What is Municipal Debt?
Municipal Debt and Capital Financing in Montana: Bonds, Borrowing, and Budget Implications
The Montana constitution requires that the legislature enact laws limiting the indebtedness that may be incurred by municipal governments. Under state law, no debt may be incurred to balance a local government’s annual operating budget which, as noted above, must balance proposed expenditures with cash reserves and anticipated revenues. However, state law does enable a local government to undertake debt for long term capital improvements such as streets and roads, government buildings and similar public facilities. (See 7-7-4101, MCA for a
listing of the purposes for which a municipality may incur bonded indebtedness.) The amount of debt that may be incurred by a local government is, however, limited to a specified percentage of the jurisdiction’s property tax valuation. With some exceptions, a municipality may incur debt up to 2.5% percent of the assessed value of the taxable property within the city or town (7‐7‐4201, MCA). Municipal debt may be further increased for construction of
water and sewer systems if the revenue from these systems is devoted to servicing that additional debt (7‐7-4202, MCA). Municipal government debt for capital improvements is most often undertaken by issuing either general obligation (G.O.) bonds or revenue bonds. However, in Montana smaller scale capital projects may be funded by shorter-term loans available to local governments from the state revolving loan program known as INTERCAP, operated by the Board of Investments in the Montana Department of Commerce. General Obligation Bonds
General obligation (G.O.) bonds are guaranteed by the full faith and credit of the local government issuing the bonds. By pledging the jurisdiction’s full faith and credit, the government undertakes a legally binding pledge to repay the principal and the interest by relying upon its taxing authority, 7‐7-4204 MCA. This obligation must 4. Municipal Budgeting
138 therefore be ratified by an affirmative vote of the citizens before the bonds may be issued (7-7-4221, MCA). Due to the relative security of repayment of G.O. bond principal and interest and because the interest paid to the bond holders (lenders) may be exempt from state and federal taxes, lenders are usually willing to accept a lower rate of interest. As a result, the cost of the capital project will be somewhat less for the local government and for their taxpayers.
Revenue Bonds
Revenue bonds, on the other hand, are not guaranteed by the taxing authority of the local government entity issuing the bonds and they are, therefore, somewhat less secure than G.O. bonds. Even though the bond-holders interest earnings on revenue bonds may also be tax exempt, the bond market will usually demand somewhat higher interest rates to attract lenders. As suggested by their name, revenue bonds are backed only by the revenues from fees paid by the users of the capital facility, such as a municipal water or wastewater system or
Special Improvement District (SID) for neighborhood improvements such as streets and sidewalks. Because revenue bonds do not involve a pledge of the full faith and credit (taxing authority) of the municipal government, revenue bonds do not require voter approval, 7‐7‐4104 and 7-7‐4426, MCA. To Borrow or Not to Borrow Taking on local government debt by issuing either G.O. or revenue bonds involves a fairly complex process that always requires the legal competence of “bond counsel” and the marketing expertise of a brokerage firm that
specializes in government bonds. Additionally, some municipal governments engage the services of a “financial advisor” to assist with the process and to represent the government’s interests in negotiating a large bond issue with a brokerage firm. However, before deciding to proceed, even before actually engaging professional consultation, it is important that the governing body understand the implications of funding a capital project with long-term debt.
• Affordability -We refer here not just to a municipal government’s ability to meet the monthly debt service payments while funding operations costs of the new project but, in doing so, to retain sufficient long-term liquidity to meet unforeseen, future demands on its revenues, including the effects of inflation on the costs of capital projects.
• Competing Capital Projects -Debt undertaken now reduces the government’s debt funding capacity (legal limit) for the life of the bonds, which is often 20 years. What other capital projects at what cost (the opportunity costs) will be required by the local government during that period? Moreover, the community’s total debt burden must be considered. A $20 million school bond to upgrade the local high school proposed on the ballot at the same time as a $10 million municipal bond proposal for a new city library are not likely to be well received by the taxpaying voters, no matter how much they may be inclined to support either one of the projects. Intergovernmental communication, coordination and cooperation among the governing bodies and executives are essential to avoid overloading the debt service capacity of the community.
• Who Pays for Capital Project? Long term debt financing of capital facilities means that those who will use the facility in the future, during the course of the indebtedness, will be those who pay the cost of the facility. It will be their additional tax dollars or fees paid to service the debt that will pay for the project. Alternatively, a capital depreciation fee built into the present tax or rate structure might be used to accumulate the capital necessary to replace the facility at the end of its useful life, thereby reducing the need for debt financing along with the attendant interest costs. In doing so, however, the present generation of users will be paying the capital costs of the facility they are now using and, by means of the capital depreciation fee included in their present tax or utility bill, they will also be paying the capital Montana Municipal Officials Handbook 139 costs of a future facility they may not need nor even have access to. In short, debt financing means that those citizens who will be using the facility will pay for the facility, which is usually sound public policy. However, in this case, sound public policy also has a fairly steep price tag, called “interest,” on the public debt.
