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OCR for page 110
c)
Financing the NaHon's
Infrast ructure Requirements
George E. Peterson
INTRODUCTION
To many governmental bodies the infrastructure financing prob-
lem consists of finding enough money to pay for the repairs and
new investments they believe are necessary. In this it resembles
the unemployment insurance financing problem, the welfare fi-
nancing problem, and the school financing problem. There seems
to be an iron law of government that estimates of spending needs
always outrun available financing and that public officials must
spend much of their time straining to bring program budgets into
balance.
This chapter does not devote much attention to identifying new
resources or creative financing techniques that local governments
might tap. Rather, it looks at the national system for financing
infrastructure investment. Where has it failed, if indeed it has failed
at all? What principles should the country follow in paying for
repairs, and what institutions are most consistent with these prin-
ciples?
From a financial perspective, the infrastructure dilemma that
has beset the country is simply stated. State and local spending for
infrastructure purposes appears to be fixed on an erratic but per-
sistently downward path. The country is approaching the point at
which, in the aggregate, it will barely hold constant its net infra
110
OCR for page 111
FINANCING THE NATION'S INFRASTRUCTURE REQUIREMENTS 111
structure assets. Since public capital expenditures still include a
large number of new projects new mileage for the interstate high-
way system, for example- net disinvestment, perhaps of substan-
tial size, is occurring in the infrastructure assets that already are
in place.
In this chapter ~ first scrutinize the evidence regarding decline
in capital investments in infrastructure. ~ consider whether the
record is what it appears to be and whether there has been signif-
icant underinvestment in the nation's public facilities.
If significant underinvestment has occurred, it in turn implies
some type of failure in the infrastructure financing system. T first
consider the two major sources of financial capital for spending on
infrastructure: federal aid and long-term borrowing. Both of these
mechanisms have been assailed of late for failing to channel the
needed resources into investments in infrastructure.
Another possibility is that public investment is simply being
squeezer} out of government budgets by competition from other pub-
lic spending. Government spending decisions may have been dis-
torted by the short-term preoccupations of public officials laboring
under fiscal duress. Or the public may be hampered in its spending
choices by a lack of information regarding either the condition of
existing facilities or the consequences of deferring repairs and main-
tenance. It is also possible that the electorate, through its public
of ficials, has purchased just the mix of public services that it desires.
Despite expert opinion that there has been underinvestment in
public facilities, the public may have decided that, given the choices
available, it prefers to make do with the physical facilities it now
has and accept some deterioration in them. The middle section of
the chapter attempts to distinguish between these explanations of
the decline in public investment in infrastructure.
Looking to the future, ~ then discuss three principles that appear
applicable to the design of an infrastructure financing system. First,
wherever economically and administratively feasible, user-cost
pricing should be exploited to finance infrastructure improvements.
Such pricing can match investment levels with economic demand,
ensure a stable revenue source for future maintenance and repairs,
and recover costs from those who benefit from a facility's use.
Second, any major federal financing initiative must draw its jus-
tification from the underinvestment and undermaintenance of fa-
cilities in past decades. There is no persuasive case for deepening
the long-run subsidy for public spending on infrastructure facilities,
OCR for page 112
112
PERSPECTIVES ON URBAN INFRASTRUCTURE
but the nation today confronts an investment backlog created by
past behavior. Some of the catch-up costs are appropriately spread
over taxpayers at large, rather than assigned exclusively to today's
users. Which elements of the infrastructure system stand most in
need of catch-up spending will differ greatly from one location to
another, as will the type of investment required. That situation
argues for great flexibility and clecentralization in the design of a
financing initiative.
Third, any newly created financial institution should use its fi-
nancial leverage to achieve better management of physical facili-
ties. Paradoxically, the greatest value of a new financing institution
may lie not in the financial help it provides, but in the opportunity
to extract, in return for financial assistance, a permanent commit-
ment to better assessments of the condition of public facilities, bet-
ter capital planning and budgeting, and wider application of full-
cost user fees.
A last introductory word. Throughout the chapter the reader may
find it helpful to keep in mind the distinction between paying for
infrastructure in the sense of raising capital to finance investment
in it and paying for capital in the sense of bearing the economic
costs of a facility. Confusion of these concepts has plagued many a
discussion of infrastructure financing.
In the long run, there are only two choices as to who will bear
the economic costs of infrastructure improvements: the users of
facilities or taxpayers in general. There are, of course, further sub-
tIeties of cost incidence. By failing to maintain or replace old fa-
cilities, the current generation of taxpayers can shift part of the
costs to a future generation. Under some conditions, users of facil-
ities will be able to pass on their user costs to the consumers of
final goods and services. But we should remember that federal grants,
bond issues, and most other methods of finance do not pay for capital
investment in an economic sense; they merely create a general tax
burden or a debt obligation that must be extinguished.
THE CURRENT INFRASTRUCTURE FINANCING SYSTEM:
HAS IT FAILED?
The most common indictment of the nation's infrastructure fi-
nancing system is that, over the last two decacles, it has generated
too little capital investment (CONSAD, 1980; Morgan Guaranty,
1982; Peterson, 1978; Schneiclerman, 19751.
