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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
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,
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.
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.
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
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).
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.
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).
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
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
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
FINANCING THE NATION'S INFRASTRUCTURE REQUIREMENTS 121 a temporary federal public works program, could have the stimu- lating effect on capital construction that is desired. Even the general obligation bone! has enjoyed a moclest renais- sance. In the November 1982 bond elections, the highest percentage of bond proposals since 1967 was approved by the electorate (86.7 percent). Many of these bonds were proposed specifically for infra- structure repair financing and were described that way to the voting public. In sum, the long-term bond market has not failed as a source of infrastructure finance. Proposals to create new capital financing institutions cannot be rationalized on the grounds that the old in- stitutions have proved unable to provide the long-term investment capital that states and local areas need. It is true that problems remain in the tax-exempt bond market. The gap between tax-exempt and taxable interest rates the sav- ings that states and local areas gain from having access to tax- exempt borrowing remains near its all-time low. In part this can be attributed to recent changes in the tax laws, which have made the holding of tax-exempt securities less attractive to commercial banks, casualty insurers, and individuals. In greater part, the narrowing interest rate advantage of tax- exempt bonds can be ascribed to a surge in nontraditional borrow- ing. The bond market has become flooded with housing mortgage bonds, industrial development bonds, pollution control bonds, and bonds for private hospitals. These uses now account for over half of all tax-exempt bond issues. The volume of supply has placed pressure on tax-exempt interest rates and has also raised a question of priority for state and local governments. If state and local gov- ernments supported rather than opposed restrictions on single-fam- ily mortgage bonds and industrial development bonds in order to help preserve borrowing rates for infrastructure investment, their pleas to the federal government to acknowledge the paramount demands of infrastructure financing would be easier to accept at face value. Insulating Infrastructure From General Budget Competition The possible failures of infrastructure financing considered thus far are failures of the mechanisms that supply financial capital. Another possibility for failure occurs in the capital budgeting pro- cess. Under intense budgetary pressures, public officials may find
122 PERSPECTIVES ON URBAN INFRASTRUCTURE it easiest to effect spending reductions by deferring maintenance, skipping repairs, or postponing capital investment.4 To some degree, this singling out of the capital budget for tem- porary cutbacks may represent rational behavior. For many capital systems, maintenance and replacement can be deferred for a time without significant damage, as long as the appropriate schedules are later resumed. The danger of temporary deferrals lies more in the precedents they establish. Temporary postponements of repairs tend to stretch into permanent neglect, and lengthened replacement cycles can gradually become customary practice. The capital budgeting failure that is alleged goes beyond these temporary adjustments and has its origin in a perceived political imbalance. Budget reductions that trigger employment layoffs, wage freezes, or cancellation of public services meet immediate and vig- orous opposition. At least in the past, maintenance deferrals and cancellation of underground capital projects have been much less visible to the electorate. Their consequences typically will not be- come apparent until some years in the future. It would be difficult to maintain that any trend as prolonged as a two-decade diminution of capital spending for all state and local governments could have its explanation in a series of fitful, emer- gency budget cutbacks. However, the tendency to single out the capital budget for cuts during fiscal crises is apparent from the two graphs of comparative spending, for Cleveland and New York City, shown in Figure 3-2. In both cases, while the current city budgets were being reduced amid great publicity, capital budgets were under far more severe attack. The subsequent turnaround in capital spending in both cities is to a great degree a result of public dis- covery of the size of the backlog of infrastructure investment that had been created. New York City and Cleveland are admittedly two very extreme cases. However, the same pattern of a sudden collapse in infra- structure spending at a time of budgetary pressure can be found in Boston, Buffalo, Oakland, and other cities that have had to wrestle with serious budget problems. The diagnosis that in fiscally burdened governments at a time of budget pressure capital spending and maintenance cannot compete effectively with other budget claims has led to efforts to remove 4 For systematic evidence that capital and maintenance spending is, in fact, the most vulnerable budget item under fiscal pressure, see Wolman and Peterson (1981).
