How Do Most States Finance Their Capital Budget?

The answer may surprise you.

Most states finance their capital budget through a combination of bonds, cash, and federal grants.

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Introduction

In order to finance their capital budget, most states rely on a combination of cash from current revenues, borrowing, and federal aid. The specific mix of these sources varies from state to state, depending on the state’s overall budget situation and its willingness to take on debt.

In recent years, many states have been cutting back on funding for their capital budgets in order to deal with budget shortfalls. As a result, more states have been relying on borrowing and federal aid to finance their capital projects.

How do most states finance their capital budget?

The primary ways states finance their capital budget are through the issuance of debt, which account for 58 percent of all capital expenditures, or by using dedicated revenue, which funds 30 percent of capital projects. The balance is financed through other means, such as federal aid (8 percent) and budgetary reserves and rainy day funds (4 percent).

Most states have some form of constitutional debt limit that restricts the amount of bonds the state can issue. In 2017, constitutional debt limits ranged from $250 million in North Dakota to $50 billion in California. Nearly half of all states require voter approval for general obligation bonds. For revenue bonds, which are not backed by the full faith and credit of the state government, voter approval is required in about a third of states.

States also finance their capital budget through dedicated revenue sources, such as gasoline taxes or vehicle registration fees that are specifically earmarked for transportation projects. In many cases, these dedicated revenue sources are constitutionally protected, which means they can only be used for their intended purpose and cannot be diverted to other purposes.

The Pros and Cons of Different Methods

There are a number of ways that states can finance their capital budget. The three most common methods are debt financing, pay-as-you-go financing, and Grants. Each method has its own set of pros and cons that should be considered before deciding which method is best for a particular project.

Debt Financing:

Debt financing allows a state to spread the cost of a capital project over a period of time, which can make it easier to afford the project. However, it also means that the state will have to pay interest on the debt, which can increase the overall cost of the project. In addition, debt financing can put a strain on the state’s budget in future years if the capital project is not completed on time or does not generate the revenue that was expected.

Pay-As-You-Go Financing:

Pay-As-You-Go financing requires a state to set aside money in its budget each year to fund capital projects. This can be difficult to do if the state is facing other budgetary challenges, but it does have the advantage of not incurring any debt or interest costs. In addition, Pay-As-You-Go financing gives a state more flexibility in how it spends its money because it is not committed to making payments on a loan for a capital project.

Grants:
Grants are an attractive option for funding a capital project because they do not have to be repaid. However, they can be difficult to obtain and competitive in nature. In addition, grants typically come with strings attached in terms of how the money must be spent, which can limit a state’s flexibility in using the funds.

Case Study: California

Each state has a capital budget that funds long-term investments, such as infrastructure and buildings. Most states finance their capital budget with borrowed money, which must be repaid with interest. The amount of money that a state can borrow is determined by its constitutional debt limit.

California’s constitution limits the state’s general obligation bond debt to 12% of the state’s total personal income. As of 2019, California’s personal income was $2.9 trillion, so the state’s maximum bond debt limit was $348 billion.

In order to finance its $138 billion 2019–2021 capital budget, California plans to sell $77 billion in bonds. The remaining capital budget will be funded by federal grants,pay-as-you-go spending, and other sources.

The interest on California’s bonds is estimated to cost the state $5.4 billion in the 2019–2020 fiscal year. This is an estimated 2% of the state’s total expenses for the year.

Case Study: Texas

The State of Texas’s budget is primarily funded through taxes and federal aid, with some additional revenue from things like fees and interest on investments. The state’s biennial budget process begins with the governor releasing a proposed budget, which the Legislature then considers and may modify before passing a final budget.

The state’s fiscal year runs from September 1 to August 31, and the Legislature appropriates money for two-year cycles. The current cycle is FY 2018–19. The governor may make supplemental appropriations during the session for any unexpended or unanticipated needs that arise during the biennium.

The Texas Constitution requires that the Legislature pass a balanced budget, meaning that the total amount of money appropriated cannot exceed the amount of revenue expected to be available. The state comptroller estimates revenue for the upcoming biennium and provides this estimate to the Legislature early in each regular session so that lawmakers can use it as they craft their appropriations bill.

Case Study: New York

New York is one of a handful of states that finance the bulk of their capital budget through the issuance of bonds. As of March 2018, New York had $63.4 billion in general obligation debt outstanding, making it the fourth most indebted state in the nation behind California, Texas, and Illinois. New York’s debt load amounts to about $2,129 per capita, which is also fourth highest in the nation.

While the use of bonds to finance infrastructure projects has been commonplace for many years, it has come under increased scrutiny in recent years due to the growing size of state debt loads. In 2017, total state debt outstanding reached a record high of $1.27 trillion, which is equivalent to about $3,836 per person.

The use of bonds to finance infrastructure projects relies on future taxpayers to repay the debt, which some critics argue is unfair to future generations who will benefit from the projects being financed by the bonds. Others argue that financing capital projects through bonds allows states to spread the cost of major projects over many years, which makes them more affordable in the short-term.

What do you think? Is it fair to finance capital projects through the use of bonds? Or should states find another way to pay for these types of investments?

Conclusion

In conclusion, states finance their capital budget in a variety of ways. The most common methods are through the use of bonds, pay-as-you-go financing, and federal grants. Each state has its own unique system, and there is no one-size-fits-all approach. The best way to understand how your state finances its capital budget is to contact your state legislators and ask them for more information.

Bibliography

The National Association of State Budget Officers (NASBO) publishes “The State of the States,” which is a report that details how each state finances its capital budget. The most recent edition, for FY 2014, can be found here: http://www.nasbo.org/Publications/State-of-the-states/FY14_Report/.

Further Reading

There is no universal answer to the question of how states finance their capital budget. Some states have a dedicated revenue stream for capital projects, while others finance them through general revenue or bonds. Many states use a combination of these methods.

Some dedicated revenue streams for funding capital projects include gas taxes, vehicle registration fees, and earmarks from the federal government. States may also issue bonds to finance capital projects. This can be done through general obligation bonds, which are repaid from the state’s general fund, or through special assessment bonds, which are repaid by revenues generated from the project itself.

Whatever the method, it is important for states to have a reliable source of funding for their capital budget in order to maintain and improve infrastructure.

About the Author

My name is Christopher Wimer. I am a senior fellow at the Urban Institute, where I conduct research on a variety of topics related to state and local government finance.

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