A Draft for ABFM, Chicago

THE EFFECT OF PUBLIC DEBT ON STATE AND LOCAL ECONOMIC GROWTH AND ITS IMPLICATION FOR MEASURING DEBT CAPACITY: A SIMULTANEOUS EQUATIONS APPROACH

Qiushi Wang

University of Nebraska at Omaha

A draft for ABFM, Chicago

October 2008

I. Introduction

Public debt has been a relatively underworked area in public administration, yet it is a very important issue in government finance. In essence, with the assumption that bonded borrowings can not be used for non-capital expenditure, the debt actually plays a role that helps adjust the public capital investment to its optimal level, given the fixed schedule of borrowing costs and tax costs for a particular jurisdiction. If no debt was allowed, jurisdictions will have to rely solely on their current revenue or savings from past revenues, and this will cause underinvestment in public infrastructure. Existing literature typically focuses on one of the following three facets of public debt: borrowing costs and risk of default, debt burden and debt capacity, and the relationship between capital investment and regional economy, but none of them has taken a holistic view that take account of the problem all at a time. In fact, public debt has very complicated impact on state and local finance and many of these impacts are simultaneously determined by a set of endogenous and exogenous variables.For example, the debt level for a particular jurisdiction usually depends on its economic situationand some other factors such as management performance, political environment, etc. The jurisdiction’s economic situation is in turn, determined by such factors as past and current capital investment in infrastructure; the level of capital investment will play an important role in deciding how much debt the jurisdiction will borrow, after an optimal share of debt against tax financing has been chosen. This simple example reveals that the real effect of public debt can only be studied in this simultaneous system.

This dissertation will contribute to the literature in following ways:

1. Explicitly link debt to capital investment and state local economy and examine its impact in a simultaneous equation system;
2. Use a better measure as well as a large and updated dataset to estimate the above equation with both pooled cross-sectional and panel data technique;
3. Propose a new method to estimate debt capacity.

II. Literature Review

2.1 Debt level

In general, borrowing level, both the aggregated borrowing level for the whole financial market across the nation and the individual borrowing level for each jurisdiction, is positively associated with borrowing costs. First, an increase in the overall borrowing level will increase the borrowing costs for all municipal borrowers and this is sometimes called the “squeezing out” effect, because the more governments borrow, the less the private sector can borrow (Needs lit. here). Study shows that this effect turns out to be relatively small, from a low .37 basis points to a high of approximately 9.0 basis points increase in bond interest cost for every $1 billion increase in state and local borrowing level. (Tuccillo & Weicher, 1981; Kormendi & Nagle, 1981). On the contrary, the effect of jurisdictions’ own borrowing level appears to be dominant. Capeci (1990) shows that a million dollar increase in the size of an individual bond issuance will lead to an increase of 3.5 basis points in the borrowing costs.

Cunningham(1989) attempts to explain debt level by using both cross-sectional and time-series data. In his model, the equilibrium amount of debt is determined by equating the marginal welfare burden of debt with that of taxes. His model also incorporates the political argument that higher income residents prefer debt financing while lower income residents prefer tax finance, because the former benefit most from a lower tax burden. He finds that his dependent variable, which is the debt over personal income ratio, is positively related to income and unemployment, but is not related to past capital spending and expected population growth.

How state and local governments make decisions on issuing revenue bonds has not been well explained by the literature. Descriptive studies of revenue bonds usually focus on the perceived costlessness to the jurisdiction (Clark & Neubig, 1984; Clark, 1985). The income from the particular investment project, rather than government revenue, is used to service the debt. Allman (1982) proposes a model of revenue bond supply, in which the elected official tries to satisfy the voters by providing as many services as possible. Because the increasing user fees are considered a sign of increasing demand for revenue bonds, the supply of revenue bonds is assumed to be positively related to the recent user fee trend. His empirical results support this assumption, but a problem arises when only a small fraction of revenue projects use user fees to service the debt. But so far the literature has not yet addressed the association between the revenue bonds level and the overall cost of borrowing for that jurisdiction. It is an important assumption in this dissertation that as the overall level of debt, including GO and RB, increases, the cost of debt for the jurisdiction will also increase. This assumption will be tested by my empirical work.

2.2 Cost of debt

Literature on the costs of borrowing for state and local governments is reviewed in this section. In the United States, the majority of governmental borrowings takes the form of municipal bonds, and therefore takes place in the financial market. The theoretical frame work about debt that this paper is going to develop is exactly based on the assumption that governmental debt is all public traded and there is no implicit debt. Suppose the governmental debt is not in the bond format (this is indeed the case for many developing countries, China for example), and the financial market is not the venue for its transaction, the analytical framework will be completely different. Furthermore, it is argued that jurisdiction is not price taker in the financial market, because the jurisdiction-specific factors can affect borrowing costs. Like in the market for other goods, the price of financial products is also determined by demand and supply, but there are reasons to believe that the financial is not fully competitive. The number of suppliers of fund in the market is limited and each of them may have certain monopolistic power, implying that they can lend the funds to the “highest bidder” and reap more supplier surplus. It is to be noted that the “highest bidder” doesn’t only refer to the price, but also the risk. As the CAPM model shows, the real interest cost depends on a risk free interest rate plus a risk premium.