FINANCING THE NATION'S INFRASTRUCTURE REQUIREMENTS 123 1500 o 70 - Current dollars Constant dollars (1966) l l l 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 YEAR 80 . _ _ Current dollars Constant 1972 dollars oo 650O 30 \~~ 1 1 1 1 1 1 1968 1970 1972 1974 1976 1978 YEAR FIGURE 3-2 Capital construction awards in New York (above) and Cleveland (below). capital spending decisions from the general budget. One device for achieving this end is the dedication of special revenues, so that they are used only for designated capital purposes. The dedication of revenue sources is intended to insulate capital spending from the vicissitudes of political budget choice. If a capital spending function has the good fortune of being tied by dedication to a rapidly growing revenue source, it has the additional advantage of guaranteed fu- ture spending growth.
124 PERSPECTIVES ON URBANINFI2ASTRUCTURE At the federal level, the most important sources of dedicated capital revenues are the highway and airport trust funds. At the local level, the use of dedicated capital revenues is most common in systems supported by user charges. But other types of revenue dedication are gaining momentum. In persuading the local elec- torate to support a municipal income tax increase, the City of Cleve- land dedicated half the proceeds to paying off debt and rebuilding the city's capital plant. The Cleveland business community assumer! leadership in the tax increase campaign, once it was assured that revenues would be used for long-term capital purposes. Many other cities have introduced proposals that would dedicate selected rev- enue sources for capital maintenance or for repayment of future infrastructure-related debt. To strengthen the effectiveness of revenue dedication, several cities have gone one step further and tied revenue change to insti- tutional reorganization of the responsibility for infrastructure man- agement and financing. When the City of Boston spun off its sewer and water operations to an independent authority, the legislation creating the authority formally dedicated revenues to use within the sewer and water system. The enabling legislation also requires that 5-year capital budgets for system improvements be prepared and that user fees be set at a rate sufficient to finance the capital investment plan. In Cleveland, a legal suit has been used to establish budget prior- ity for water system investment. The suit was brought against the city by suburban communities on the grounds that the city's failure to adequately maintain the water distribution system was wasting an asset of crucial importance to the entire region. A local judge ordered the city to surrender ownership of all water assets to a new regional authority. Only under the threat of this court order did the city and suburbs reach legal agreement on a capital reinvest- ment plan under which the city would retain ownership ofthe water system but commit itself to carrying out some $800 million of capital improvements on it. The legal obligation to carry out this invest- ment has brought an urgency to capital budgeting that formerly · . was missing. Efforts like these seek to remove the capital financing decision from the ordinary realm of political debate. In effect, they acknowI- edge that infrastructure investment cannot compete equitably with other budget claims and seek to substitute expert analysis, man
FINANCING THE NATION'S INFRASTRUCTURE REQUIREMENTS 125 datory court orders, or revenue dedication for the uncertainties of political budget choice. There is little doubt that these various devices have succeeded in boosting public capital spending and stabilizing capital financ- ing. Whether the institutional fragmentation they have spawned and the removal of larger and larger portions of the capital budget from general taxpayer control will be desirable over the long run is difficult to know. FINANCING PRINCIPLES: THE USER-COST PRINCIPLE What principles should guide us in designing a national infra- structure financing system of the future? One principle is the ap- plication, wherever possible, of user fees. User fees establish an analog to the private market, where prices are set and users pay according to the size of their service consumption. When applied to capital infrastructure services, user-cost pricing has some signal advantages. The user-fee structure itself helps to regulate capital demand. Estimates of capital financing needs, both for the nation as a whole and for individual localities, now run so high that it is inconceivable for them to be met in full. Under these conditions, it only makes sense to enlist the financing mechanism itself in demand restraint. The fact that users must pay for the use of a facility limits their demand for it and reduces the physical capacity necessary to satisfy demand. User fees set to recover the full incremental costs of facility usage have been shown to effectively limit demand and enhance economic efficiency in water supply and distribution (GilIand and Hanke, 1982), airport construction, wastewater treatment, and many other areas of capital infrastructure. Many cities employ user fees in the form of special assessments explicitly to frame demand for capital improvements. The City of Milwaukee's streets department, for example, annually measures street surface condition and proposes those streets in worst repair for resurfacing. Since street resurfacing is financed by special as- sessments on abutting landowners, however, these owners have the final say in deciding whether capital investment is carried out. This contrasts with the city's practice of selecting major arterials for resurfacing based solely on professional judgment about the need
