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The Capital Budget

Most local governments maintain a separate capital budget and capital improvements plan (CIP). In fact, in many states, local governments are required to maintain a capital improvements plan, often with a time horizon of five years or so.4 The CIP lays out the expected sequence of investments and thus gives the municipal government a rough schedule of when and in what amounts it will have to issue bonds and also a rough indicator of how much it will have to spend on debt service (payments of interest and principal) each year. Adopting the capital budget is the prerogative of the municipality's legislative body. Generally, the budget that the legislature passes, with or without modification, is proposed by the municipality's executive branch. Because capital expenditures have such a powerful effect on how the municipality develops, it is very important for the planning agency to have a hand in the preparation of the capital budget and the CIP.

Types of Bonds

Two main types of bonds are issued to finance public capital investment. For a task such as financing a new municipal building, the most common practice is to issue a general obligation (GO) bond. Such a bond is guaranteed by the "full faith and credit" of the municipal government, meaning that if the municipal government fails to make interest or principal payments on time, a court may require the municipal government to use any resources that it has to repay the bondholders. Because such bonds are a direct obligation on the municipal government, they are issued under strict limits. In many states, a municipality's total outstanding general obligation debt may not exceed a certain percentage of its property tax base. For example, in Virginia, state law limits a municipality's outstanding general obligation debt to 10 percent of its real property tax base. A referendum is required in a number of states before local or state government can issue general obligation bonds. Municipal governments are also prohibited from using bonds to pay for operating expenses because the temptation to shift the burden of present operations to future taxpayers would be a very strong one.

Although the line between capital investment and operating expenses is clear in principle, it can become a little fuzzy in practice. Creative accounting may classify as capital expenditures those which are really operating expenses and thus enable a municipal government to shift some of today's operating expenses onto future taxpayers. A leaseback arrangement may permit a municipal government to, in effect, make a capital expenditure without that expenditure counting against its general obligation debt limit. Here, an investor builds the facility and the municipal government signs a long-term lease with the investor. When the lease payments have been completed the facility is then transferred to municipal ownership. In terms of flow of funds the arrangement is almost the same as if the municipality had sold bonds to finance the facility. It seems like a transparent subterfuge but the courts have sustained it. In a number of cases municipal governments have sold off revenue-raising public facilities. Perhaps the most notable case was that of Chicago selling the rights to the toll revenues for the Dan Ryan Expressway noted in Chapter 12. In that case the municipality gets the funds up front to be used in whatever manner it chooses and in return it gives up a future revenue stream. Conceptually, giving up future revenues to support current expenditures is not so different from taking on debt to do the same thing.

Thus the very sharp distinction between capital and operating expenditures can become blurred, and strictures on borrowing for current expenses can sometimes be circumvented. Nonetheless, on balance the system operates more or less as described above.

One might ask why municipal (and state) governments are often so eager to take on debt rather than raise taxes. One reason is that there may be less citizen resistance to debt as opposed to taxes. In the U.S. anti-tax climate few politicians want to be hit with the "he raised your taxes" charge in the next election. Then, too, there is the fact of intermunicipal and interstate economic competition. As noted in Chapter 13, tax rates are not the most important factor in corporate decisions about where to locate but they do carry some weight.

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