OCR for page 113
FINANCING THE NATION'S INFRASTRUCTURE REQUIREMENTS 113
The concept of underinvestment is an elusive one. :It requires
reference to a standard of how much investment should take place.
Since there is no such standard, most observers have limiter! them-
seIves to pointing out the great declines that have occurred in state
and local spending on infrastructure. Coupled with engineering
observations indicating that the condition of at least some impor-
tant classes of facilities has deteriorated, the decline in public
spending suggests (but does not prove) that there has been under-
investment certainly in the sense that most "experts" believe that
more should have been spent, but also in the sense that a fully
informed electorate, faced with an understanding of the true costs
and consequences of different investment levels, would have chosen
to spend more on the preservation of facilities.
How conclusive are the signs of declining public capital forma-
tion? One readily available measure is the rate of new investment
or gross capital formation. Almost all public investment in infra-
structure is carried out by state and local governments.) Although
the standard data sources for state and local spencling differ some-
what in their definitions and historical series, most point to the
same conclusion. State and local capital spending in real terms has
declined erratically but steeply since 1968. Table 3-1 provides one
measure of this downward trend, for total capital spending on struc-
tures and equipment.2
More extreme and more persistent than the decline in real spend-
ing has been the decline in the share of state ant} local budgets
devoted to capital investment. Recently capital investment has
~ One other important source is the mandatory facilities that communities require
private residential developers to install and turn over to public-sector ownership. See
Peterson (1978) for estimates of the aggregate level of such activity. For the special case
of California, where these requirements have been especially important, see Kirlin and
Kirlin (1982).
2 There is room for a good deal of discretion in using statistics on capital spending.
The data in Table 3-1 are deflated by a special price series that the Bureau of Economic
Analysis (BEA) has constructed for state and local capital spending. If capital spending
were deflated instead by the general nonresidential construction price index, it would
follow a flatter path. A significant share of the measured decline in state and local real
capital spending has its origin in the special price inflation that has affected the sector's
capital purchases. This, in turn, may be connected to the state and local sector's man-
agement of construction work.
As measured by the Bureau of Economic Analysis, capital investment in structures
has fallen off much faster than capital investment in equipment. Those who want to
dramatize the decline in state and local capital expenditures therefore tend to measure
capital for structures only and to report real spending as deflated by the BEA special
. . .
price 1nclex.
OCR for page 114
114
PERSPECTIVES ON URBAN INFRASTRUCTURE
TABLE 3-1 Trends in State and Local Capital Expenditures
Gross Capital
Investment
(billions of 1972 Percent of Total
Year dollars) Expenditures
1960 21.8 27.1
1965 29.6 26.8
1968 36.8 (peak) 25.7
1970 33.2 21.8
1975 31.7 18.3
1976 28.9 16.2
1977 27.3 15.1
1978 28.5 15.9
1979 26.9 15.5
1980 26.8 15.3
1981 24.9 14.4
1982 22.2a 12.9a
a = preliminary estimate
SOURCE: Gross Capital Investment figures from Bureau of Economic Analysis (un-
published). Total expenditures from National Income and Product Accounts, Table B-
77, Economic Reports of the President (Feb. 1983).
claimed half or less of the budget share that was customary in the
mid-1960s. The social programs of the Great Society appear to have
displaced some of the traditional responsibilities that these gov-
ernments performed.
Of course, not all declines in spending are to be lamented. It can
be argued that outlays for school construction were too slow to be
cut back in the face of public school enrollment declines. The sIow-
down in capital spending for roads and highways reflects in part
the completion of the greater part of the interstate highway sys-
tem as well as a painfully slow recognition of the need for repair
of the parts already built.
The national income accounts also attempt to measure capital
consumption or the depreciation of existing infrastructure assets.
Different types of facilities are assigned different useful lives, on
the basis of professional rules of thumb regarding their service
expectancy. Annual depreciation rates are calculated by assuming
that facilities wear out at a uniform rate over their assigned life-
times. Applying these annual depreciation rates to the value of the
facilities in place yields an estimate of annual capital consumption.
This capital consumption can be subtracted from new capital in
OCR for page 115
FINANCING THE NATION'S INFRASTRUCTURE REQUIREMENTS 115
vestment to estimate net capital formation, or the rate at which
society is adding to its public infrastructure.
A calculation of this type is necessarily imprecise. There is not
enough experience with some types of infrastructure, like water
and sewer lines, to form a reliable judgment of expected lifetimes.
For other systems, like roadways, we know that depreciation does
not proceed linearly but accelerates as the road surface reaches the
end of its scheduled life (Eckrose, 19791. Nonetheless, these esti-
mates provide a good general index of the rate of additions to the
nation's infrastructure. They are much more meaningful as an ag-
gregate index of investment in infrastructure than as a guide to
decisions about repairing or replacing individual pieces of it.
Figure 3-1 shows the course of net investment by states and
localities in structures (excluding equipment), which has fallen off
much more precipitously than has gross investment. The difference
is due to the accumulation of older structures subject to deprecia-
tion.3 The rate of net addition to state and local structures has now
almost reached zero. An extrapolation of the recent trend would
find the country disinvesting in public assets, on balance, starting
in 1983 and using up its inherited infrastructure at an ever-faster
rate as it moves into the future. A parallel conclusion holds for some
of the principal components of the infrastructure inventory, such
as roads and highways and school buildings.