126 PERSPECTIVES ON URBAN INFRASTRUCTURE for upgrading. The benefits from such improvements extend well beyond adjoining landowners and hence improvements are not fi- nanced through special assessments or subject to local property owners' referenda. Of less theoretical benefit but of equal practical advantage in the eyes of many public capital managers is the fact that the revenue stream generated by the sale of capital facility services can be easily segregated and dedicated to facility reinvestment. The prospect of a reliable revenue stream makes it possible to issue revenue bonds to finance the initial capital costs of a project. For cities that stand in need of debt relief or major infusions of capital, user-cost pricing holds forth another possibility. Once a full- cost pricing policy is adopted, including allowance for capital re- placement or "profit," the system's fixed assets take on an economic value. They then can be recapitalized or sold. When the City of Boston spun off its sewer and water system, the independent au- thority absorbed all of the city's debt for the system and macle a one-time cash transfer to the city as well. Suffolk County, New York, is in the process of attempting to transfer legal title and tax depreciation rights to a part of its county sewer system to a con- sortium of private investors, in return for which it will receive a payment of several hundred million dollars. The scope for employing user fees in meeting capital demands can be illustrated by the nation's water system. The President's Intergovernmental Water Policy Task Force (1980) estimated in June 1980 that 87-90 percent of the water supply and distribution investment needs it projected would be met with rate increases no greater than twice current rates. Rate hikes of this magnitude are politically explosive and may require institutional reorganization to accommodate, but, given the current rate structure in most cities, they do not impose an unrealistically stiff financial burden. FINANCING PRINCIPLES: AN INFRASTRUCTURE BANK The nation's current infrastructure financing policy incorporates three clear principles as well as one that is not so clear. First, federal aid is provided to support capital spending on in- frastructure facilities that are national in coverage or where capital investment is necessitated by the establishment of new federal standards. The interstate highway system and major hub airports are good examples of facilities in the first category; EPA construc
FINANCING THE NATION'S INFRASTRUCTURE REQUIREMENTS 127 tion grants for wastewater treatment plants are the best example of facilities in the second category. Second, user-fee financing is used to finance improvements to facilities where fees are economically and administratively appro- priate. Reliance on the fee structure is by no means universal, even in these cases, but the principle of user fees and revenue bond financing is now generally accepted. Third, state and local general tax revenues and general obligation borrowing are used to pay for remaining general-purpose infra- structure facilities. The ongoing repair, improvement, and main- tenance of local water distribution systems, sewer collection sys- tems, schools, parks, and other facilities are recognized in principle as local financing responsibilities, although state governments (and to a minor degree the federal government) sometimes offer financ- ing assistance to offset inequalities in local revenue-raising capac- ity. The element of uncertainty concerns the financing of large-scale investments needed to discharge repair and replacement backlogs inherited from past neglect of primarily local facilities. Such facil- ities do not fit easily into any of the financing categories. Although the benefits of capital spending are primarily local, the magnitude of investment required may greatly exceed the expenditure that would normally be required to maintain and replace local capital systems if there had been a history of adequate care. There is no clear reason why today's users of these facilities should bear the costs created by the previous generation's violation of the implicit social contract that each group of users passes on to the succeeding one a capital plant in basically good repair. Current federal financing policy reflects the uncertainty of this principle. There is a large federal commitment to repairing or re- placing major bridges, even when these carry benefits principally to local users. The expense involved in requiring local taxpayers to absorb these costs has appeared unreasonably great. The federal bridge repair and rehabilitation program represents a federal com- mitment to assist in one-time, catch-up investment. However, there is no comparable federal program for assisting in catch-up invest- ment necessitated by decades of depreciation of water or sewer lines or other types of facilities. It is the challenge of finding efficient and equitable ways of fi- nancing today's backlog of infrastructure investment that suggests the creation of a new financing institution. Such an institution
