- COVID-related economic challenges have caused an estimated $2.2 billion deficit in the state budget for the current fiscal year, with only four months to bring the budget back into balance.
- With economists projecting a strong bounce back in economic activity, some observers have suggested issuing debt to avoid deep spending cuts.
- Constitutional restrictions limit the use of debt to balance the COVID-depleted budget and some guiding principles should be followed if borrowing is employed, even as a partial solution.
Michigan’s budget has a COVID problem. After the Consensus Revenue Estimating Conference updated state revenue numbers on May 15, the Senate Fiscal Agency has estimated a combined General and School Aid Fund (SAF) budget deficit of $2.2 billion for the current fiscal year. With just four months remaining to course correct, and such a large shortfall, revenue and spending adjustments will have to be proportionately larger to balance this year’s budget.
Unfortunately, these problems are not confined to Fiscal Year (FY)2020; the state is projecting a $3.5 billion deficit in FY2021 and a $1.7 billion deficit in FY2022. While these are big numbers, the re-opening of the state economy is expected to start the recovery. Revenue projections expect the state to be back to FY2019 levels by FY2022; while that is still far below what was projected in January, such a recovery in state revenue would be significantly quicker than the last recession.
Given the sharp ‘V’ shape in revenue estimates, there has been some discussion of borrowing as a potential solution to balancing the budget to get through these tough times. The idea is that the state could use borrowed money to stabilize revenue levels during the worst years and address the deficit. The proceeds would be used to finance appropriations until which time revenues have rebounded sufficiently. But if the state looks to additional borrowing to help in this crisis, there is a lot to consider.
What limits are there on borrowing?
The state Constitution provides guideposts to issuing debt. Long-term general obligation or “GO” debt requires the state to make debt service payments as a first priority in the budgeting process, from any revenue sources that are available. Revenue generated from issuing GO debt is typically used for specific purposes, but one such purpose could be for funding any programs financed by the General Fund or SAF. In other words, debt can be used to address the state’s operating deficits in both major funds.
This type of borrowing must be authorized by a two-thirds vote in each chamber of the Michigan Legislature and approved by voters in a November general election. This creates a timing issue: the fiscal year ends September 30, and the state needs to act to bring the budget into balance before then. The state cannot rely on long-term debt to help in FY2020.
Because the adopted budget must be balanced, this timeline also poses a challenge for including borrowing as part of the FY2021 budget, which is currently being considered by the legislature. The state’s fiscal year starts on October 1, before a November vote can be taken.
There are, however, other borrowing options that policymakers might consider as a partial solution to the state’s fiscal problems. These include borrowing against certain revenue sources and issuing bonds to pay down the school pension system.
What is the revenue bond option?
Aside from GO debt, the state can borrow against certain non-tax revenue streams. In the past, the state has issued securitization bonds, where a state authority promises a portion of annual payments received from a non-tax source. This was done twice with money received from the 1998 tobacco company settlement, once to fund the 21st Century Jobs Trust Fund in 2005, and then again in 2007 to balance the state budget. In the latter instance, the state borrowed $400 million, promising $46 million annually from the tobacco settlement revenue to cover principal and interest payments.
Further use of the tobacco settlement funding would yield limited sums. Tobacco settlement revenue is the largest non-tax stream the state could borrow against. After accounting for revenue previously securitized, the state received $203 million in FY2020. This would obviously not be sufficient to solve the state’s current crisis, but could be used to tackle part of the problem. However, that revenue is currently distributed among a number of programs, which would have to be either cut or backfilled with General Fund dollars to open up the revenue stream for debt service.
Borrowing to pay down the pension system?
In recent discussions about road-funding options, the West Michigan Policy Forum proposed a unique mechanism to raise revenue: borrowing billions to pay down the unfunded liability of the Michigan Public Schools Employees’ Retirement System (MPSERS), invest the proceeds, and use the interest earned to pay off debt service and make additional payments towards the unfunded liability. By doing so, the state could free up money currently used to make payments towards MPSERS. At the time, it was estimated that doing so could free up to $980 million in SAF resources. While the initial proposal was to fund roads, the money could now provide a way to reduce annual payments to the retirement system without cutting educational programs.
The main issue that sidelined this proposal was risk. To work as expected, the market would have to perform well enough to pay off the initial bond; otherwise the SAF would be on the hook for additional payments over the long term. Had this option been pursued last year, the recent sharp decline in stock market values would have been exactly that scenario. Given continuing market uncertainty due to COVID-19, the economic risk now is significantly higher than when this idea was initially proposed.
Has the federal government helped states to borrow?
The federal CARES Act allowed the Federal Reserve to change the way it deals with municipal bonds and make loan guarantees on bonds sold by local governments. This helped reinvigorate the market, as many investors had stopped investing due to the uncertainty. While this does improve the market and can lower bond prices, it does not go to the extent changes made with the American Recovery and Reinvestment Act did in 2009, where the federal government created mechanisms for state and local governments to offer bonds with federal tax credits offered in lieu of interest, and by subsidizing interest on bonds.
Words of Caution
Constitutional restrictions limit the extent that bonding can be used to solve the state’s budget problems. But bonds could still potentially play a part. The size of the deficits are so large and the hoped-for recovery may be healthy enough that there may be a role for debt-financing state spending. However, the state should be very cautious if it proceeds down this path.
Prior to the recession, the General Fund was in a precarious position. With a weakened long-term future, any approach to balancing the budget, especially borrowing, should be designed without placing future stress on the state’s discretionary resources. It is important to remember that bond proceeds are a one-time revenue source; state collections would need to recover sufficiently not only to fund bond revenue, but also make debt service payments. Otherwise the state may just be delaying future cuts. Unless financing the deficit is paired with revenues from a new tax, the necessary budget cuts will need to be stretched out over a much longer duration.
The state should also take care not to shift too much of the financial burden to the future. If bonds are issued for short-term gain, it places a portion of the burden of repayment on future taxpayers who will not see the same benefits, creating an intergenerational equity issue. Any borrowing to stabilize the budget should be mindful of these concerns.
The scope of the budgetary problem facing the state justifies placing all options on the table. But that does not mean all options are created equal. Policymakers should carefully evaluate the long-term implications of the choices in front of them, and not just consider what is the easiest way to get through the current crisis.