One may quarrel with some of the procedures used by the Bureau
of Economic Analysis in making these estimates. The exact location
of the point of "zero net investment," for example, remains un-
known. But such quarrels should not obscure the direction of net
investment trends or their emphatic character.
The statistical argument for more infrastructure investment bears
some resemblance to the statistical argument for greater defense
spending or greater private investment. Just as the sustained de-
cline in real outlays for defense and the share of the federal budget
devoted to defense through 1980 established a presumption in favor
of greater defense spending, so does the decline in real infrastruc-
ture spending and the decline in the share of state and local budgets
expended for this purpose. In neither case are spending trends alone
the best evidence. The apparent lag in infrastructure investment
3 Structures are also the category of capital spending that has suffered the most severe
decline in gross investment (see note 1).
OCR for page 116
116
PERSPECTIVES ON URBAN INFRASTRUCTURE
30
20
on
cry
~1 0
o
C]
ran
11
o
onO
at
010
J
m
Total structures
J
J
A
,
\_,
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
air
5
o
_:
Total excluding highways and education
~~IV:
1 1 1 1 1 1 1 1 1 1 1 1 ~ 1 1 1 1 ~ 1 1 1 1 1 1 1 1 1 1 1 1 1
1950 1960 1970 1980-81
YEAR
FIGURE 3-1 Net investment in structures by states and localities. SOURCE: Data
from Bureau of Economic Analysis. Figure from "Rebuilding America's Infrastructure,"
The Morgan Guaranty Survey, July 1982.
needs to be checked against the condition and performance of public
facilities. We have undertaken this task elsewhere (Peterson et al.,
19831; it suffices here to note that condition assessments point to
a moderate deterioration of facility condition and performance in
recent years for several categories of infrastructure and to no de-
cline in others. This record is better than one might anticipate from
the aggregate investment trends and far better than some of the
apocalyptic estimates of capital needs would! imply. It seems prob-
able that earlier generations bequeathed us a capital plant that
was more durable and more resistant to temporary neglect than
our standard accounts assume.
OCR for page 117
FINANCING THE NATION'S INFRASTRUCTURE REQUIREMENTS 117
CAPITAL FINANCING INSTITUTIONS:
ARE THEY AT FAULT?
If there has been significant underinvestment in public capital
assets, it would seem that some part of the nation's system of capital
financing or capital budgeting must be at fault. A common assertion
holds that one or more of the traditional sources of capital financing
has simply ceased to perform its role of channeling capital to in-
frastructure investment. The logical culprits are the two most im-
portant sources of financial capital federal aid and long-term bor-
rowing.
Federal Aid
Federal aid to state and local governments for investment in
infrastructure presents a mixed picture (see Table 3-21. Since the
mid-1970s, federal assistance has been the principal engine of what-
ever growth (in nominal dollars) there has been in state and local
capital spending. The federal share of specifically subsidized capital
formation did not change much over the period 1960-1975, then
increased at the same time that total spending (in real terms) was
on the decline. Starting in the first half of the 1970s, funds from
TABLE 3-2 Federal Capital Aid
Total Capital
Investment Federal Capital Aid
(billions of current (billions of current Federal Capital Share
Year dollars) dollars)a (percent)b
1960 13.5 3.3 (3.3) 24.4
1965 20.1 5.0 (5.0) 24.9
1970 29.1 7.1 (7.1) 24.4
1975 42.4 10.9 (8.5) 25.7 (20.0)
1980 54.6 22.5 (18.7) 41.2 (34.2)
1981 55.4 22.1 (18.4) 39.9 (33.2)
1982 54.0 20.2 (16.7) 37.4 (30.9)
aFigures in parentheses exclude Community Development Block Grants; only a small
portion of these funds have been used to finance spending that is classified as state and
local capital investment in this table. Both figures in this column exclude general rev-
enue sharing funds expended on capital formation.
bFigures in parentheses exclude Community Development Block Grants.
SOURCE: Total capital investments from Bureau of Economic Analysis (unpublished);
federal capital aid from Special Analysis D and Special Analysis H of U.S. Budget (fiscal
1984 and earlier years).
OCR for page 118
118
PERSPECTIVES ON URBANINFRASTRUCTURE
general revenue sharing also found their way into local capital
budgets. Toward the end of the period, special public works grants
were installed as a federal antirecession too! and used to fund in-
frastructure repairs.
Since 1980, capital grants to state and local governments have
been cut back, as have other types of grants-in-aid. The Reagan
administration originally announced its intention of reducing fu-
ture capital assistance to state and local governments far more
drastically. Since 1982, however, the course of federal capital aid
has been reversed somewhat. Passage of the gasoline tax bill will
boost highway and mass transit aid by about 50 percent between
fiscal 1982 and fiscal 1984 and lead to a projected 17 percent in-
crease in all federal capital assistance to state and local govern-
ments between fiscal 1983 and fiscal 1984.
