Municipal Debt Affordability

Debt and Limited Municipal Resources
Government revenues are finite, and not all revenues are flexible in their use – for example, federal categorical grants are only issued for specific purposes, earmarking those funds for one use only. As such, municipal debt service payments compete with operating costs and other demands for a slice of limited government revenue. When municipal debt service payments are too high – that is, when they demand too large a portion of overall government resources to properly doll out funding for other programs and services – governments must choose between cutting funding for programs and services, or increasing taxes to make up the difference.

Municipalities can ameliorate some of the burden of debt service interest by refunding and/or refinancing their debt under a lower interest rate. Generally speaking, however, debt service can only be discharged by paying off the debt and interest; even in municipal bankruptcy, the municipality will still be on the hook for some of the debt obligations in which they have entered.

As a result, debt level is intimately related to a government’s taxation level and ability to offer public services. If a municipality's debt level is too high, it will need to cut back on public programs or increase taxes to make up the shortfall. If public program offerings are too sparse, or tax levels are too high, residents will start voting with their feet and moving. Fewer residents means less taxes to pay of all obligations, starting a vicious cycle which, if left unchecked, can lead to dire financial consequences.

In order to remain solvent, municipalities must assure that their debt level is affordable.

Debt Affordability
What defines debt affordability? The somewhat short answer is that municipal debt affordability is the threshold at which a government can afford to sustain its debt and services without adversely impacting its ability to remain economically competitive. The long answer, however, is that this is much more complex than a simple threshold, and is contingent on a variety of variables and conditions.

When is debt considered affordable?
Different debt measures show different aspects of debt affordability. Debt per capita is useful because it shows how much debt is owed per resident. It says nothing about resident income, however, so we cannot access the power of the resident population to actually pay off that debt. Likewise, debt to GDP is a useful measure because it shows how municipal debt levels compare to total municipal economic activity. But the sum total in dollars of all economic activity does not get used to pay back municipal debt; only those dollars that go to government as revenue and is not earmarked for other specific purposes (ie: categorical grants). As a result, it can understate a municipality’s actual debt burden, making the situation look better than it actually is.

In this same vein, debt levels are affordable under varying economic conditions. During economic expansions, when revenue streams are robust, personal income levels are high, unemployment is low, and the amount of people reliant upon social assistance decreases, debt ratios will seem low. During recessions, however, when revenue streams contract and more residents file for unemployment and social assistance, debt ratios will seem high. Municipalities will also likely need to borrow more in order to make up for lost revenues and grants, increasing the debt-to-resource ratio as the downturn progresses. This impact is so pronounced that some experts argue that all calculations which are meant to determine the level of debt a municipality may incur in the coming year while remaining financially sound should account for economic downturns.

What debt affordability measures are most accurate?
Budget analysts, policy experts, and economists do not agree on how to measure debt affordability. Some argue that affordability can be measured using a concrete number or proportion of debt to a financial or other common standard. For example, debt is affordable if it is below 5% of municipal personal income. Others, however, argue that debt affordability is a function of competition: debt is affordable only so far as it does not make you noncompetitive in comparison to the municipalities around you. As such, a debt-to-personal income ratio of 10% is perfectly affordable so long as it does not require you to raise taxes or cut back public programs beyond the level of other competing municipalities.

Overall, however, there is no one-size-fits-all solution for assessing municipal debt affordability. First and foremost, municipalities have varying capital project needs. New York State, for example, has older infrastructure that requires more regular and costly capital investments than newly-developed states like Arizona. Similarly, New York City’s robust public transit system requires more capital investment than the bus and rail system in Buffalo, New York. The City, state, and Metropolitan Transit Authority (MTA) may be able to fund some of these improvements with pay-as-you-go financing (PAYGO) - money specifically earmarked to pay for capital projects upfront - but given the large sums needed for capital improvement projects, it will inevitably require the City, state, and MTA to incur more debt in order to finance these programs. And in fact, it is only fair that debt pay for capital projects with a long life-expectancy; that way, all those residents that benefit from the project inevitably pay for part of it: a concept called inter-generational equity.

Second, resident priorities across municipalities differ. Some municipalities, most notably conservative municipalities, are less apt to accept high levels of indebtedness because of their political culture. They are also more likely to offer fewer public services, and to have lower tax burdens. Liberal municipalities, in contrast, are more apt to support higher levels of indebtedness, to offer more public services, and to have higher tax burdens. Benchmarking a conservative municipality against a liberal municipality can be a false alternative, since many people choose to live in liberal states over conservative states because they value those spending priorities, and vice versa. Therefore, the base level of debt affordability is contingent upon the parameters of each municipality’s actual municipal competition; there is no measure that will work across all municipalities regardless of political, social, and economic composition.

Third, and arguably the most important reason as to why there is no one-size-fits-all solution: some measures are useless when put in a specific municipality’s context.

To illustrate: Town A has $20 million in debt outstanding, and has 20,000 residents with a median income of $250,000. Town B has $20 million in debt outstanding as well, but has 40,000 residents with a median income of $100,000. Comparing both using debt-per-capita, Town A's debt burden is significantly larger: $1,000 per resident compared to $500 per resident. But Town A also has much higher income levels, leading to greater revenues through income and sales taxes, and better chances of getting more money through higher taxes. Town A's capacity to pay back it's debt is likely greater than Town B, given Town A has more power to raise revenue and taxes when necessity dictates. As a result, debt per capita is not a meaningful measure for assessing the affordability of Town A's debt.

In conclusion, in order to accurately assess the affordability of municipal debt, analysts must consider multiple metrics for assessing debt level, and also the context in which each municipality is operating.

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