The swirling debate over MWRA bonds: Who pays?

from NewsLink, Vol. 2, No. 1, Fall 1997

by Aniko Laszlo

Few issues ignite public passions in the Bay State as much as water and sewer rates. So it is not surprising that elected officials have different ideas on how to moderate the high costs associated with cleaning up Boston Harbor. ¹

Considering the volatility of water and sewer rates, particularly on the advent of a gubernatorial election year, the Cellucci administration has urged the MWRA to spread the cost of financing of a proposed new aqueduct facility over 50 years.

The controversy swirls around the fact that water and sewer user charges for residents of the Greater Boston area could jump as much as 48% in the next five years. The rate increase is attributable, among other things, to the increased costs of servicing previous bond issues and to the financing needs of a new aqueduct facility.

On the surface, the Governor's preference appears to be a fair method of spreading the costs among ratepayers. A 50-year bond can lower yearly payments on the bond in the near term, although there are higher total repayment costs in the long run. However, the relevant public finance question remains: Who is going to bear the cost burden?

While the idea that government borrowing imposes a burden on future generations might seem to represent common sense, the issue has, in fact, been a hotly debated one in the annals of economic thought. More than 150 years ago, economist David Ricardo provided the basis for the counterintuitive view that public debt imposes no burden on future generations.²

Ricardo maintained that any public expenditure financed by debt would burden only current, not future generations. This is because current generations would anticipate the future taxes associated with future bond amortization payments. Thus, they would increase their private saving by whatever amount was needed to amortize government debt issued in the present period.

Nobel laureate economist James M. Buchanan challenged this Ricardian version of public debt theory in 1958. Buchanan argued that the burden of public debt rests on future generations of taxpayers that must defray the cost of amortizing it.³

Buchanan pointed out that public debt was analogous to private debt. Debt, whether public or private, imposes financial burden on those who service it in future years. Since debt financing is an act of voluntary trade, private investors voluntarily purchase bonds in exchange for the issuer's pledge of a revenue stream coming from user charges or taxes, whichever the case might be. If, then, government expenditure is financed by the issuance of debt rather than by the imposition of current taxes, the burden of debt is shifted to future generations.

While the Ricardian and Buchanan views seem, at first blush, to be irreconcilable, they are in fact mutually consistent. Debt financing does, in fact, offer a choice to the current generation of taxpayers: They can spend their money for consumption goods now or save it for future periods. If taxpayers consume more in the current period, they shift the burden of government expenditure to future generations. How? In a world of scarcity, what is consumed now cannot be saved. Society gets more government projects, more consumption and fewer private investment projects. That means fewer factories, office buildings and other forms of private capital that create jobs and goods for future generations.

If, on the other hand, taxpayers use the same money for saving, they impose the burden of government expenditure on their own generation. They provide the funds needed to maintain private investment projects that would otherwise have, in the previously described consumption scenario, been abandoned. Society gets more government projects, less current consumption and no cutback in private investment projects.

Why would individuals as well as public agencies prefer to service the public debt for an extended period of time instead of paying for the public good at the time it was created? Debt financing allows taxpayers to smooth out any big fluctuation of their consumption over time, thus shift part of the burden of government expenditure to the next generation of taxpayers. Likewise, it permits the borrowing agency to spread out the cost of debt over time and across generations.⁴

Proceeding on the principle that public services should be financed on a benefit basis, the nature of the expenditure to be financed becomes of crucial importance. For public expenditures that are expected to yield benefits in a reasonably short period, current taxation or user charges are the appropriate means of financing. For example, if citizens need more police protection, police departments are expected to hire more police officers. Current residents will enjoy benefits of police protection today and in the near future. The use of long-term borrowing to pay for current police protection would simply exploit future taxpayers for the benefit of those who enjoy safer streets and neighborhoods in the present.

Long-term borrowing is a means to finance a public good or service that is expected to yield benefits for a long time. A case in point is MWRA's new aqueduct facility, which is expected to serve the residents of the Greater Boston area for over 30 years. ⁵ Furthermore, financing on a benefit basis requires that the maturity of the bond and that of the underlying physical asset match. It is important from both a financial and policy perspective. From a credit perspective, lenders want to be assured that assets will last and rate payers pay for their benefits at least as long as the debt is fully amortized. From a policy point of view, each year, ratepayers pay a representative portion of the cost of the asset they use. Since the asset's economically useful life is about 30 years, neither the recommendation of the Governor's office to issue a 50-year bond, nor the agency's bond offering of a 40-year maturity seem to represent sound public finance.

For the sake of simplicity let us assume that the new asset will fully depreciate at the end of the 30th year. If the bond's maturity is 40 years, ratepayers who amortize the loan in year 31 and then on, will only assume the financial burden but will not enjoy any benefit from the asset. Moreover, the cost of servicing outstanding bond securities can fluctuate on a yearly basis. ⁶ The MWRA also faces higher repayment costs of previously issued debt securities in the next few years. Therefore, it plans to issue a bond with a 40-year maturity to jointly cover the capital needs of a new facility and reduce the yearly bond service payments that are to become heavier in the near future. Even though ratepayers might not be pleased with higher user charges in an election year, the only sound fiscal policy would be to issue a 30-year bond for building the new facility and increase user charges to cover yearly fluctuations on outstanding debt issues. If the MWRA issues a new long-term bond to finance its new facility as well as to deal with its temporary budgetary imbalance, future generations will shoulder the costs without enjoying the benefits of already amortized facilities.

According to three respected credit agencies, Fitch Investor Services, Moody's and Standard and Poor's Rating Group the MWRA's "A-level" credit rating is dependent on two factors. ⁷ One, the asset's economically useful life has to be the limitation of the final maturity to be issued. Second, the extension or backloading of any outstanding debt through a refunding would raise credit concerns because of its potential added cost impact on future ratepayers. In fact, beyond 40 years the markets are untested and bond issues over a 40-year maturity could result in greater credit exposure and interest expense for the issuing agency. Since state and local governments are readily exposed to credit market mechanisms, it is likely that the final maturity of the MWRA's new debt issue will be set by market demand not by the governor's office. Finally, even with a 40-year maturity bond, our children and grandchildren are likely to unduly bear some of the financial burdens of the current and previous bond issues. I think neither Ricardo nor Buchanan would be pleased.

Footnotes

¹ Peter Howe, "Cellucci team pressing MWRA on bills,"Boston Globe, September 17, 1997.
² David Ricardo, The Principles of Political Economy and Taxation,(New York: E. P. Dutton, 1960).
³ James M. Buchanan, Public Finance in Democratic Process, (Chapel Hill: University of North Carolina Press, 1967).
⁴ James M. Buchanan: Public Finance in Democratic Process, Chapel Hill, NC 1967.
⁵ Telephone interview with Barbara Gottschalk, Chief Financial Officer, MWRA.
⁶ Depending, among other things, on fluctuations in market rates of interest, variability in principal repayments such as backloading, amortization payments can fluctuate heavily on a yearly basis. Backloading refers to the possibility that principal payments are minimized in the early years of the issue and become heavier in later years.
⁷ Analysis of MWRA's debt extension by Lamont Financial Services Corporation, Feb. 27, 1997: 2.

Aniko Laszlo is a Research Associate at the Beacon Hill Institute and Senior Lecturer in the Department of Economics at Suffolk University.

NewsLink is the quarterly newsletter of the Beacon Hill Institute for Public Policy Research at Suffolk University. © 1996-1997. All rights reserved.

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