Whatever the cause of the sIowclown in state and local capital
spending, it seems unfair to pin responsibility on inadequate growth
in total federal assistance. Over the period 1975-1980, federal cap-
ital aid was growing in real terms at the same time that state and
local expenditures from their own resources were rapidly declining.
A better case can be made that the nature of federal assistance
has been ill-suited to the long-term needs of states and local areas.
For one thing, federal aid has followed an erratic off-again, on-
again path. Adoption of the construction grant program of the En-
vironmental Protection Agency (EPA) was followed by Richard Nix-
on's attempt to impound capital funds, then a period of rapid growth
in federal funding, and finally legislation that cut back sharply on
the federal aid commitment. The experience with special public
works programs has been even more volatile. The obviously tem-
porary nature of these 100 percent federally funded programs caused
state and local governments to postpone or cancel their own capital
spending in anticipation of the receipt of federal dollars. One study
concludes that the net effect of federal public works grants was to
depress state and local capital spending and to cause the postpone-
ment of as much as $22 billion in capital expenditures (Gramlich,
1978), although this estimate seems implausibly high.
It is the short-term horizon of most federal assistance programs
and their instability that have damaged state and local capital
budgeting, not an inadequacy in funcling levels.
Federal assistance, too, has been slow to reorient itself toward
repair of existing capital facilities. Until 1976, the use of federal
highway funds for repair or rehabilitation of the interstate highway
OCR for page 119
FINANCING THE NATION'S INFRASTRUCTURE REQUIREMENTS 119
system was prohibited. Although recent highway legislation rec-
tifies this bias to a considerable degree, the greater part of federal
aid continues to be tilted toward new projects. The new clean water
legislation, for example, eliminates repair of old sewer lines as a
category eligible for federal assistance. This federal posture does
not reflect a lack of awareness of repair needs, but rather the con-
viction that ordinary repair and replacement of existing facilities
is a local responsibility that should be locally financed.
Long-Term Borrowing
If state and local governments have chafed at federal capital aid
policy, they frequently have been on the verge of offering a requiem
for the long-term bond market. Tax-exempt interest rates have
suffered violent swings over the last decade. At the height of the
interest-rate cycle, in 1974-1975 and again in 1980-1981, the use
of long-term borrowing by state and local governments for infra-
structure financing withered away (see Table 3-31.
Until recently it appeared that the most recent swing in interest
rates and infrastructure borrowing might presage a permanently
altered capital financing market for infrastructure. In 1980, for
example, state and local governments borrowed for infrastructure
investment purposes an amount equal to less than 18 percent of
their reducer} investment levels. This was an all-time low and con-
trasts with a historic share of well over 50 percent bond financing.
On top of the discouragement offered by high interest rates came
public resistance to approving general obligation bonds in bond
elections. Many commentators forecast that the general obligation
bond, the historic financing vehicle for multipurpose infrastructure
investment, would be virtually phased out of the capital market. A
look at Table 3-3, treating 1980 or 1981 as the final reporting year,
seems to reveal an ominous decade-Ion" deterioration in the ability
of long-term borrowing to meet capital investment requirements.
In today's perspective, matters look much more encouraging. State
and local borrowing rebounded to unprecedented levels in 1982, for
infrastructure investment as well as for other purposes. The 1979-
1981 period now appears as largely a cyclical phenomenon, albeit
an extreme one, not the prelude to a new capital financing era.
Some of the fall-off in long-term borrowing during 1979-1981 was
offset by a surge in short-term borrowing, as states and localities
tried to avoid long-term commitments to unprececlentedly high in
OCR for page 120
120
PERSPECTIVES ON URBAN INFRASTRUCTURE
TABLE 3-3 Long-Term Borrowing as a Share of Total Capital
Investment 1970-1982 ($ billion)
Long-Term
Bonds Sold Total Long
Total (Less (Less) Term Long-Term
Capital Refundings) Nontraditional Borrowing Borrowing
Investment (TCI) Uses of Bonds for TCI as Percent of
Year ($) ($) ($) ($) TCI
1970
1971
1972
1973
1974
1975
1976
1977
1978
1980
1981
1982
29.1
30.1
31.6
36.2
42.7
42.4
40.8
40.8
47.2
54.6
55.4
52.2a
18.0
24.4
22.0
22.2
22.9
29.6
32.2
37.9
39.3
46.3
46.4
74.9a
1.3
4.3
3.1
4.7
4.2
8.8
11.6
16.8
20.3
36.5
33.1
44.4a
16.7
20.1
18.9
17.5
18.7
20.8
20.6
21.1
19.0
9.8
13.3
30.5a
57.4
66.8
59.8
48.3
43.8
49.1
50.5
51.7
40.2
17.9
24.0
58.4a
a = preliminary estimate
NOTE: Nontraditional borrowing is defined as borrowing for housing, hospitals, in-
dustrial development, student loans, and pollution control. In addition, for the purposes
of this table, public power is also included because privately owned public power facilities
are not included in BEA's definition of state and local capital investment.
SOURCES: Data: Total Capital Investment, from Bureau of Economic Analysis, un-
published, calendar year gross fixed state and local capital formation.
