Debt Affordability: A Stochastic Model

Kenneth A. Kriz1
DRAFT FOR JOURNAL REVIEW Draft Date: 09 May, 2007

JEL classification codes: H74, H63

Associate Professor, School of Public Administration, University of Nebraska at Omaha; Mailing Address: Annex 27, 6001 Dodge Street, Omaha, NE 68182. Phone: 402.554.2058; Email: kkriz@mail.unomaha.edu. The author would like to thank Qiushi Wang for his research assistance and Fred Thompson for his comments on the paper as well as his encouragement in pursuing the topic.

Debt Affordability: A Stochastic Model

Abstract Many normative models of debt affordability have been proposed. However, most have been ad hoc in nature. This paper develops and calibrates a normative model of debt affordability based on the ex ante stochastic distribution of future changes in tax base. We find that the most important variables in terms of explaining the likelihood of future default are tax base volatility, desired future operating (non-capital) expenditure growth, and the effectiveness of investments financed by debt in increasing economic growth. Less important factors were initial tax rates, interest rates, and a jurisdictions political sensitivity to increases in tax rates or cuts in spending. Introduction In December 1994, the Board for Orange County, California announced one of the largest municipal bankruptcies of all time. The renunciations of the actions of the County Treasurer in precipitating the default on over $1.6 billion dollars of municipal debt, and the fallout associated with the event, were immediate and drastic. Many individuals lost their jobs in the resulting budget cuts, political careers were cut short or at least changed inexorably, and citizens had services reduced or eliminated (Baldassare, 1998). Unfortunately, Orange County was neither the first nor the last municipal bankruptcy. Beyond explicit bankruptcies which occur at infrequent intervals, there have been a host of de facto bankruptcies where spending patterns of subnational jurisdictions (and even a few sovereign nations) had to be changed dramatically in order to accommodate debt payments. Default on debt presents a crisis for most borrowers. In the private sector, default can cause the loss of control over firm assets. In the public sector, control obviously has a different meaning. However, in a public default situation citizen owners may lose control over their jurisdiction, with receivership or loss of access to capital markets as potential penalties. The political penalties for elected leaders may involve loss of control through loss of access to their office. Needless to say, there is a lot at risk when jurisdictions choose to borrow. However, there is also risk that comes from not 2

borrowing. Lack of borrowing may produce underinvestment in capital, resulting in slower than potential economic growth (though there is much debate on this point, see Munnell (1990) for a review of the seminal literature and Zou (2006) for a recent contribution). The question thus becomes one of affordable debt levels. At its heart, the central debt affordability question is: Does the issuance of a bond issue of size b significantly increase the likelihood that the jurisdiction will not be able to make payments on its total debt B? A related question is whether the issuance of a bond issue b makes the level of debt B politically unsustainable. In order to answer these questions, one needs to realize that there is tremendous uncertainty regarding future revenues and expenditures. The more uncertain are future revenues and expenditures, the more likely that the jurisdiction will not be able to service its debt burden. Therefore, the question of debt affordability is a question of probabilities. Despite the inherently stochastic nature of the debt affordability question, previous models of debt affordability have largely taken a benchmarking approach comparing debt levels of a jurisdiction either against some fixed standard or against other jurisdictions. But there are several reasons why a benchmarking approach may not reflect the true nature of the debt affordability question. This paper takes a different approach, one that attempts to model more fully the financial implications of issuing debt. We will produce a model that takes more fully into account specific financial, economic, and demographic realities of the jurisdiction. Using this model, jurisdictions will be able to say not only if a certain level of debt will be affordable, but also the reasons why or why not this is the case.