128 PERSPECTIVES ON URBAN INFRASTRUCTURE should be designed as well to overcome the most conspicuous defects of the present mix of financing arrangements. Specifically, it should: · Provide a stable, long-term financing source to offset the in- stability of both federal aid and the bond market. · Use its financial resources to institutionalize new capital man- agement and maintenance practices. The value of one-time, catch- up investment will be wasted if the nation's infrastructure facilities, once in better condition, are turned back to the same ineffective arrangements that allowed them to deteriorate. · Use its financial resources or leverage to establish long-term user-fee financing of capital assets wherever possible. · Link capital financing more effectively to capital planning by requiring recipients to generate their own assessments of capital condition, long-run capital investment and maintenance require- ments, and immediate investment priorities. · Allow states and local governments flexibility in deciding what the local priorities for catch-up investment are. These priorities cannot be established uniformly at the federal level. One institution that meets these requirements is a federal infra- structure bank linked to a series of state infrastructure banks. These banks would make below-market loans for infrastructure repairs and perhaps other infrastructure investments. Upon repay- ment of the loans, the funds would be recycled to other capital projects. One of the attractions of an infrastructure bank is that it rep- resents a long-term commitment to dealing with the capital infra- structure dilemma. It is an implicit guarantee of permanent atten- tion to public capital needs. Once a bank has been created and endowed with a professional staff, it is unlikely to disappear. Loans will have to be repaid and the bank will have to be there to receive them. If the initial legislation establishes a revolving fund, so that loans that are repaid are recycled to new infrastructure users, a second generation of lending activity can be ensured. Permanence, visibility, and professionalism are the critical ar- guments in favor of an infrastructure bank. It is not that below- market loans to support public capital spending represent a magical or costless source of financing, but rather that an infrastructure bank is a tangible, long-term commitment, more difficult to disavow than a new federal block grant program. What of the financing requirements of such a bank? To have an
FINANCING THE NATION'S INFRASTRUCTURE REQUIREMENTS 129 impact on infrastructure conditions, it would have to consolidate some existing categorical grant programs and have an additional capitalization of $10-$20 billion. That represents a large amount of new federal borrowing, given today's budget conditions. The argument for a new institution of this type would be more persuasive if state and local governments would volunteer to sur- render some of their current borrowing capacity in exchange for this new financing vehicle. If infrastructure finance is a priority, these governments might consider or be required to consider off- setting reductions in the volume of tax-exempt debt issued to sup- port middIe-income housing mortgages or industrial development. It would be a mistake to think of the infrastructure problem as one of dollars alone. It is also a problem of institutions. There is little to be gained from boosting investment in the nation's public capital stock unless we can also be certain that, once this investment is carried out, ordinary repairs and maintenance will not again be deferred. It is essential that federal policy allow local discretion in deciding how any new infrastructure dollars are spent. It is entirely appro- priate, however, to have in place the institutions that can guarantee capital preservation. An infrastructure bank, for example, should make loans to a water or sewer system only on condition that the system charge full-cost pricing for its services. User fees should include amounts needed to sustain a long-term capital repair and replacement strategy. At present, too many water systems are dis- investing in their assets simply because they do not have the po- litical will or ability to charge full-cost fees. The bank may also want to make a condition of loans that the local government have in operation a system of capital assessment and capital budgeting that meets professional standards as estab- lished by the bank. These conditions are no more onerous than those a private bank would require of a private borrower. They help ensure that the loan can be repaid and that the public funds used to subsidize loan rates will serve their public purpose. In fact, the ability to exert insti- tutional leverage of this sort is one of the principal advantages of a bank structure. Paradoxically, the least essential contribution an infrastructure bank may make is the actual financing of the next generation of capital formation. More critical is the leverage it can exert on the nation's institutional capacity to plan and manage capital facilities.