Measurement is another important issue in the study of borrowing cost. Over the past decade, a large body of literature has focused on this issue, taking one of the three different paths: net interest rate (NIC), true interest rate (TIC) and reoffer yield. Hopewell and Kaufman (1974) have a complete discussion of NIC and TIC. Both of them measure the interest cost of the entire bond issue and the key difference between the two is the time value of money. The reoffer yield is the interest cost for one particular maturity of the whole issue. It has several advantages such as easier control for general level of interest rate (Peng, 2000), but a big concern is that it does not include the cost of underwriter spread. Comparing the three methods, Peng (2000) concludes that TIC is the best measurement of the actual interest cost to the issuer, but NIC and offer yield may be more accessible to researchers.

Temple (1990, p.14) presents the tax exempt rate facing the ith jurisdiction with the following two equations:

and

where and are jurisdiction i’s interest costs on its general obligation bonds and revenue bonds, respectively. and are the level of general obligation and revenue bond issued by jurisdiction i during a particular period of time. is a vector of variables that contains information on jurisdiction i’s credit worthiness while consists of particular factors of the projects being financed, such as the predicted profitability. Further, Temple (1990) concludes that the costs of each type of borrowing (GO and RB) are positive function of the size both types of borrowing. Findings from Hendershott and Kidwell (1978), Leonard (1983), and others seem to support this conclusion. With respect to the interaction effect between GO and RB bond, Hendershott and Kidwell (1978) and Kidwell, et. al. (1984) imply that the interest costs associated with issuing general obligation bonds will increase with increase in the level of revenue bond issues and vice versa. Epple and Spatt (1986) cite evidence from the WPPSS’s default and argues that such large-size default has had an adverse effect on that state’s GO borrowing costs, even if the jurisdiction typically is not responsible for repayment of revenue bonds.

Capeci (1990) studies the effect of local fiscal policy on the jurisdiction’s borrowing cost. Using a sample of 243 bonds issued by New Jersey bond issuing entities, he finds that the amount borrowed per dollar of property value has a positive impact on the borrowing cost while the level of discretionary revenue per dollar of property value has a negative effect. Similarly, other researchers also find the positive relationship between bond issue volume and interest costs (Leonard, 1983; Hendershott & Kidwell, 1978). Hendershott and Kidwell (1978) also notice that a change in the supply of tax-exempt bonds may have effect on the interest costs in that particular regional market relative to the interest costs nationwide. Kidwell, Koch and Stock (1984) empirically prove that jurisdictions exempt from state income tax on the interest from bonds can issue bonds at lower interest cost.

The cost of borrowing depends on its own level of borrowing while the latter also depends on the borrowing cost that the jurisdiction is facing. In corporate finance research, the introduction of endogenous borrowing costs serves to limit borrowing and results in an optimal debt/equity structure (Barnea, et. al. 1981). In the public sector, such endogeneity will also result in an optimal structure of debt/tax ratio for jurisdictions (Temple, 1990).

Factors other than borrowing level also play an important part in the determination of jurisdictions’ borrowing costs. Although the exact information on the evaluation criteria of the three major rating agencies is unknown to the public, studies (needs lit) have approximated their process and it is widely believed that factors reflecting the financial health and the overall ability of the jurisdiction to repay the principal as well as interest are included in . These factors are the ratio of total general obligation debt to the taxable wealth in the jurisdiction, GO debt per capita, GO debt as a percentage of personal income, among others. , however, may contain specific information on the project, other than the common ones in , because the revenue bond financed project rely on its own proceeds to repay the revenue bond debt. Cook (1982) divides these factors into five broad categories: issue characteristics, issuer characteristics, marketing, regional market conditions and others (revenue versus GO bonds, size of issue, etc.). Some of these explanatory variables will be employed in the estimation model. Since the interest of borrowing is used in this dissertation only to control for the possible simultaneity, I will not go into further depth of this issue.

The interest cost is an important consideration for jurisdictions to make borrowing decisions. And it is partly responsible for the debt level to show a diminishing return with respect to the local economic growth. This will be further discussed in later sections.