Literature Review The literature on debt affordability is relatively well developed.2 Discussion of debt affordability issues began with Bernards work on meeting the financing needs of government. He noted that while the private sector finance literature was replete with
2

As the principal purpose of this research is to develop a radically different method for assessing debt affordability, the review of past literature will be necessarily brief to leave room for the theory development. Recent and much more detailed literature reviews can be found in Bartle, Kriz and Wang (2006) from which this review was derived and in Denison and Hackbart (2006).

articles dealing with debt affordability, public sector researchers had yet to take up the challenge (Bernard, 1982). As noted in Ramsey, Gritz & Hackbart (1988), techniques in assessing debt affordability have generally developed into three approaches: the debt ceiling approach, the benchmarking approach, and the regression approach. In the debt ceiling approach, a limited number of measures of debt burden (for example, debt as a percentage of assessed property value) are calculated, and then compared to some maximum level. Often times this technique is formalized into statute or constitutionally mandated. For example, in the state of Minnesota, local debt outstanding cannot exceed 3 percent of the total market value of property. In the benchmarking approach, more measures of debt burden are calculated, and then they are compared against some set of similar jurisdictions. This approach is formalized in guidelines issued by the Government Finance Officers Association (GFOA). GFOA recommends several measures of debt burden and debt size be calculated and compared against a peer group (Miranda & Pincur, 2000). An example of a benchmark that is commonly cited is the debt to assessed property value ratio. Presumably, as more debt is issued against a property tax base, it puts a jurisdiction more at risk to default on the debt. The final approach used in a few affordability studies is the regression approach. Here, measures of debt burden for many different jurisdictions are regressed against different explanatory factors and results are captured. Then any one city can generate a predicted debt burden against which its current situation can be compared. In essence, this is just another type of benchmarking. The difference between this and other types of benchmarking are that instead of measuring a jurisdictions debt burden against some other set of similar jurisdictions, the debt burden is here compared against a prototypical case developed statistically. This is the methodology developed in Ramsey, Gritz, and Hackbart (1988). As pointed out in Bartle, Kriz, and Wang (2006) hereafter BKW-, the above methodologies are often problematic in terms of their ability to measure debt capacity and affordability. They cite three sources of problems. First, benchmark type measures 4

and debt limits are often incomplete in that they do not take into account differing circumstances between jurisdictions. The authors cite the case of Omaha, Nebraska, a city that is much more reliant on sales taxes than other jurisdictions. Obviously, a debt to property value measure of affordability for a city with a relatively small property tax does not make much sense. A similar view was voiced in Denison, Hackbart, and Moody (2006) who argued that more than one type of debt limit might be necessary due to different characteristics of jurisdictions. One recent paper that attempts to adjust the benchmarking approach to take into account some differences between jurisdictions is that of Brecher, Richwerger, and Van Wagner (2003). They develop measures of the revenue base for states using representative revenue systems and relate them to general obligation debt burdens in order to assess the relative likelihood of default. While this paper is an improvement on previous work, their model is still ad hoc in that it does not proceed from first principles and does not develop a solution for the relative amount of revenue volatility that can push a jurisdiction into a dangerous situation with regard to its debt. Second, BKW cite the static nature of existing debt affordability measures. Dynamics are mostly left off the table in calculating debt affordability, which seems strange given the dynamic nature of revenue, expenditures, and economic condition. Last, debt affordability measures are seen by BKW as mechanical: In essence the city is seen as having zero probability of encountering financial difficulties as long as its benchmarking calculations fall below some point, then the probability increases to certainty of difficulties when some magic point is reached (Bartle, Kriz, & Wang, 2006). Model In order to address these difficulties in assessing debt affordability, we take a different approach than any of those papers discussed above. We model the likelihood of default on debt given different combinations of revenue base growth, the tax rate of the jurisdiction, desired growth of expenditures other than capital expenditures, the impact on revenue base growth of the expenditures that debt will be issued to fund, interest rates, and the willingness of citizens in a jurisdiction to make large expenditure cuts or tax increases in the event of a budget shortfall. Our model looks most like that of Thompson 5

