When a state wants to build a road or building, should it borrow the money or use current taxes? The new Minnesota Legislature faces that question.
The consensus is that we need more roads. The governor favors borrowing while many Democrats and some Republicans favor paying as we go even if that means increased gas taxes. Who is right?
The answer involves political as well as economic variables. Different people with equally good intentions can come to different conclusions. The objective today is not to indicate some optimum approach, but rather to discuss key arguments in the debate.
Pragmatism and fairness drive traditional arguments for borrowing. When first established, Minnesota and other states did not have the resources to build large infrastructure projects out of annual revenue. The money simply was not there. If key public works were needed, the state had to either borrow or do without.
A young family in a rented apartment with little net worth would be an analogy. With limited income and assets, such a family either has to borrow to buy a house or rent until they accumulate enough savings to buy.
In wealthy countries with ample mortgage markets, nearly everyone in this situation chooses to borrow. Similarly, in the historical development of the United States, most states borrowed to construct needed facilities.
Borrowing to build things that have long lives also seems fair to most people. If citizens are going to use a bridge for 50 years, why should one cohort of taxpayers have to pay for it in a year or two? Borrowing money by selling bonds and then amortizing the bonds with small, regular amounts from annual taxes can spread the apparent cost over generations.
Opponents of borrowing often focus on interest costs. Minnesota is now an established “going concern,” they argue. We need to build roads and state buildings each year to replace those that wear out and to meet the needs of the state’s growth. Why borrow millions of dollars a year via new bonds while paying off similar amounts of old bonds? Bonds require interest payments. We could save taxpayers this interest expense if we taxed a bit more and paid for more roads as we built them.
Bonding, they argue, might be justified for very large new projects, but annual taxes should pay for bread-and-butter rebuilding and upgrades of existing facilities.
Their household analogy would be that a family should borrow to buy a house and perhaps a car, but that they should pay cash for other expenses, including major items like a new roof for the house or a transmission job for the minivan. Borrowing for such expenses just adds unnecessary interest costs to the household budget.
At this point in the debate, public finance specialists note another consideration. By exempting interest earned on municipal and state bonds from federal income taxation, the U.S. government subsidizes borrowing by states. Because the interest is tax-free to bondholders, state and local governments can borrow at lower rates of interest than they would if the interest they pay to bondholders were taxable.
The federal government has put money on the table, they argue. To forgo borrowing because of some inappropriate analogy to a private household is to let that money lie unclaimed.
Gov. Tim Pawlenty has dusted off an old argument to support taking on more debt. Interest rates are less than the rate of inflation, he argues. If we borrow, we can eat our cake now and it will cost us less than if we waited to accumulate tax money and buy cake in the future, even considering interest costs.
The governor’s strategy was one followed by some households and businesses in the high-inflation 1970s. Borrow to consume or invest now, and pay off your debt with devalued dollars in the future, was the rule. The strategy now depends on a crucial assumption: that real interest rates are negative — that is, less than inflation.
If one considers only the last two or three years, the rate of growth of road construction costs has been higher than interest rates on state bonds. But this is largely true because road construction is energy-intensive and because it uses materials such as asphalt, steel and Portland cement, which have become more expensive with China’s booming economy.
Such increases are not usual if one looks back over 20 or 30 years rather than two or three. They certainly will not continue over the decades-long life of highway bonds. Long-term interest rates will be positive even if they are not compared to construction inflation right now.
Moreover, we are living in a fool’s paradise of low interest rates resulting from the Federal Reserve’s response to a recession and unprecedented Asian Central Bank lending to our country. Neither will continue apace.
The final — and perhaps most important — factor to consider is the opinion of bond markets. Minnesota pays relatively low interest rates because it has a history of fiscal prudence.
We can sell more bonds, but as we increase our indebtedness relative to the size of our state revenue, financial markets eventually will demand higher interest rates. Bond rating agencies, rather than lobbying groups or coalitions in the Legislature, will have the final say on how much Minnesota should borrow.
© 2004 Edward Lotterman
Chanarambie Consulting, Inc.