Bond Issues: Public Securities Association and Weekly Bond Buyer. Table compiled
by the General Accounting Office.
forest rates. Some of the fall-off in new borrowing was made possible
because states and localities used up their accumulates! bond funds.
Just as state and local governments in 1979-1981 converted into
physical capital investment the bond funds they hac! borrowed ear-
lier, so in 1982 they replenished their depleted cash reserves and
even took advantage of lower interest rates to borrow ahead of
investment needs. By the third quarter of 1982, state and local
governments had bought almost $19 billion of Treasury debt with
the excess cash they had from long-term borrowings. This amount
was nearly twice as high as purchases in any full year in the pre-
vious decade.
For now, financing availability is not an effective constraint on
state and local capital investment. In fact, the excess cache of long-
term borrowed funds that governments have on hand raises severe
questions as to whether a further infusion of capital funding, from
OCR for page 132
132
PERSPECTIVES ON URBAN INFRASTRUCTURE
the greatest problem for financing capital projects is the willingness
of the ultimate payers to pay the price. Public disinvestment has
been a fairly deliberate process, whether the public is ill-informed
or not. The grant mechanisms and the bond market really are not
the root causes of the disinvestment.
~ have some problems with the data that are included in-the
chapter, and those that are used generally. This is an endemic
problem because the amount of research on public spending is rel-
atively slight and has always been fairly weak. For example, Table
3-3 can be very misleading. First, it is not clear which long-term
bonds are included: general obligation or revenue bonds. Second, it
does not take into account the role of rates. One very good expla-
nation for the drop in 1979 in the ratio of long-term debt to total
expenditures is the incredible increase in interest rates in that year.
Many governments merely deferred projects in that year due to the
increase in rates, not because of any general aversion to long-term
debt.
The data also leave out the role of short-term debt. Many of the
same governments, instead of deferring financing altogether, used
short-term debt because they thought rates would be lower in 1980.
Almost everyone ended up paying higher rates by using the short-
term approach. Looking at only long-term debt leaves out the ex-
plosion in short-term financing as governments have tried to avoid
the higher long-term rates. Short-term financing, of course, depends
on the ability of governments to roll over their debt forever. As the
experience of New York indicates, such confidence can be badly
misplaced. That city ended with $6 billion worth of short-term debt
coming due in one year and found itself, furthermore, with no mar-
ket access.
In terms of fiscal pressure causing budget cuts, particularly for
ongoing maintenance aspects of capital financing, the role of market
access cannot be excluded. The reason New York's capital program
declined dramatically is because no one would lend it any money.
One of the reasons the recovery program for the city had a major
capital component was to make it very clear that merely getting
the city's past debt taken care of was not enough. It was also nec-
essary to address the problem of needing at least a billion dollars
a year for capital.
We normally do not think about the loss of market access for
local governments. Traditionally local governments could borrow
at a reasonable price. But as we have recently seen, governments
OCR for page 133
FINANCING THE NATION'S INFRASTRUCTURE REQUIREMENTS 133
with good credit ratings can lose market access. Not only did New
York City lose market access, but also the state lost it for a time,
and so did many other local governments that had nothing to do
with New York City's financial problems. So, in looking at historical
experience, we have to consider the thought that there may be times
in which governments simply cannot borrow, regardless of their
desires.
~ generally agree with the economists that there are a great
number of benefits from user fees. There are also, however, some
costs. User fees are not tax deductible. Citizens may prefer to tap
their subsidy from the U.S. Treasury by deduction of local taxes
that support their services and facilities. When we begin to talk
about very large user fees, a substantial subsidy is lost.
Beyond some point, user fees may not be financable. It is hard
to sell revenue bonds, for instance, where there are free alternatives
to the facility in question. Bonds for a toll bridge will not sell if
there are good nearby free bridges. If there is any danger that other
facilities will be used or that the fees to finance the debt will be so
high as to induce use of competing facilities, bond buyers will not
take the risk. This means that, for the most part, only essential
services are susceptible to user charge financing, particularly where
private business cannot provide a competitive service. Where there
is no monopoly and perhaps even where there is a monopoly
the market may be unwilling to accept the agency's view of the
demand for use of its facility. Such facts as the sharp downward
shift in demand for electricity, for instance, have made the market
extremely skeptical of earlier estimates of the need for additional
power plants by electric utilities.
Large capital projects should be an area of major concern. There
are tremendous risks involved in large, new public investments.
These risks have a great impact on the ability to finance them. This
can be illustrated by the effort of the Milwaukee Metropolitan Sew-
erage District to finance and build a $2 billion interceptor project.
The first big problem is the risk of noncompletion. What happens
if it does not work or cannot be completed? The experience with the
Western Washington Public Power system shows that rate payers
do not follow through on "take or pay" contracts. Rate payers seem
to see no reason to pay for plants that produce no electricity. A lot
of people try not to pay. Anything that engineers are not sure they
can finish are things in which bankers are sure they do not want
to be involved.
OCR for page 134
134
PERSPECTIVES ON URBAN INFRASTRUCTURE
Related to noncompletion is the problem of escalating cost. In
Milwaukee all estimates for the interceptor were originally made
in current dollars. But bankers want to know what it is really going
to cost. This produces big numbers and may result in political op
· ~
position.