and Gates (Thompson & Gates, 2006). They address a different question in their paper. They solve for the sustainable growth in expenditures given debt, revenues, and other variables. We solve for maximum debt, which is a distinct policy question. We use a median voter model with an existence theorem regarding the compensation of a government official to motivate our model setup. Assume that a single rational, utility-maximizing decision maker rules a jurisdiction consisting of a single citizen whose utility is a function of government operating and capital expenditures, along with private consumption from an initial allocation of wealth. Our model initially occurs across two time periods with decisions made at three points in time. At time t0 the citizen employs the decision maker and provides him with a fixed wage W0. The wage is an increasing function of the expected amount of utility generated by government spending. At time t1, after the first time period, the citizen provides the decision maker with a fixed wage W1 that holds during the second period. At time t2, the decision maker pays the decision maker a fixed amount W2 which is in essence payment for retention of the decision makers services over another set of time periods. Since the wage and final payoff to the decision maker are based on expected future utility, there will be a set of information and actions by the citizen that will create an incentive for the decision maker to act in the best interest of the citizen when making choices. However, it is not readily apparent either to the decision maker or to the citizen what those choices should be. We turn to the dynamics of the revenue and expenditure generation model for the jurisdiction to try to reason a set of principles for the determination of optimal debt levels. Assume that at time t0, the jurisdiction has a balanced budget with no debt outstanding, so revenues equal operating expenditures R0 = EO0. The decision maker formulates a first period budget based on projections of future revenues R1 and future expenditure needs EO1. Given this formulation, the required revenues at time t1 are equal to the desired future expenditure EO1. Assuming that the government cannot run an operating deficit, required revenues will be equal to actual revenues such that R1 = EO1. Now assume that the government wishes to borrow an amount B to finance capital expenditures at time t0. Also assume that the debt is one-period debt issued at par value at an exogenous and 6

fixed interest rate r. While borrowing effectively raises revenue in the first period, the debt must be repaid in the second period. Now the budgetary constraint in the second period becomes:
R1 = EO1 + B0 (1 + r ) (1)

Next we recognize the simple relationship between first period revenue and second period revenue:
R1 = R0 + 0,1 R

(2)

and the relationship between first period expenditure and second period expenditure:
EO 1 = EO 0 + 0,1 (3) EO

In (2) and (3), the terms with represent the change in revenues and operating expenditures, respectively from time t0 to t1. Substituting from (2) and (3) into (1), we obtain:
R0 + R0,1 = EO 0 + EO 0,1 + B0 (1 + r )

(4)

Isolating B and noting that R0 will equal EO0 by definition, we find the question to the question of the maximum amount that can be borrowed in period 1:
R0,1 EO0,1 (5) 1+ r

B0 =

Equation (5) captures the obvious relationship that the change in revenue from the first period to the second must be greater than the change in operating expenditures, otherwise, the jurisdiction will have to default on the bond.3 Also, the higher the interest
3

Note that we preclude borrowing for operating expenditures. If jurisdictions can borrow for operating expenditures, this will allow the jurisdiction to avoid default. However, in a multi-period model, cash flow

rate at which the jurisdiction borrows, the less the jurisdiction can borrow safely. Therefore, if revenues are less than expected, the citizens of the jurisdiction would have to accept a cut in operating expenditures or accept a default on the bond issue. The formulation of (5) yields basic results. But revenues are only partially within the control of the jurisdiction. Rewriting (5) in terms of the controllable and uncontrollable portions of tax revenue yields additional insights. Assuming an ad valorem tax, we can write the revenue term to consist of a tax rate tr and a tax base TB:
Rt = trtTB t

Rt +1 = (trt + trt ,t +1 )(TB 0 + TB t ,t +1 )

(6)

where the subscript indicates the time period. We can expand the polynomial in the t+1 period to obtain the following:
Rt + =trt T t +trt B t ,t + + t ,t + T t + t ,t + B t ,t + B T tr 1 B tr 1 T 1 1 1

