The 2023-24 Budget

Financing Approaches to
Capital Outlay Projects

This post: (1) provides background on common approaches to financing capital outlay projects, (2) identifies key trade-offs associated with the Governor’s approach to financing certain capital outlay projects in the 2023-24 budget, and (3) provides recommendations to the Legislature when considering capital outlay financing approaches.

Background

Overview of Options for Capital Outlay Financing. The two most common ways of paying for capital outlay projects are (1) cash financing and (2) bonds. Cash financing means that the state uses available money to pay for the costs of a project as they occur. In contrast, bond financing is a type of long-term borrowing that the state uses to raise money for capital outlay projects. The state obtains this money by selling bonds to investors. In exchange, it agrees to repay this money, with interest, according to a specified schedule. These regular payments—typically made over a 25- to 30-year period—are known as debt service payments. Two main types of state bonds are:

• General Obligation Bonds. Most of these are directly paid off from the state’s General Fund, which is largely supported by tax revenues. General obligation bonds must be approved by the voters and their repayment is guaranteed by the state’s full faith and credit.

• Lease-Revenue Bonds. These bonds are paid off from lease payments (primarily from the General Fund) by state agencies using the facilities the bonds finance. These bonds do not require voter approval and are not guaranteed by the state’s general taxing power. As a result, they have somewhat higher interest costs than general obligation bonds.

Bonds Can Be Taxable or Tax-Exempt. The market for bonds sold by the state and local governments is called the municipal bond market. The appeal of municipal bonds to investors is that, in most cases, the interest income they receive is not taxable (tax-exempt) by the state or federal governments. In some cases, the interest income from state bonds is subject to federal income taxes. For example, this can occur when a portion of the project would not be completed within three years of initial project expenditures—a federal requirement that must be met to issue tax-exempt bonds. Since taxable bonds do not offer the same tax benefits to investors, they typically have somewhat higher interest rates.

General Fund Debt Service Ratio (DSR) Is Within Normal Range. The DSR is often used as one indicator of the state’s debt burden. This ratio indicates the portion of the state’s annual General Fund revenues and transfers that must be set aside for debt-service payments on infrastructure bonds and, therefore, are not available for other state programs. Estimated debt service payments on general obligation bonds in 2022-23 total about $6.8 billion—or about 3.25 percent of estimated General Fund revenues. For context, the state’s DSR in past decades has typically been between 3 percent and 6 percent.

Governor Previously Proposed to Use Cash for Capital Outlay Projects. In recent years, when the state had a budget surplus, the Governor proposed to use General Fund cash—rather than lease revenue bonds—to finance the construction of certain capital outlay projects. In some cases, such as certain California Highway Patrol (CHP) and Department of Motor Vehicles (DMV) projects, the Legislature approved cash financing for the projects.

Proposal

Governor’s Budget Would Use a Combination of Cash and Lease Revenue Bonds for Capital Outlay Projects. The Governor estimates that the state now faces a $22 billion General Fund budget problem. As a result, as shown in Figure 1, the Governor’s 2023-24 budget proposes to switch financing for many capital outlay projects from cash to lease revenue bonds. (The Governor proposes other changes related to capital outlay projects—such as for the University of California and California State University—that we analyze in other budget reports.) The only projects that would use cash are three courthouses (Redding, El Centro, and Sacramento) and the Department of General Services’ Richards Boulevard project. For these projects, a total of $491 million General Fund 2023-24 would be allocated to fund a portion of the cost. These projects would otherwise need to use taxable bonds to finance these costs because they exceed the three-year window required for tax-exempt bonds.

LAO Assessment

Either Bonds or Cash Can Be a Reasonable Way to Finance Capital Outlay Projects. In our view, there can be reasonable arguments for using either bonds or cash to finance capital outlay projects. Each approach comes with trade-offs. One advantage of bonds is that they can better align who pays for the project with who benefits from the project. Since capital outlay projects will provide benefits for many years, future taxpayers would pay for the future benefits (through debt service payments) rather than current taxpayers paying for the entire project (through cash financing). A second advantage of bonds is that they can be an important tool for financing high-priority projects, even if there is limited funding available to pay the up-front costs. For example, if the state has a budget deficit, bonds can fund important projects without forcing the state to cut into existing programs.