This raises the issue of loss of public support before completion.
The day is past when a project can be slid past the public with the
argument that so much has already been spent that it cannot be
stopped now. People are increasingly willing to shut down an in-
complete project when costs have escalated and public support has
evaporated. So rather than avoid the public controversy, it is better
to be up front about the costs and let people know all of the problems
that may arise.
Another problem is the risk of political mismanagement. Local
officials cannot always be depended on to do the right thing. Even
with a court order, for instance, it took a year for the Cleveland
City Council to increase the water rates to finance capital improve-
ments. Political mismanagement usually takes the form of being
unwilling to face up to current dollar costs.
Next is the risk of forecasting and the risk of scale. Rule of thumb
estimates of cost ranges are simply not good enough from a fi-
nancing standpoint.
Last there is the risk of underlying economic viability. Financing
depends on the underlying economic strength of the jurisdiction
its ability to pay the bill. Sometimes needs for capital investments
simply do not line up with the ability to pay. When that occurs, the
only way projects can be financed is through capital grants from
other levels of government. Private capital will not rush to those
areas.
In facing all of these problems, Milwaukee's financial plan in-
volved a careful analysis of the Metropolitan Sewerage District's
strengths and weaknesses and all possible sources of financing.
Their weakest point was bonds. There had been an assumption that
the entire $2 billion would have to be raised through bond issues-
this was simply inaccurate. It was also impossible to market such
a large issue without a terrible burden on the member jurisdictions.
The task was to increase the amount of cash put into the project
and to reduce the amount of debt that had to be financed.
It is no longer going to be possible to capitalize interest out of a
bond sale. There is a growing need to put in cash up front and
throughout a project to reduce debt service costs. In Milwaukee a
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FINANCING THE NATION'S INFRASTRUCTURE REQUIREMENTS 135
financial plan was developed that in each year used more cash from
taxes, grants, and other sources than from bond proceeds. This
reduced the amount that had to be borrowed. It also allows for the
whole program to be paid for in the last year of capital expendi-
ture-1996. It was easier to sell this shorter payment schedule to
the rate payers in a period of high interest rates. The tax rate was
brought up in three steps to pay for the entire project, rather than
try to drag it out over a long period of time. If costs should escalate,
this would require that the new tax rate be held for an additional
year.
Not only do we have a problem of maintenance and ongoing cap-
ital improvements, but also the large project poses a need for a
special type of planning. Financial planners should be involved at
the earliest stages of the process to develop schedules and financing
plans in the context of local problems and politics, to develop a
strategic plan attuned to local circumstances.
Forest Witsman
One issue with regard to spending and financing is whether we
have overbuilt some of our facilities. In Sedgewick County, Kansas,
we have decided that in some instances we have. Where a paved
road serves a single farm, for instance, we are turning it back to
gravel, rather than bear the cost of maintaining it as if it were an
urban street carrying heavy traffic. In far too many cases we have
tried to provide urban services to areas that will not support them.
There have been poor practices with the use of special assess-
ments. Systems were built on the basis of optimistic assumptions,
and now local governments are faced with high rates of tax delin-
quencies. In other cases, governments have not been strict enough
with developers in requiring the dedication and construction of
adequate facilities for the kinds of subdivisions that eventually are
built.
Another area for further investigation with respect to the costs
of facilities is the role of unions. Especially in cities that have
prevailing wage contracts, labor costs are important considerations
in the financing of public works and in operating costs as well. We
also need research on the effects of the Davis-Bacon Act on infra-
structure costs.
In my judgment the apparent conflict between capital and op-
erating spending is basically a political failure. It raises a question
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PERSPECTIVES ON URBANINFRASTRUCTURE
of political structure, whether the ways we choose and organize our
governments are satisfactory. There are certain commonalities among
the cities that have had the most severe financial problems. Without
making a pitch for the city manager system, ~ observe that there
are no cities run by city managers on that list.
We have missed an opportunity in our discussion of the New
Federalism. The municipalities have not raised the issue of what
services are to be provided by each level of government and who
will provide the financing for them. Instead there was a lot of fruit-
less argument between nineteenth-century liberals and twentieth-
century liberals over whether particular grant programs should be
kept. The important debates of the next 20 years will revolve around
things like capital. The places that survive will be the places that
can handle shifts from operating to capital expenditures.
Clearly there is a need for further and better needs assessment.
We should do some sampling and also use surrogate measurements
to establish what the needs really are. In the 1960s and 1970s we
made some serious mistakes by building too many buildings. We
were not prepared to operate all of the facilities we built. Some of
these facilities have had to cease operations just a few years after
they were built because of the lack of operating funds. In addition,
we have not closed down some facilities whose operation can no
longer be justified because of political pressure to keep them open.
In building facilities, whatever the source of revenue for them, it
is essential to know what the full maintenance costs will be.
~ do not think there has been a failure in financial mechanisms
or markets. In fact, ~ am not all that enthusiastic about creative
financing for facilities. The cutting edge hurts. In many states the
only source for capital financing is the property tax. As a result,
the only way to get more money into the capital budget in such
states is to cut the operating budget. The proper relationship among
federal, state, and local finances has not been adequately debated.