(7)

The change in revenue is the difference between revenue in period t and in period t+1. Substituting from (6) and (7), taking the difference and simplifying yields:
t ,t + = Rt + Rt R 1 1

t ,t + = trt T t [trtT t +trt B t ,t + + t ,t + T t + t ,t + B t ,t + ] R 1 B B T tr 1 B tr 1 T 1 1 t ,t + = trt B t ,t + + t ,t + T t + t ,t + B t ,t + R 1 T tr 1 B tr 1 T 1 1

(8) Thus the change in revenue between periods can be broken down into changes strictly attributable to changes in the tax base (the first term in (8)), changes strictly attributable to changes in tax rates (the second term), and changes attributable to both factors (the last term). Given this and our notation we can rewrite (5) as:

borrowing can also lead to default.

B0 =

[tr0 TB 0,1 + tr0,1TB 0 + tr0,1TB 0,1 ] EO 0,1 1+ r

(9)

One method of analyzing the maximum amount of debt that a jurisdiction can have outstanding is to use (9) directly. A common way of expressing debt outstanding is to standardize the debt figure in relation to some base. Dividing through by the tax base in the base period standardizes the debt burden to a percentage of tax base in the jurisdiction:
[tr TB 0 ,1 + tr0 ,1 + tr0 ,1TB 0,1 ] EO 0 ,1 B0 = 0 TB 0 TB 0 (1 + r )

(10)

Equation (10) shows that the maximum ratio of debt to tax base is a function of the jurisdictions initial tax base and tax rate, changes in the tax base, tax rate, and operating expenditures between periods and the interest rate on the jurisdictions debt. If we denote the maximum ratio of debt to tax base as D, analysis of the comparative statics of (10) shows the following relationships:
Table 1. Determinants of the Maximum Debt to Tax Base Ratio

D ?

Sign + + + -

TB TB tr tr r EO

The story behind equation (10) is that the jurisdiction at the beginning of the period makes an estimate of the change in the tax base and then sets the proper borrowing level and changes in tax rates and operating expenditures in order to avoid default. Of course, relying on a point estimate of changes in tax base exposes the jurisdiction to significant risk. If the realized change in tax base is far below that which was predicted, 9

significant cuts in operating expenditures and/or increases in tax rates may be required. Assume temporarily that the change in the tax base and the interest rate were known perfectly. Then determining the maximum borrowing would simply reduce to a mathematical model of the effects of the choice of tr and the change in EO. The government could simply set tr and EO so as to avoid default in each period. Viewed this way, it can be seen that default for a bond is some combination of debt burdens, tax base deficiencies, and unwillingness either by the public or their elected officials (or both) to make necessary changes in tax rates or expenditures. So a default is at least in some respects a political event. Jurisdictions could absorb relatively large shortfalls in revenue through revenue rate and spending adjustments or they can default. Another conclusion of this analysis is that there is hardly ever a case where one debt-to-tax base figure will capture the maximum amount that a jurisdiction can safely borrow. This becomes even more apparent when one relaxes the assumption that the change in tax base is known. In most cases the change in tax base is wholly stochastic. The decision to issue debt is now a decision based at least in part on expected growth in the tax base. In an ex ante sense, that expectation will only be realized within a given confidence level. In order to analyze the maximum amount of debt, officials must now assess the likelihood that the growth in the tax base will be sufficient to cover debt payments. To look at this decision, we can rewrite (9) in terms of the change in the tax base necessary to support debt service: B0 (1 + r ) + EO0,1 tr0,1TB0 = TB 0,1 (tr0 + tr0,1 )

(11)

Dividing (11) through by tax base to standardize, we see that the minimum percentage change in tax base necessary to support a debt of size B is a function of that debt size, the interest rate, the desired expenditure change, and the change in tax rate, standardized to a percentage of future tax base:

