The Minnesota Legislature is ending work on its biennial “bonding” or “capital improvements” bill. It considers such spending for building long-life physical facilities separately from appropriations for day-to-day government operations.
This distinction between capital and non-capital spending, common in state government, is not necessarily as clear-cut as it might seem. It introduces some perverse incentives into public administration. Despite these problems, such a split in authorizing appropriations probably remains the most workable approach. Citizens should be aware of the pitfalls, however.
Drawing a line between operating and capital spending is based partly on inherent differences between the two categories and on some quirks of state constitutions and federal laws.
One can draw analogies between the state and a household. Historically, it was assumed that prudent families should not borrow to buy groceries and clothing or to make minor repairs on houses and autos.
Large expenditures, such as the purchase of a home or new car, were different. These occurred infrequently. Few households could make such purchases out of regular income without saving for inordinate periods. Resorting to borrowing was a commonsense solution.
Analogies to business also exist. A manufacturer should be able to buy raw materials and meet its payroll out of normal ongoing income. Building a whole new factory or even purchasing an important new machine is different. Here a small firm could finance this major expense by borrowing from a bank or by selling corporate bonds.
Thus, following the analogies, a state should pay normal operating expenses such as salaries, expendable supplies and so forth out of annual tax revenues while borrowing for major new state buildings, roads and parks.
Because new bridges and buildings last for decades, taxpayers should pay for them over a period of decades. One cohort of taxpayers should not bear the entire fiscal burden of building facilities that would serve several generations.
This distinction is enshrined in some state constitutions that require balanced annual operating budgets. The assumption is that it is fiscally imprudent for a state to borrow to pay state college teachers or put gas in the tanks of highway patrol cruisers. This restriction should not, however, apply to building new college buildings or bridges.
The problem is that what is true for an individual family or small business is not necessarily true for a state. If a farmer has one barn with a roof that must be replaced every 40 years, that infrequent event may justify borrowing. However, suppose a state has 240 buildings scattered at various colleges across the state and it needs to replace six roofs or so per year. Do such regular, predictable repairs justify selling bonds?
If there are thousands of state highway bridges and a hundred are replaced every year, couldn’t such regular replacements be treated as an annual item? After all, homeowners know they will have to fix a few broken windows and leaky faucets each year and do not normally seek a loan to paint a bedroom.
A practical answer is that U.S. law is such that the federal government subsidizes borrowing by states and local government. A legal decision in the 19th century established a principal that one autonomous level of government cannot tax activities of another autonomous level. In practice, this is interpreted that interest earned on most bonds issued by state and local governments is exempt from federal income tax.
Some of the benefit of this tax exemption accrues to those individuals who buy eligible bonds. But because interest on such bonds is free of tax, they are an attractive investment and can be sold even when they pay substantially lower interest rates than corporate bonds of comparably larger risk and term.
This implicit federal subsidy tempts states to borrow money for regular and foreseeable construction projects even when such borrowing would not be favorable in the absence of the subsidy. This is a classic example of a government policy distorting market signals and leading to inefficient use of resources.
The operating/capital split also distorts incentives for prudent maintenance. Consider a state university system that must request operating funds from the Legislature every two years. Within the total request, building maintenance competes with faculty salaries and new computers.
Administrators know that if they skimp on building maintenance, they will have more money for instruction. They under-fund maintenance, with intentions to make up the gap a couple of years down the road when the state’s fiscal situation is better and the Legislature is likely to be more generous. But that never seems to happen, and the list of leaking roofs and steam pipes grows longer.
Ten years down the road, the system administrators go to the Legislature and say, “Gosh, there are so many problems in our physical plant, we need money in the next bonding bill to totally redo the roofs of several buildings and overhaul the whole campus heating system.”
What might have been accomplished at lower cost on an annual operating budget basis becomes a “capital expenditure” that ultimately costs the taxpayers substantially more. Minnesotans can take comfort in the fact that this phenomenon in our state remains small compared to that in the highway ministry of any Latin American country. But perverse incentives still exist, and legislators and citizens need to be on guard.
© 2004 Edward Lotterman
Chanarambie Consulting, Inc.