Getting Local Governments Where They Need to Go Without Taking Taxpayers for a Ride: “Cabs,” Why They Are Used, and What Can Be Done to Prevent Their Misuse

 

Getting Local Governments Where They Need to Go Without Taking Taxpayers for a Ride: “Cabs,” Why They Are Used, and What Can Be Done to Prevent Their Misuse

white_h
Heather White
Counsel, Nixon Peabody LLP
Fellow, Taxation Law and Policy Research Group,
University of Western Australia Law School

                        Heather White

State and local governments construct hundreds of billions of dollars of public infrastructure in the United States every year, ranging from schools, roads and parks to ports, power plants and water systems.

Ideally, the cost of this infrastructure, much of which is intended to last for decades, would be spread evenly over its life so that neither today’s nor tomorrow’s taxpayers pay more than their fair share.  Borrowing money to finance facilities while also spreading principal and interest payments over the life of the facilities, allows state and local governments to spread the cost in this way. And, state and local governments do borrow.  According to the Securities Industry and Financial Markets Association, they issued more than $400 billion of debt in 2015.  Much of this debt is in the form of “municipal bonds” sold to investors.  Borrowing governments pay interest on the principal amount of the bonds, usually every six months.

In recent years, there has been considerable—some would say excessive—reliance on long-term compound interest bonds (referred to as “capital appreciation bonds” or “CABs”), on which neither principal nor interest is paid until at or near maturity.  The use of CABs by school districts, in particular, has received considerable negative attention in the press, from grand juries and elsewhere and both California and Texas have enacted laws restricting local government issuance of capital appreciation bonds.

There is no doubt that CABs are problematic.  Most of the time, they bear higher interest rates than bonds on which interest is paid periodically (“current interest bonds”).  They can also place an inequitable burden on future taxpayers, and because of the way that they are counted against debt limits, they make it appear that less is being borrowed than actually is.

Nevertheless, as I read articles and reports condemning CABs, my sense was that much of the criticism was incomplete, and at least arguably unfair because it overlooked the context in which CABs were being used and the reasons they were used.

As a result of my years practicing as a public finance lawyer in California, I knew that some local governments were issuing CABs because that was the only way they could issue bonds, and I believed that some local governments could only complete much-needed projects by borrowing.

It seemed unlikely that many local governments were spending too much on infrastructure.  I had heard stories about the sorry state of schools in California, and I recalled the regular roof leaks at my high school in the 1980s.  This experience seemed to reflect the current state of American infrastructure in general.  The American Society of Civil Engineers assigned US infrastructure a “grade” of D+ in 2017 and indicated that nearly $4.6 trillion in infrastructure spending would be needed nationwide in the next 10 years.

I also knew that, most of the time, CABs were issued in conjunction with bonds on which interest is paid periodically—an important piece of the puzzle that seemed to be missing in some of the critiques.

My work with state and local governments had introduced me to many remarkably dedicated, hard-working, intelligent people who were committed to serving the public.  While there probably were some officials engaging in practices to benefit themselves at the expense of their constituents, or to benefit their constituents in the short term without regard for the long-term, I believed that this was rare.

I wanted to understand the complete story, and to test my own assumptions and those of others about why CABs were used.  I believed that identifying reasons that CABs were issued was the only way to come up with ways to prevent their misuse without creating other problems—preventing local governments from repairing or constructing critical facilities, prohibiting borrowing that was beneficial, or driving local governments to other financing structures that simply created different problems or the same problems in a different form.

Because of this, I decided to study CABs and the reasons that they are used, and to propose some alternative ways to prevent their misuse.  I focused on “general obligation bonds”—which are paid from property taxes—issued by school districts in California and Texas. These are two of the states where CABs are used most, and school districts are the most frequent issuers of CABs in both states.

I identified several factors that contribute to the use of CABs, including the desire to avoid near-term tax increases, the need to comply with statutory restrictions, the pressure to meet the needs of a rapidly growing population, the difficulty of fulfilling promises to voters about both projects and tax rates when circumstances change, and lack of information or understanding by board members and officials.

I then considered several potential ways to prevent the misuse of CABs in light of these reasons, including providing additional information to governing board members and the public, providing additional training to local government officials, and prohibiting or restricting the use of CABs, or changing restrictions on debt that have the effect of encouraging their use.

The results of my research are presented in Getting Local Governments Where They Need to Go Without Taking Taxpayers for a Ride: “CABs,” Why They Are Used, and What Can Be Done to Prevent their Misuse, 49 St. Mary’s L.J 363 (2018), http://www.stmaryslawjournal.org/wp-content/uploads/2018/03/White_Local_Governments-Taxpayers-CABs.pdf.  This article provides an introduction to municipal bonds and the legal limits that apply to California and Texas school district general obligation bonds, discusses the most significant problems associated with CABs, details the reasons that CABs are nevertheless used, describes California and Texas legislation restricting their use, and presents alternative ways to prevent the misuse of CABs.

The lessons presented in this article apply to local governments, generally, and are critical given the huge infrastructure needs facing the United States and the significant role that local governments and municipal bonds are likely to play in meeting those needs.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s