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B0 (1 + r ) + EO0,1 tr0,1 TB0 ,1 = TB0 ( tr0 + tr0 ,1 ) TB0

(12)

Comparative statics of (12) tell us something about the relationships between variables. Jurisdictions with higher debt loads and greater expenditure demand as well as those that pay higher rates of interest need greater changes in tax base to sustain comparable debt burdens. And jurisdictions with bigger tax bases and higher tax rates, along with those that can raise their tax rates more, have an ability to sustain debt loads with smaller percentage changes in tax base. If we call the right-hand side of (12) T the comparative statics are:
Table 2. Determinants of the Minimum Change in Tax Base Needed to Support Debt of Size B

T ?

Sign + + +

B TB tr tr r EO

Equation (12) can be generalized for multiple-period debt. The only thing that changes will be the required debt payment in each period. Given fixed rate debt, in all periods t prior to maturity m, the required payment P on the bond will be the interest payment equal to the face value of the bond times the interest rate and at maturity the payment will be the last interest payment, or:
Pt = B0 r t < m

Pm = B0 (1 + r )

(13)

The required tax base increase necessary to pay the debt without cutting expenditures or increasing taxes can then be written as:

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Pt + EO0,t tr0,t TB0,t = TB0 ( tr0 + tr0,t ) TB0 Pm + EO0,m tr0,m TB0,m = TB0 ( tr0 + tr0,m ) TB0

t < m

(14)
t =m

The question of interest for rational utility-maximizing decision makers is therefore whether the growth in the jurisdictions tax base is going to be sufficient to service the debt load without causing a cut in expenditures and/or an increase in tax rates. This requires some type of modeling of the future growth in tax base. Following Merton (1974) and others, we model the growth of the tax base as a diffusion-type Markov stochastic process. Most previous papers have used a Geometric Brownian Motion process. The Geometric Brownian Motion process is especially attractive for modeling because the past history of tax base growth has no influence on the next period growth rate (there is no memory). Given this stochastic process, the diffusion of the tax base would be:
B = B + B T T t T t

(15)

Dividing through by the tax base yields a form as in (14):

TB = t + t (16) TB

The likelihood of default from a debt issue of a certain size then would become the probability in period t that the realized growth of the tax base is less than the required growth rate. Combining (16) and (14), we find the probability of default P(Def):

P + EO0,t tr0,t t + t < t ( tr0 + tr0,t ) P ( Def ) = P P + EO0,m tr0,m t + t < m ( tr0 + tr0,m )

t<m
(17)

t=m
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Analyzing the comparative statics in Table 3, we find that the mean growth rate of the tax base, the tax rate, and the change in tax rate have an inverse relationship with the probability of default. We also find that the volatility of the tax base, the amount of debt, the interest rate, and the desired change in operating expenditures have a positive relationship with that probability.
Table 3. Determinants of the Probability of Default

(D ) P ef ?

Sign + + + +

B tr tr r EO

Simulation In order to benchmark the relative influence of different variables on the maximum debt burden, simulations must be run. Equation (17) and Table 3 show the various factors that might influence the probability of default, but says nothing about the magnitude of the risk that they introduce. In order to assess relative magnitudes, we developed Monte Carlo simulations of (17) to study the effects of changes in the important variables. In order to develop the simulation, we had to initially set some parameters that would not change over the simulation iterations. We chose arbitrarily a desired growth rate of expenditures (EO) of three percent, initial tax rate (tr) of five percent, average tax base growth rate () of five percent, tax base volatility () of 2.5 percent, risk-free interest rate (r) at six percent, and debt maturity of 30 years. Two important policy variables for the simulation are the disposal of surpluses during the bond payoff period and the default rule the level of expenditure cuts or tax increases which would produce a situation where either the official would choose not to 13

