States: New Year, Same Debt Policy

Recently, state governments have taken advantage of low interest rates and issuing bonds to cover revenue losses from 2020. In doing so, states are adding to their tab of outstanding bonded obligations, which already total over $1 trillion. As the economy recovers, interest rates will rise and the cost of issuing debt will increase.

Rather than taking on new debt, a better New Year’s resolution for states is priority-based budgeting, to help them focus on the core functions of government and cut back on wasteful spending.

Here’s why interest rates will not stay low forever:

Interest rates are affected by many factors such as monetary policy, economic growth and inflation. Economists Scott Sumner and Alexander Salter note the Federal Reserve’s Federal Open Market Committee can set an interest rate target for the federal funds rate (the rate banks charge each other on overnight, unsecured loans for borrowing funds held at the fed), but due to the numerous factors affecting interest rates, the Federal Reserve can only influence real (inflation-adjusted) interest rates temporarily.

Sumner explains that expansionary monetary policy may reduce interest rates in the short term by adding liquidity to the economy, known as the liquidity effect. This expansionary monetary policy can also increase GDP and inflation. As GDP rises, demand for borrowing increases, pushing interest rates higher, known as the income effect. Lenders also raise interest rates in anticipation of higher inflation caused by the increase in the money supply, known as the Fisher effect.

What does this mean for state and municipal governments?

Cheap borrowing is not here to stay. As the economy recovers, interest rates will inevitably rise, and the cost of borrowing will increase for state governments. The increase in debt service payments means increased burdens on future taxpayers.

While it may be appealing for state governments to take advantage of the low interest rates now, they should remember the billions of dollars in debt they already owe. The ALEC annual report State Bonded Obligations found that states and their component units already have $1.16 trillion in outstanding bonded obligations.

Some states, such as Illinois, are drowning in debt. The State of Illinois and its component units have $62 billion in outstanding bonded obligations. The state also has $64 billion in unfunded other post-employment benefit (OPEB) liabilities (such as retiree health insurance) and $360 billion in unfunded government pension liabilities.

More than a decade of ALEC research shows that Illinois has mismanaged tax dollars while increasing tax and debt burdens. Illinoisans rejected a graduated income tax proposal last November because they do not trust policymakers in Springfield with their money.

Illinois bond prices and New York MTA bonds rallied in the bond market in early January. Why? Municipal bond investors hope that the new presidential administration and senate majority will bail out Illinois and New York. Additional federal aid, however, would only worsen the cycle of state spending and debt. The promise of additional federal aid, which comes in the form of better-than-market borrowing rates or few strings attached, encourages state policymakers to rack up debt with the promise that they will get bailed out by the federal taxpayers if they cannot afford to pay the debt.

New Year, New Policy: Priority-Based Budgeting

The way forward for states in 2021 is priority-based budgeting. As Economists Jonathan Williams of ALEC and Dave Trabert of the Kansas Policy Institute noted in The Wall Street Journal, legislators should make a systematic effort to determine what the state needs to do and how those priorities could be achieved efficiently.

Williams explains this systemic effort breaks down into five questions policymakers must ask themselves:

1. What is the purpose of government?
2. What are the essential services government must provide to fulfill its purpose?
3. How will we know if government is doing a good job?
4. What should all this cost?
5. If budget cuts are necessary, how are they to be properly prioritized?

This is a longer process than the current method of automatic increases, but it is well worth the work.

In 2001, Washington state lawmakers from both parties worked with then-Gov. Gary Locke and used priority-based budgeting to trim waste, eliminating a more than a $2 billion deficit without burdensome tax increases.

Last year taught us to appreciate what we have rather than what we want. It would be wise for state policymakers to appreciate this lesson as well.  Enacting priority-based budgeting instead of piling on “cheap” debt is a great resolution for 2021.