1 trillion, according to Mercer Human Resources. Unless benefits are cut, taxpayers could end up on the hook for these huge costs.
Governments should take steps to end the bias towards debt and avert future state and local tax hikes. First, Congress should end the tax exemption for municipal debt in exchange for cutting overall tax rates on savings and investment. Second, states should use greater pay-as-you-go or current financing for needed infrastructure. Third, states should privatize items such as highways and airports that can support themselves by charging the people who use them for the benefit of their services. Fourth, states should cut employee retirement benefits and transition to pre-funded structures like defined-contribution pensions and health savings accounts.
Government debt is simply deferred taxes, and it imposes costs on families sooner or later. With debt now rising at every level of government, tomorrow’s families will have to fend off tax hikes on three separate fronts—federal, state, and local.