make the payment on the debt or the citizenry would revolt, refuse to make payment, and fire the official. These are trenchant not only in simulation, but in reality. As Kriz (2002), Hou (2003) and many others have pointed out, keeping surpluses as savings (through the use of reserve funds or another mechanism) reduces risk that jurisdictions will have to reduce expenditures or raise taxes during times of economic downturn. Also an elected or appointed official must be able to somewhat accurately gauge the willingness of citizens to bear tax increases or expenditure cuts. With no prior knowledge of disposal rules, we initially assume that the jurisdiction keeps all surpluses during the bond payment period and invests them at an annual interest rate of three percent. This assumption may produce overly optimistic results given the many studies which show little savings behavior on the part of governments. However, later we will relax this assumption along and analyze the results, as we will with the parameters we used in setting up the base simulation. The other policy variable, the default rule, is difficult to define a priori. So we estimate our simulations at rule levels ranging from five percent to 30 percent in five percent steps. That is, we run one simulation with a default rule of five percent, a second simulation with a default rule of ten percent, etc. The results of the simulations are shown in Figure 1 below. The lines in the chart are probability contours - estimated probabilities of default from equation (17) given various combinations of default rules and borrowing as percent of tax base. FIGURE 1 GOES HERE. CAPTION: Results from Base Simulation

The results show that at low levels of borrowing, the probability of default is very low regardless of the tolerance for reductions in expenditures or increases in taxes. But the probability grows as borrowing increases. This much is probably not unexpected. However, two more subtle points emerge from Figure 1. First, the increase in default probability from increases in borrowing is fairly linear until the 50 percent point and then it becomes exponential. After a certain point, borrowing dominates growth in the tax base 14

and overwhelms it. We estimate that point to be when borrowing is greater than 50 percent of the tax base. As borrowing approaches 90 percent of the tax base, it becomes more likely than not that debt service in a given year will force expenditure cuts or tax increases of more than 15 percent. The second intriguing result is the relative unimportance of citizen tolerance for changes in budgets, at least at relatively low levels of debt. There is statistically no difference in probabilities of default regardless of the default rule for borrowing under 50 percent of the tax base. It isnt until the buildup of debt becomes relatively large that citizen tolerance for cuts or increases becomes important. Our model suggests that the ratio of the mean growth rate of the tax base to its standard deviation is vital in determining debt affordability. High volatility in the growth rate of the tax base compared to the mean growth rate increases the probability that in a given period the growth of the tax base will be insufficient to cover the required debt payment and normal operating expenditures. Figure 2 shows the results of our simulation model when the tax base standard deviation is changed. FIGURE 2 GOES HERE. CAPTION: Results of Simulation at Different Levels of Tax Base Volatility Figure 2 shows that at low levels of tax base volatility compared to mean growth (which was kept at its base value of five percent) the debt burden can become quite high (up to 70 percent of the tax base) without the jurisdiction incurring a large probability of default. After this point is reached, however, the probability of default grows exponentially. As tax base volatility grows, so too does the probability of default, until it becomes high and more linear as the base volatility approaches the mean growth rate of the base. Desired future expenditure growth is yet another important variable in determining the likelihood of default. To some extent, taking on debt represents a tradeoff for jurisdictions. They get capital projects in the current period or near future. In exchange they tradeoff some amount of future expenditures on operating items, replacing 15