130 PERSPECTIVES ON URBAN INFRASTRUCTURE Recent history speaks eloquently that one covenant to a subsi- dized loan agreement is worth a thousand exhortations in planning articles. CONCLUSION The idea that there has been a failure of infrastructure financing and budgeting is often advanced as an explanation for the steep decline in state and local capital spending. Two of the commonly proffered explanations that federal aid growth has been inadequate and that the long-term bond market has ceased to provide capital for infrastructure finance- receive very little support from the evidence. A third assertion that cap- ital infrastructure spending has been unable to compete effectively with other budget claims for political reasons-has greater plau- sibility, at least for those cities in severe fiscal straits, but it cannot account for the strong secular decline in capital spending. Most of the explanation for the decline in infrastructure spending would appear to lie elsewhere. It has been a deliberate budget choice exercised by public officials and by voters. The fact that infrastruc- ture bond issues fall precipitously when long-term interest rates climb, that local capital spending is postponed or supplanted when federal funds become available, that communities invest in waste- water treatment plants up to the limit of availability of federal matching funds but not beyond are signs of economic decision mak- ing at work. Government officials and the public make their capital budget decisions without much information. It is possible-indeed, likely- that with better and more plentiful information as to the condition of facilities and the consequences of deferring repair investment, local governments would have chosen to spend more for these pur- poses. The information generated by the federal requirement for annual bridge condition assessment provides a good example of the spending stimulation created by new information as well as new federal aid dollars. If the capital financing problem is one of inadequate information, however, the solution to it lies in the collection of better information and more effective communication of it to voters not new capital- financing vehicles or formal efforts to extricate capital expenditures from a government's general budget.
FINANCING THE NATION'S INFRASTRUCTURE REQUIREMENTS 131 REFERENCES CONSAD 1980 A Study of Public Works Investment in the United States. Washington, D.C.: U.S. Department of Commerce. Available from the National Technical Infor- mation Service, Springfield, Va. Eckrose, Roy A. 1979 Measuring effectiveness of pavement preservation techniques. Public Works (July). Gilland, E. J., and Hanke, Steve 1982 Crisis: financing water and wastewater. WaterlEngineering and Management 129(7):41-43. Gramlich, Edward M. 1978 State and local budgets the day after it rained: why is the surplus so high? Brookings Papers on Economic Activity 1:191-217. Kirlin, John J., and Kirlin, Anne M. 1982 Public Choices Private Resources: Financing Capital Infrastructure for Cal- ifornia Through Public-Private Bargaining. Sacramento: California Tax Foun- dation. Morgan Guaranty 1982 Rebuilding America's infrastructure. The Morgan Guaranty Survey (July). Peterson, George E. 1978 Capital spending and capital obsolescence. In Roy Bahl, ea., The Fiscal Outlook for Cities. Syracuse, N.Y.: Syracuse Press. Peterson, George E., Miller, Mary John, Godwin, Steve, and Shapiro, Carol 1983 Benchmarks of Urban Capital Condition. Washington, D.C.: Urban Institute. President's Intergovernmental Water Policy Task Force, Subcommittee on Urban Water Supply 1980 Urban Water Systems: Problems and Alternative Approaches to Solutions. Washington, D.C.: U.S. Government Printing Office. Schneiderman, Paul 1975 State and local government gross fixed capital formation: 1958-73. Survey of Current Business (Oct.):17-26. Wolman, Harold, and Peterson, George 1981 State and local government strategies for responding to fiscal pressure. Tulane Law Review (April). DISCUSSION Franklin D. Raines ~ will discuss the peculiar problems of financing large capital investments. We have not always clearly distinguished between ongoing capital expenditures, especially for maintenance, and large projects. Each raises different management and financial issues. This chapter does a good job of disproving the hypothesis that if we are investing too little there must be something wrong with the financing mechanisms. Both the chapter and experience argue that
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
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.
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
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
136 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
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
138 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
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.
140 PERSPECTIVES ON URBAN INFRASTRUCTURE 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
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.
142 PERSPECTIVES ON URBAN INFRASTRUCTURE 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.