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Financing Public Infrastructure: Generational Equity and Municipal Debt

By Jenifer C. Merkel, Assistant City Attorney, City of Seattle, with Alice M. Ostdiek and P. Stephen DiJulio, Foster Pepper PLLC

Municipal infrastructure is expensive. In deciding when and how to finance large capital projects, a council or commission must balance many competing factors. Should the local government borrow money to pay for the project? Or should it set aside funds over time – saving up to pay with cash? Is it fair to tax a resident over many years to provide funds to acquire and construct a public park, only to construct the park after the resident has moved away and can no longer enjoy that facility?

When approaching these decisions, some basic equity issues confront all municipal governing bodies. Generational equity is the concept that users of a capital project will change over its useful life and fairness requires those costs to be spread to those who will use the infrastructure over time. From this perspective long-term financing is often more equitable than using currently available funds (collected from current and prior residents who may not enjoy the future improvement).

To Borrow or Not to Borrow? That is the Question

After the Great Seattle Fire of June 6, 1889, the city had an immediate need to reconstruct essential public facilities. Borrowing money was critical to the city’s rebuilding – and its future. The decision to borrow after this disaster was not only necessary, it was also equitable. Charging the cost of a capital improvement to future generations of residents, users and ratepayers meant that beneficiaries of the new infrastructure contributed financial support.

Financing a family home with a mortgage is not so different. A mortgage provides a family the immediate use of their residence and spreads the cost of the home over the lifetime of the investment. As the family enjoys the economic and quality of life benefits of the home, the family continues to pay for the capital investment on an on-going basis.

But municipal infrastructure is more like a landlord financing a new roof or a new plumbing system in an apartment building. Residents come and go. If the landlord now charges higher rent to replace the roof in ten years, is that fair to a current resident who puts up with the leaks? That is not to say that the landlord shouldn’t establish a reserve and plan ahead. But few apartment dwellers would be happy to pay the full cost of a new roof while they are being rained on.

In terms of public infrastructure, there is yet another value in financing a long-term capital facility. The public’s immediate use of that facility can foster economic development. This provides an immediate economic benefit, which in turn provides certain community benefits. While economic benefits may be easier to measure by evaluating how the numbers "pencil out," quality of life or other benefits can be more difficult to quantify but are equally important to a community.

Fiscal Prudence and Counter-Cyclical Smarts

Washington State has a history of fiscal conservatism with origins in municipal defaults that occurred throughout the West in the late 1800s. Railroads influenced municipalities to issue bonds to finance their expansion, by promising economic booms that never materialized. Drafters of Washington’s constitution reacted by placing strict debt limitations and other restrictions on the use of public debt, and a foundation for fiscally conservative public financing was established. See, e.g., Washington Constitution, Article VIII, Section 7 ("No county, city or town . . . shall hereafter give any money, or property, or loan its money . . . to or in aid of any individual . . . .").

So we have firmly established that too much debt is not a good thing. But, how much is too much? A "pay-as-you-go" or "cash-only" approach may stifle the development of urgently needed infrastructure and delay important public benefits. Such an approach may result in an inequitable cost sharing, with most of the public benefits to be enjoyed by future taxpayers or ratepayers who do not pay a share of the cost.

It is also important to consider the cost of capital and to weigh this against what is known as "negative carry." Collecting money and stashing it in a reserve fund, results in a loss of value in any inflationary environment, particularly because public funds must be conservatively invested. Over the 3-year period from July 2009 to July 2012, public funds invested by the Office of the State Treasurer in the Local Government Investment Pool have earned an average of 0.25% interest.  Inflation, measured by the change in consumer price index (Seattle-Tacoma-Bremerton, All Urban Consumers) over the same 3-year period was 5.21%.  Thus, the money has lost value in terms of purchasing power.  All other things being equal, the value of public improvements that can be completed with the same dollars has shrunk.

The governing board recognizes that the ability of the community to absorb the cost of debt service through additional taxation or increased rates can never be overlooked. However, when a "negative carry" is factored in, cash funding (pay-as-you-go) is often more expensive than debt financing (pay-as-you-use).

Long-term financing of capital infrastructure during an economic downturn may allow a municipal entity to develop infrastructure at a lower cost and to assist the community in its recovery and future redevelopment. But, in economically challenging times, discussing debt can become politically charged. To inform that debate for Washington local governments, the following points should be remembered.

First, Washington local governments operate within strict constitutional and statutory fiscal controls, including debt limitations, tax limitations, and a balanced budget requirement. The balanced budget requirement prevents local governments from financing operating deficits with long-term borrowing. Second, long-term financing of infrastructure is equitable because it matches up the users with the payors (pay-as-you-use) and is fiscally responsible because it takes into account the negative carry costs of cash funding and the comparatively low cost of capital. Third, local governments will not lose sight of the benefits to the community from a capital project (including economic development and the general health and welfare). Finally, whether using borrowed money or available cash, each local governing body will determine what is in the best interest of the community, within available, albeit limited, resources.

MRSC is a private nonprofit organization serving local governments in Washington State. Eligible government agencies in Washington State may use our free, one-on-one Ask MRSC service to get answers to legal, policy, or financial questions.

About Jenifer C. Merkel