those expenditures with payments on the debt incurred to build the capital infrastructure. Unless tax base growth is sufficient to generate sufficient revenue to offset the debt service payments, cuts in expenditures, increases in taxes, or default on the debt becomes likely. Figure 3 demonstrates the extent of the tradeoff. FIGURE 3 GOES HERE. CAPTION: Results of Simulation at Different Levels of Desired Future Operating Expenditure Growth Figure 3 shows clearly that if a jurisdiction has a strong preference for capital spending (and is thus willing to accept much lower expenditure growth) then default is unlikely. At a level of expenditure growth three percent below the mean growth rate of the tax base (desired expenditure growth of two percent versus mean tax base growth rate of five percent), even with debt apprising 90 percent of the tax base, the probability of default is a mere 13 percent. However, if citizens of a jurisdiction want their cake and eat it too, demanding high growth rates of operating expenditure along with new capital projects, they are likely to run into trouble. At a level of desired expenditure growth one percent below the mean growth rate of the tax base, default is more likely than not for any debt level in excess of 45 percent of the tax base. Interest rates may also affect debt affordability. As interest rates rise, required debt service rises. Debt service requirements may overwhelm tax base growth. However, Figure 4 shows the obvious interaction between interest rates and debt levels. At modest levels of debt, differences in interest rates have very little influence on the probability of default. However, as debt rises, the probability of default becomes much greater at higher interest rates. FIGURE 4 GOES HERE. CAPTION: Results of Simulation at Different Interest Rates The final variable which is predicted to have an effect on the default probability is the initial tax rate. The initial tax rate amplifies changes in the tax base, so we expect to see higher tax rates lead to lower probabilities of default. In practical terms, if jurisdictions have difficulties collecting revenues then they are less likely to be able to 16

collect enough revenues to service debt payments. Figure 5 shows the results of default probability simulations where initial tax rates are varied. The effects of tax rates are dramatic. At low tax rates, the default probability climbs dramatically as debt is added, reaching an asymptotic high above 90 percent. At higher tax rates, the climb is much less dramatic, with 7 percent tax rate default probabilities only reaching 25 percent. FIGURE 5 GOES HERE. CAPTION: Results of Simulation at Different Initial Tax Rates The final variable which must be considered is the endogenous growth in the tax base caused by adopting the capital project. Since tax base growth is such a strong determinant of the probability of default, we anticipate that stronger rates of endogenous growth should have an equally dramatic effect on default rates. In order to analyze whether this was the case, we created simulations with debt having a multiplier effect on tax base growth rates. We simulated our base model varying the multiplier in the range 0 (no endogenous effect) to 2.0 (a 10 percent increase in debt causing a 20 percent increase in annual growth rates of the tax base). Below (Figure 6) we present the result only for multipliers from 0 to 0.5, because the results for multipliers greater than 0.5 are essentially the same as for a multiplier of 0.5. We also present only debt levels of 50% of the tax base, because this shows the general pattern of results. Figure 6 clearly shows the dramatic effect we predict. As the multiplier approaches 0.5, the probability of default goes to less than 1 percent. However, as the multiplier gets smaller, default probabilities climb dramatically. FIGURE 6 GOES HERE. CAPTION: Results of Simulation at Different Tax Base Multipliers

Conclusions/Policy Implications In this paper we have developed and simulated a model of debt affordability that takes into account the stochastic nature of revenue growth. Our model has yielded many important insights into those factors that may go into determining the affordability of 17

debt. First and foremost, our model strongly refutes the notion that a single measure of debt affordability can in any way capture the likelihood that a jurisdiction will default on its debt. Simple benchmarking exercises are not worthwhile when seen in the context of the tremendous sensitivity of default likelihood to changes in variables such as tax base volatility. Even regression approaches taken in isolation can only tell us a limited amount about the likelihood of default. This is because regression results alone can only tell us about one variable such as the income elasticity of the tax base, and little about other factors such as the willingness of the jurisdiction to forego current expenditures to sustain a capital investment program. Beyond this, our research indicates several issues regarding the direction and magnitude of various factors that lead to a jurisdiction being more or less creditworthy. The first observation yielded by our research is that the political will to sustain debt service in the face of tax increases or service cuts (as proxied by our default rule variable) has a negative but very minor effect on the likelihood of default. At low levels of debt in fact, there is almost no effect of increased political will. At higher levels of debt, the difference is small but present. This indicates that jurisdictions should worry about citizen sensitivity to tax and expenditure changes only at higher rates of debt. The second observation is that revenue base volatility has a strong positive effect on default probability. The implication here is that borrowing should be primarily supported by revenue bases which are less volatile. If individual jurisdictions have a choice, they should borrow more against revenue bases that are stable, such as the property tax. In a comparative sense, jurisdictions that have lower revenue volatility should be able to borrow more than those jurisdictions with high volatility. Another factor that emerges as being very important in determining the likelihood of default is the desired rate of operating expenditure growth. Operating expenditures may crowd out the ability of jurisdictions to pay debt service. Jurisdictions that wish to have high growth rates of operating expenditures can ill afford to burden themselves with high debt levels. And jurisdictions that have high expectations or requirements for capital investment must work to restrain other spending pressures to ensure that debt is affordable. 18