One with experience at the local level can only smile at state of-
ficials who admonish local officials for poor fiscal management. By
and large, local governments are in much better shape than the
state governments so far as financial management is concerned.
Public works departments are not the best run parts of local
government, however. Some of it has to do with the way they have
been allowed to charge the costs they incur to capital and operating
accounts. There has been a tendency to look on all funds as a trough
at which to feed. There is also a need for more management talent
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FINANCING THE NATION'S INFRASTRUCTURE REQUIREMENTS 137
in public works departments. Financial departments are much
stronger. Finally, there is a lack of direction and philosophy in
public works, although the environmental movement has begun to
provide some direction for some parts of the public facilities system.
The role of the media is very important in financing. They can
make it almost impossible to carry out some worthwhile projects.
It is important to the success of any effort at facilities financing
that the media understand large capital issues. Otherwise their
reaction is that local government is just trying to spend money and
that ought not be done.
We have made poor use of resources that are available in some
cases. For instance, during the time when high interest rates could
be obtained on the investment of bond proceeds, many local gov-
ernments did not set these funds aside for augmentation of capital
funds but allowed the interest revenues to be used in the operating
budget. There are often state limitations on how money can be
moved around at the local level. Rules created when counties and
cities were not that well run now impede good financial manage-
ment.
We are also suffering from several years of budgetary dishonesty
at all levels of government. There has been a consequent loss of
trust in financial estimates and needs projections by government.
Another area that is important is stability. Governments with sta-
ble governments and good management have been able to make
better use of their resources, such as their own taxes and grant
programs. They have programs and have been able to carry them
out. In areas in which there is a turnover in every election, there
is an inability to carry out programs. This in itself breeds lack of
public trust in the capacity of government to perform.
SUMMARY
Distinctions Between New Capital Programs and Maintenance
In developing financial programs, it is important to distinguish
between new capital projects and maintenance spending. It is also
important to separate the different kinds of maintenance, ranging
from routine operating maintenance, to major repairs, to upgrading
of facilities. It is important not to use capital funds for the routine
operations of a facility, but some of the things we generally regard
as maintenance may be alternatives to new facilities. We must
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PERSPECTIVES ON URBAN INFRASTRUCTURE
avoid the trap of letting facilities run down to the point that they
need "capital" repairs because there is no money available for on
· .
going mains ;enance.
The current rules as to what are capital and what are mainte-
nance expenses are made not by public works engineers, managers,
or bankers but by accountants following accepted government ac-
counting practices. Their definition is not one that managers or
bankers should necessarily accept. Bankers are interested in the
useful life of a facility being long enough to retire the debt on it.
They are not as a rule concerned that some parts of a facility or
some elements of the capital program do not last for the entire life
of the bond issue that finances them, so long as the part of the debt
financing those aspects of the program is paid within the useful life
of the part in question.
From a management perspective, there are anomalies in using
the accounting definition. Equipment in a new building, for in-
stance, is clearly a capital expense. When equipment is being re-
placed in an existing building, it is sometimes considered as an
operating expense. Many managers prefer to err on the conservative
side in making such decisions to avoid abuse of the borrowing power
to finance small-scale and routine maintenance and repair or re-
habilitation projects. New York City, for instance, got into its fiscal
problem in part by rationalizing human capital investments, such
as the salaries for vocational education, as a capital expense.
It is essential to distinguish among operating maintenance, de-
ferred maintenance (repair and replacement), and new public fa-
cilities. Managers must make these distinctions every day. Such
distinctions are critical in state, local, and national perceptions
about how to handle this problem. If there is a distinction between
public works and infrastructure, then public works are what you
build, while infrastructure is what makes the place work.
The Advantages of an Infrastructure Bank
Most existing laws require cities to maintain facilities that are
debt financed or allow the bondholders to establish such require-
ments. How could a federal infrastructure bank impose require-
ments if the bondholders will not do it?
Two separable issues are raised. With revenue bonds the interest
of the bondholders is in a revenue stream adequate to repay the
debt. There is no particular concern with setting a fee structure
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FINANCING THE NATION'S INFRASTRUCTURE REQUIREMENTS 139
that provides for maintenance beyond the maturity date of the
bonds or for the eventual replacement or upgrading of the facility.
There is no incentive for requiring a long-term management pro-
gram or a fully adequate system of user fees. While most revenue
bonds include covenants requiring adequate maintenance of the
structure and increasingly there are requirements for capital plan-
ning and programming systems, most facilities are not financed by
revenue bonds. Instead they are financed by general obligation
bonds or even by current appropriations and capital grants, over
which none of the financial instruments have any control. If, as a
nation, we are going to tackle a capital rebuilding program, whoever
is lending the money, especially if the loans are made at subsidized
rates, has an immense opportunity to establish as a quid pro quo
that local government make the institutional changes necessary to
adequately maintain and replace facilities.
The Opportunities for and Limitations of User Fees
There is more to the user-fee concept than simply changing to
whom the bill is sent. If we are to make wider use of the mechanism,
there will have to be some dramatic improvements in the system.