On the other hand, cash financing has certain benefits over bonds. Most notably, using cash can lower overall spending for a project. This is because the state does not have to make interest payments. Assuming a bond carries a 5 percent interest rate, the total cost of paying the debt over a 30-year period is close to $2 for each $1 borrowed—$1 for repaying the amount borrowed and close to $1 for interest. In other words, for every $1 spent on cash financing, the state reduces its future debt payments by a total of $2. (Over the long term, inflation will erode the real cost of these payments, which are fixed in nominal terms once the bonds are issued, resulting in inflation-adjusted costs of about $1.40 for each $1 borrowed.)

Cash Financing Presents Trade-Off Between Reducing Long-Term Obligations and Funding Short-Term Budget Priorities. Ultimately, the Legislature will have to weigh the trade-off between reducing long-term budget obligations versus funding short-term budget priorities. For example, at projected interest rates in fall 2023, the Governor’s proposal to use $491 million cash for certain capital outlay projects avoids about $42 million in annual debt service payments over the next 25 years. The avoided costs for these projects are somewhat larger than normal because:

• Taxable Bonds Have Higher Interest Costs Than Tax-Exempt Bonds. The cash would be used for projects that would otherwise need to issue taxable bonds. Taxable bonds are projected to have about 7 percent interest rates in fall 2023—or 1.35 percent higher than tax-exempt bonds. As a result, the annual debt service savings on these taxable bonds is about $5 million more than tax-exempt bonds.

• Projected Interest Rates Are Higher Than Recent Years. Currently, interest rates for bonds are projected to be about 6 percent to 7 percent in fall 2023. This is significantly higher than recent years, when rates have been less than 5 percent.

On the other hand, using cash also means less funding is available to support near-term budget priorities. This is especially problematic when the state faces a significant budget problem. Using cash instead of bonds for these projects means the state has to identify an additional $491 million in near-term budget solutions—including cuts to existing programmatic commitments.

Fund Source for Bond Debt Service Is Not Always Clear. For some proposed bonds, such as those supporting projects at DMV and CHP, the administration does not identify the fund source that will be used to make debt service payments. In our view, having clarity about what fund source will be used to support debt service payments is a key component of a lease revenue bond proposal. Importantly, without this level of detail, whether the fund has sufficient capacity to support the debt service is unclear. If there is insufficient budget capacity, then approving the bonds could force the state to reduce programmatic activities supported by the fund and/or increase the taxes or fees supporting the fund. For more detail on some of the challenges that can arise when a fund source does not have adequate capacity to support debt service payments, see our report, The 2023-24 Budget: Proposed Fund Shift for CHP and DMV Capital Projects.

We note, however, that whether the General Fund or a special fund is the intended source of repayment, municipal bond investors will view the General Fund as ultimately backing the bonds. As such, under either approach, investors would include the lease revenue bonds as part of the state’s debt portfolio in their assessment of the state’s overall creditworthiness.

Recommendations

Consider Shifting to Lease Revenue Bonds. Ultimately, the Legislature’s financing approach will depend on how it weighs support for short-term budget priorities against reducing long-term budget obligations. However, given the current budget problem facing the state—including our office’s assessment that the problem will likely be even larger than the Governor projects—and the state’s relatively low DSR, the Legislature might want to switch to lease revenue bonds instead of cash financing for some of the projects. In our view, this would be one reasonable way to free up some General Fund cash to maintain funding for existing programs that might otherwise need to be cut to address the budget problem. Even though interest rates are relatively high right now, if interest rates come down in the future, the state typically has the option of effectively refinancing at a lower interest rate.

Specify Fund Source for Bond Debt Service Payments. To the extent the Legislature authorizes new lease revenue bonds for projects, we recommend the Legislature provide clear direction to the administration regarding which source of funds it intends to use to make debt service payments. The Legislature could provide this direction in various ways, such as through provisional language in the budget act or intent language included in budget trailer legislation.