2.3 Debt financing vs. tax financing

This section will discuss state and local governments’ decision on how to finance capital projects and the determinants of the portion that is financed by general obligation bonds. For the private sector, Miller (1977) argues that in the equilibrium, the market value of any firm must be independent of its capital structure even interest payments are fully deductible in computing corporate income taxes. Auerbach (1979), and Feldstein, Green and Sheshinski (1979), however, challenge Miller’s point of view by claiming that a unique optimal debt-equity ratio will exist if the cost of capital varies with the degree of debt finance, or “leverage”. Nadeau (1989) holds a similar view that the fact that interest costs vary with the level of borrowing may serve to guarantee a unique optimal point of debt. In the public sector, capital expenditures are financed by a combination of taxation, general obligation bonds and intergovernmental transfers. Among these three sources, intergovernmental transfers can largely be considered exogenous, and analogous to the private firm’s choice between debt financing and equity financing, the jurisdiction has the power to choose between debt financing and tax financing, or the debt share. Since the public borrowing costs also vary with the degree of borrowing, there may also be a unique optimal debt/tax ratio for each jurisdiction. Temple (1990) applies this analytical framework to the determination of optimal debt share. She assumes government official selects the mix of financing methods that minimizes the cost of a dollar of per capita public expenditure to the residents of the jurisdiction, in particular, to the median voter of the jurisdiction (p.23). Her analytical framework will be revisited in more detail in Chapter 3.

The existence of statutory control on debt may have impact on officials’ ability to adjust the debt share to the optimal level. There are two common types of restrictions on jurisdictions’ borrowing practice. First is the restriction that debt is only to be used to finance capital projects. Second is that debt should be limited to a certain percentage of some assessed value in the jurisdiction, or the “debt ceiling”. The first restriction is assumed to be true for GO bonds, because there is no evidence that suggests otherwise. It will be argued in this dissertation that the debt ceiling, however, is not binding, an assumption that has also been made be Gordon and Slemord (1986).

Another theory is also relevant to the optimal debt and tax share. Adams (1977), Asefa, et. al. (1981), Gordon and Slemord (1986) and Metcalf (1989) argue that municipal governments issue bonds in order to earn arbitrage. The direct form of municipal bond arbitrage consists of issuing tax exempt bonds and investing the proceeds in higher yield taxable bonds, but it is limited by law (it has been largely eliminated by TRA 86). Alternatively, jurisdictions can engage in other two types of indirect arbitrage. Since governments can earn pre tax rate of return on taxable investment, residents in higher tax bracket may prefer that their governments save for them by collecting more tax revenues and using the proceeds to invest in taxable securities, because these residents would earn lower rate of return on their own investments. In contrast, jurisdictions can take advantage of the different yields on tax-exempt and taxable securities by issuing tax-exempt bonds and using the proceeds to lower tax rate. This substitution of bond for tax may be preferred by residents in lower tax bracket, because they can use the extra income gained from lower tax rate to invest in taxable securities and earn the greatest after tax yield. In their empirical work, this type of bond supply model usually includes such important determinants as the federal marginal tax rate of the residents in the jurisdiction and the marginal tax rate implied by the tax-exempt/taxable bond yield ratio.

2.4Capital investment in the infrastructure and economic growth

The neoclassic model of economic growth dates back to the late 1950s, with some early contributions made by Frank, Ramsey (1928), Harrod (1939) and Domer (1946). Solow (1956) and Swan (1956) build a model that adopts the neoclassical form of the production function. Their specification assumes constant return to scale, diminishing returns to each input, per capita variables and some positive and smooth elasticity of substitution between each input.The Cobb-Douglas production function and mathematical methods of dynamic optimization and differential equations are widely used to generate some general equilibrium of the economy, based on a set of strict assumptions some of which will be relaxed in variations of the main model. Attention has also been given to the government which plays an important part of regulator as well as consumer and producer in the economy. In a various modifications of Ramsey model, government purchase, tax effects, etc. and some government economic policies (monetary policy for example) are studied[1]. This dissertation will not go into the depth of these macroeconomic theories, but will borrow the languages and techniques from this tradition to analyze the government’s behavior in borrowing and public capital investment. More closely related to this dissertation is the literature focusing on the public sector, which will be presented next.

In the early 1990s, the Congress Budget Office and the Associated General Contractors of America estimatedthe gap between the investments needed to provide adequate public infrastructure and available resources to fund these projects range from $17.4 billion to $71.7 billion. Associated with this problem is the concern about the possible adverse effect on economic growth (Deno & Eberts, 1990). Pubic capital plays an important role in regional economic growth because it provides such goods and services as highways, bridges, sewer systems and water treatment facilities which can be viewed as inputs in the production (Meade, 1952). Helms (1985) and Garcia-Mila and McGuire (1987) find that capital expenditures on highway have a positive and significant effect on state personal income. Mera (1975) and Costa et al. (1987) examine the effect of capital stock, instead of capital expenditures, on the manufacturing, and find it to be positive. Several other studies also find the positive relationship between public capital and production output at the regional level (Eberts, 1986; Deno, 1988).