Fees collected will have to be clearly dedicated to the purposes for
which they have been charged. To some extent we are trying to
simulate a private market in setting user fees, and that market
may give us more than we have asked for. Generally, the impetus
for user fees has been to raise revenue. They have not been used
as market or efficiency devices. The efficiency claims for fees as a
market device relates to the way the fees are structured. When a
public service monopoly charges any fee it wants and calls it a user
fee, it loses its efficiency advantage.
The user fee concept is not universally applicable. It is very hard
to apply it to streets, for instance. In many other areas of trans-
portation it is difficult to come up with a politically acceptable
system of allocating costs for the services that are provided. There
is a question about just how far the user-fee concept can be pushed.
The important point, therefore, may not be broadening the ap-
plication of user charges but deepening their use where they are
appropriate so that the prices that are charged are economic prices
rather than prices of political convenience. We should remember,
however, that charging the economic price for services may help
with efficiency problems, but it can also raise serious equity issues.
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Such fees may have no correlation to the ability to pay. This is a
problem to which we must be sensitive as the proportion of the local
budget financed through user fees increases. There is also a growing
equity problem with the use of franchises to private companies to
provide services and with taxes on utilities (which are among the
fastest-growing sources of new revenues), as these approaches can
leave those without the ability to pay unserved.
Some other problems arise when the user fee is pushed too far.
When fees for garbage collection become too high, can we stop pick-
ing up the garbage of those who cannot pay? Not if the reasons for
public garbage collection are based on public health. We could also
end up transferring our garbage problem from the sanitation to the
parks department as people find alternative ways to dispose of refuse.
Some very sophisticated management problems can arise when
services are priced at their true economic value or cost. The value
to a potential user may be different than the cost of providing the
service. Another problem is that people are used to certain levels
of cost for some kinds of services. Rates that reflect the real cost of
a utility constitute sea changes in the way people think and what
they do. Rather than pay high electric power bills, they may buy
wood stoves. If enough people take alternative measures to avoid
these costs, the revenue stream produced by economic pricing may
diminish rather than increase, upsetting the financial plan.
One final issue related to the user-fee concept is the notion that
as services deteriorate in central cities, those who can pay for the
services they want will just move to other places where they can
purchase them. This raises the question of whether we want to or
should want to maintain our cities. Perhaps there is no real choice,
because there is such an enormous investment in existing cities in
infrastructure alone. Moreover, if people can move to Lake Tahoe
and do their work from a remote computer terminal, we had better
start thinking about the kind of city Lake Tahoe will become. There
are going to be aggregations of people, even as we move away from
the older central cities.
The Role of Interest Rates in the Financing of Facilities
There may be an undue reaction to high interest rates. Typically,
debt service constitutes only about 5-6 percent of the municipal
budget. Higher rates are unlikely to raise that proportion by as
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FINANCING THE NATION'S INFRASTRUCTURE REQUIREMENTS 141
much as a single percentage point. We may have gotten caught up
in the psychology of the investors' market, and we should de-
mythologize interest rates for normal, day-to-day, general obliga-
tion bond financing, at least aside from the very large projects.
There is a lag or delay in adjustment to interest rates. There is
also a tendency on the part of municipal borrowers to assume that
rates will return to their historic low levels, therefore they assume
that a year's deferral will have little effect. Unfortunately, there
are successive deferrals based on such assumptions. With regard to
perceptions, the absolute numbers can be very frightening.
Volatility is also a problem. In the 1960s, the municipal interest
rate changed 10-15 times. Now it can change that many times a
month. People are not used to that kind of market fluctuation for
municipal bonds. In the past, a half point change in a year was
considered a problem. Now one has to think about changes of half
a point in a day. People are adjusting, but it will take time.
The major problem is the cost of real interest the difference
between the rate paid and the rate of inflation. Real interest is now
4-6 percent higher than the rate of inflation. In the past, the real
cost of interest was zero or less. Today municipal bond interest rates
are about even with long-term Treasury rates. As a result, there
is no particular advantage to the investor from the tax exemption.
As a result one can no longer borrow, invest in Treasury bills, and,
under the arbitrage rules, end up paying no real interest. Today
we are talking not just about no arbitrage, but negative arbitrage.
The Opportunity for Use of a Form of Commoclity Bond
The basic problem with commodity bonds for which inflation might
be offset by the rates charged for future delivery of a service or good
relates to who buys them. Bond buyers are people who are adverse
to risk. Commodity bonds require that the buyer make an educated
guess that prices will keep up with the rate of inflation. That is too
complicated a calculation for the typical municipal bond buyer.
Another instrument, however, may work; a pass-through certificate
would be sold to a more sophisticated customer, but that person
probably will not be interested in the tax exemption.
The problem is the disappearing interest rate advantage of state
and local bonds. The clearest response would be some forbearance
by state and local governments in issuing all other types of bonds.
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The narrowing of the spread between municipal general obligation
bonds and other types of issues is largely due to the flooding of the
market with other types of local issues, such as industrial revenue
bonds. So far officials of these governments have declined the op-
portunity to declare that infrastructure is indeed a priority for debt
financing and to voluntarily restrict other types of issues.
Representative terms from entire chapter:
capital investment