Interest rates can play an important role in determining debt affordability. This is especially true for jurisdictions with high debt loads. These jurisdictions become much less financially viable as the level of interest rates rises. A possible corollary of this result is that as interest rates increase, the spread between debt interest costs at issuance of jurisdictions with low debt and high debt will rise. This would suggest the possibility of a vicious cycle as interest rates rise where jurisdictions with high initial debt levels must pay more for their new debt, which reduces the likelihood of repayment on all of their debt, which in turn increases the interest rate on further debt, and so forth. Another variable whose impact increases with higher debt levels is the initial tax rate. The ability to sustain higher tax rates can dramatically affect the likelihood of debt service payments being made. This suggests that the credit rating practice of trying to assess the political will to sustain tax rates is sound. Returning to the story of Orange County, the actual trigger for the countys bankruptcy was the failure to pass a tax increase in the wake of the pension fund debacle (Baldassare, 1998). This result confirms our earlier one that jurisdictions with high debt loads must be much more aware of citizens sensitivity to tax rates. The final variable which is extremely important in determining the likelihood of debt repayment is the multiplier effect that is created by the use of debt proceeds. Our results indicate that public capital investments that are effective create economic growth which will essentially defease the debt. This would indicate that effective capital budgeting by jurisdictions is vital to ensure that debt is affordable. In practical terms, the model which we have developed can be easily analyzed for a particular jurisdiction and debt issuance decision. Given a set of historical data on tax base growth, effective tax rates, and debt burdens, debt of a certain level can be analyzed in terms of how likely it is to be repaid. And the sensitivity of those results can be calculated with respect to changes in key variables such as the investment multiplier and tax rate changes. In the end, almost any analytical approach to debt affordability is bound to make assumptions. Our model makes far fewer assumptions and produces output which decision makers can use to better guide debt issuance decisions.

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Bibliography Baldassare, M., 1998. When Government Fails: The Orange County Bankruptcy. Berkeley: University of California Press. Bartle, J. R., Kriz, K. A., & Wang, Q., 2006. Combined sewer separation projects: Affordability and financing. Paper Presented at the 18th Annual Conference of the Association of Budgeting and Financial Management. Atlanta, GA: October 25-27. Bernard, J., 1982. Meeting state and local financing needs in the 1980s: Can the municipal debt market do its share? Public Budgeting and Finance 2, 59-70. Brecher, C., Richwerger, K., & Van Wagner, M., 2003. An approach to measuring the affordability of state debt. Public Budgeting & Finance 23, 65-85. Denison, D. V., & Hackbart, M., 2006. State Debt capacity and debt limits: Theory and practice. In H. A. Frank (Ed.). Handbook of Public Financial Management. Boca Raton: CRC Press, 317-336. Denison, D. V., Hackbart, M., & Moody, M., 2006. State debt limits: How many are enough? Public Budgeting & Finance 26, 22-39. Hou, Y., 2003. What stabilizes state general fund expenditures in downturn years Budget stabilization fund or general fund unreserved undesignated balance? Public Budgeting & Finance 23, 64-91. Kriz, K. A., 2002. The optimal level of local government fund balances: A simulation approach. Proceedings of the Annual Conference on Taxation. Orlando, Florida: National Tax Association, 78-84.

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