• Grants and Debt -Finally, if a municipal government wishes to seek federal or state grant assistance in funding capital projects, such as Montana’s Treasure State Endowment Program (TSEP), the local government itself must demonstrate a need for the capital facility and financial need. In this regard, financial need includes a consideration of the debt capacity of the local government, which is to say the ability and willingness of that government and its taxpayers (or rate payers) to participate in funding the project by assuming its reasonable and affordable share of the costs through debt financing. Most TSEP projects are, for example, funded by a package of state and federal grants, along with a substantial debt obligation undertaken by the municipal government.
listing of the purposes for which a municipality may incur bonded indebtedness.) The amount of debt that may be incurred by a local government is, however, limited to a specified percentage of the jurisdiction’s property tax valuation. With some exceptions, a municipality may incur debt up to 2.5% percent of the assessed value of the taxable property within the city or town (7‐7‐4201, MCA). Municipal debt may be further increased for construction of
water and sewer systems if the revenue from these systems is devoted to servicing that additional debt (7‐7-4202, MCA). Municipal government debt for capital improvements is most often undertaken by issuing either general obligation (G.O.) bonds or revenue bonds. However, in Montana smaller scale capital projects may be funded by shorter-term loans available to local governments from the state revolving loan program known as INTERCAP, operated by the Board of Investments in the Montana Department of Commerce. General Obligation Bonds
General obligation (G.O.) bonds are guaranteed by the full faith and credit of the local government issuing the bonds. By pledging the jurisdiction’s full faith and credit, the government undertakes a legally binding pledge to repay the principal and the interest by relying upon its taxing authority, 7‐7-4204 MCA. This obligation must 4. Municipal Budgeting
138 therefore be ratified by an affirmative vote of the citizens before the bonds may be issued (7-7-4221, MCA). Due to the relative security of repayment of G.O. bond principal and interest and because the interest paid to the bond holders (lenders) may be exempt from state and federal taxes, lenders are usually willing to accept a lower rate of interest. As a result, the cost of the capital project will be somewhat less for the local government and for their taxpayers.
Revenue Bonds
Revenue bonds, on the other hand, are not guaranteed by the taxing authority of the local government entity issuing the bonds and they are, therefore, somewhat less secure than G.O. bonds. Even though the bond-holders interest earnings on revenue bonds may also be tax exempt, the bond market will usually demand somewhat higher interest rates to attract lenders. As suggested by their name, revenue bonds are backed only by the revenues from fees paid by the users of the capital facility, such as a municipal water or wastewater system or
Special Improvement District (SID) for neighborhood improvements such as streets and sidewalks. Because revenue bonds do not involve a pledge of the full faith and credit (taxing authority) of the municipal government, revenue bonds do not require voter approval, 7‐7‐4104 and 7-7‐4426, MCA. To Borrow or Not to Borrow Taking on local government debt by issuing either G.O. or revenue bonds involves a fairly complex process that always requires the legal competence of “bond counsel” and the marketing expertise of a brokerage firm that
specializes in government bonds. Additionally, some municipal governments engage the services of a “financial advisor” to assist with the process and to represent the government’s interests in negotiating a large bond issue with a brokerage firm. However, before deciding to proceed, even before actually engaging professional consultation, it is important that the governing body understand the implications of funding a capital project with long-term debt.
• Affordability -We refer here not just to a municipal government’s ability to meet the monthly debt service payments while funding operations costs of the new project but, in doing so, to retain sufficient long-term liquidity to meet unforeseen, future demands on its revenues, including the effects of inflation on the costs of capital projects.
• Competing Capital Projects -Debt undertaken now reduces the government’s debt funding capacity (legal limit) for the life of the bonds, which is often 20 years. What other capital projects at what cost (the opportunity costs) will be required by the local government during that period? Moreover, the community’s total debt burden must be considered. A $20 million school bond to upgrade the local high school proposed on the ballot at the same time as a $10 million municipal bond proposal for a new city library are not likely to be well received by the taxpaying voters, no matter how much they may be inclined to support either one of the projects. Intergovernmental communication, coordination and cooperation among the governing bodies and executives are essential to avoid overloading the debt service capacity of the community.
• Who Pays for Capital Project? Long term debt financing of capital facilities means that those who will use the facility in the future, during the course of the indebtedness, will be those who pay the cost of the facility. It will be their additional tax dollars or fees paid to service the debt that will pay for the project. Alternatively, a capital depreciation fee built into the present tax or rate structure might be used to accumulate the capital necessary to replace the facility at the end of its useful life, thereby reducing the need for debt financing along with the attendant interest costs. In doing so, however, the present generation of users will be paying the capital costs of the facility they are now using and, by means of the capital depreciation fee included in their present tax or utility bill, they will also be paying the capital Montana Municipal Officials Handbook 139 costs of a future facility they may not need nor even have access to. In short, debt financing means that those citizens who will be using the facility will pay for the facility, which is usually sound public policy. However, in this case, sound public policy also has a fairly steep price tag, called “interest,” on the public debt.
• Grants and Debt -Finally, if a municipal government wishes to seek federal or state grant assistance in funding capital projects, such as Montana’s Treasure State Endowment Program (TSEP), the local government itself must demonstrate a need for the capital facility and financial need. In this regard, financial need includes a consideration of the debt capacity of the local government, which is to say the ability and willingness of that government and its taxpayers (or rate payers) to participate in funding the project by assuming its reasonable and affordable share of the costs through debt financing. Most TSEP projects are, for example, funded by a package of state and federal grants, along with a substantial debt obligation undertaken by the municipal government.