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FINANCING CAPITAL EXPENDITURES

Capital expenditures are generally financed with bonds. A bond is basically a promise to make repayments to the buyer on a regular, prearranged basis. Generally, interest payments are made once or twice a year, and the principal is repaid on the bond's maturity date. Between the time that a bond is issued and its maturity date, the bond's market value will vary, but the periodic interest payments (dividends) and the final payment at maturity are fixed from the beginning.1

One reason for using bonds is that capital expenditures often involve large sums of money and they are often "lumpy," meaning that they come along in an irregular manner. Thus financing them out of the municipality's or state's operating budget would lead to big swings in expenditures from year to year. Another reason is that capital expenditures generally deliver their benefits over a period of decades. Thus asking current taxpayers to pay for a project up front would be asking them to fund something from which they may receive only a small share of the total benefits.2

In contrast to capital expenditures, the ordinary operations of state and local governments are funded with current revenues rather than with bonds. In fact, states and local governments are generally prohibited from borrowing to pay for short-term expenses.3 The prohibitions may be in state constitutions or in state-enabling legislation that specifies the rules under which local governments operate. This prohibition makes a great deal of sense, since politicians might otherwise be tempted to borrow long term to pay for recurrent expenses to keep down tax rates. But that ultimately can put the state or municipality in an untenable financial position. In the nineteenth century a number of state bankruptcies came about in just this manner, and that is why the prohibitions came into being.

 
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