WPRI Report:

THE EXPLODING USE OF DEBT TO FINANCE
GOVERNMENT IN WISCONSIN

By Christian Schneider

Table of Contents:

I.      Executive Summary
II.     Introduction
III.    The History of Debt in Wisconsin
IV.    Wisconsin's Growth in Debt Reliance
V.     Bonding to Pay for Things Government Can't Afford
VI.    Bonding Used to Balance the Operating Budget
VII.   Consequences
VIII.  Summary

Every new tax is immediately felt more or less by the people. It occasions always some murmur, and meets with some opposition. . . . [D]ebt is not immediately felt by the people, and occasions neither murmur nor complaint.

Adam Smith—An Inquiry into the Nature And Causes of the Wealth of Nations, 1776

EXECUTIVE SUMMARY

Throughout the early part of Wisconsin history, governmental debt was limited primarily to capital building projects. In 1969, the Wisconsin Constitution was amended to allow the state to issue debt directly. Previously, the state funded capital expenditures by using “dummy corporations,” which issued bonds on behalf of the state. Road projects were often funded by local governments, which were then reimbursed by the state. The 1969 constitutional amendment allowed state government to take control of its own debt issuance, rather than leaving it up to independent corporations.

Since Wisconsin began issuing debt directly, the level of debt issuance has expanded dramatically—much of it within the last decade. In addition, the purposes for which the state takes on debt have greatly expanded. Whereas once bonding was used exclusively for state “brick and mortar” projects, debt is now used for programs to provide home loans for veterans and poor individuals, to purchase land for conservation, to clean chemical spills, and sometimes even to boost school aids and fund local governments.

In 1969, when the constitution was amended to allow the state to issue bonds, Wisconsin had $392.8 million in outstanding debt, issued primarily through building corporations. In December 2006, Wisconsin had $19.3 billion in outstanding debt, or $3,476 for every state resident. By comparison, the total amount of general fund taxes the state is expected to collect in 2007-08 is $12.8 billion.[i] Shortly before the 1969 constitutional amendment passed, Wisconsin ranked 40th in the nation in state debt per capita.[ii] By 2003, Wisconsin had risen to 10th in per capita debt outstanding[iii]—and state debt has increased substantially since then.

Furthermore, the state has issued debt in excess of taxpayers’ ability to support that debt. Chart 1 illustrates the growth in General Purpose Revenue (GPR)-supported General Obligation (GO) bonds relative to actual GPR. In 1979, outstanding GPR-supported GO bonding equated to 16.1% of state GPR. By 2006, that number had more than doubled, to 33.9%. This tells us that GPR-funded GO bonding has grown substantially in relation to tax revenue:

As the amount and purpose of debt issuance in Wisconsin continues to expand, two things have become clear. First, state government has utilized debt to purchase things it may not have otherwise been able to afford if it had to use cash financing. Increases in building and land procurement programs indicate the short-term desire to deliver projects to legislative districts, while delaying the cost of these projects for future generations to pay.

Secondly, debt is more often being used as a budgetary tool, rather than a way to buttress the state’s infrastructure. Increasingly, debt has been relied upon to bail the state out of difficult budgetary situations brought on by declining revenues and increasing funding pressures.

INTRODUCTION

Recent tight state budgets and citizen distaste for higher taxes have prompted the Wisconsin governor and legislature to greatly expand the purposes for which the state issues debt. In doing so, the state and separate authorities created in state statutes have taken on large amounts of new debt, which could have serious consequences for future taxpayers.

For over a century, debt issuance in Wisconsin was primarily used for capital projects. There are a number of benefits to bonding for construction costs. First, the cost of a project is spread out throughout the life of the project, and spreads the liability to future users. Thus, the benefits for the project will be paid by the people that actually benefit from its construction (drivers, dorm residents, etc.).

Second, citizens receive the near-term benefit of a project being completed more quickly when bonding is used. Since higher short-term taxes are avoided to complete a project, buildings and roads can be built immediately, rather than having to raise taxes all at once or wait years for completion.

Third, when a state uses bonding to construct a building or purchase land, that property increases in value over time. The value may actually increase at a rate faster than the bond repayment rate, which could turn the state a profit in the event the property were ever sold.

Despite the benefits of using debt to finance capital projects, there are also disadvantages. First, debt repayment commits the state to many years of fixed costs. In tough economic times, debt service is the first draw on general fund revenues. Debt service must be paid before any other state government programs are funded—if state revenue goes down, debt service must still be paid at the same levels. It cannot be reduced to aid in repairing budget shortfalls, although it can be refinanced if interest rates are favorable.

Second, as anyone with a mortgage knows, the total cost of projects increases substantially when debt is used, as interest accrues. When thirty years of interest is paid, the state might end up paying double or even triple for a project over its base cost, depending on the rate of the bond’s issuance.

Furthermore, by utilizing bonding, some low-priority projects that wouldn’t be approved by using cash gain approval. Projects are far easier to approve knowing the costs will be borne by future legislators and governors. Many projects that wouldn’t get the green light if cash financing were used are easier to approve if the costs are pushed off.

Finally, excessive bonding without commensurate increases in funding sources can affect state credit ratings, which may increase the cost of borrowing. While the market determines interest rates, a lower bond rating could increase the cost of government borrowing. The credit rating on Wisconsin’s bonds has been downgraded twice by credit agencies since 2002, due in large part to various fiscal management techniques employed by the governor and legislature.

Securities that are general obligations of the state, and which are secured by taxing power, are known as “general obligation” (GO) bonds. These bonds are backed by a pledge of the “full faith and credit” of the state, and generally receive lower interest rates as a result.

Securities backed by a dedicated stream of revenue are generally referred to as “revenue bonds.” In general, there are two types of revenue bonds in Wisconsin: those that are used for enterprise operations, such as water systems, and those that are used for dedicated revenue sources, such as the transportation and clean water revenue bonds.

In general, when user fees are relied upon to pay for the financing of the facilities, revenue bonds are used. General obligation bonds are generally used when the citizenry as a whole is to pay for the facilities through taxes.

In some circumstances, bonding unrelated to capital expenditures can save the state money, if interest rates are favorable. For instance, in the 2003-05 biennial budget, Governor Doyle recognized that Wisconsin had a large unfunded liability with regard to the state’s pension and sick leave obligations. While the state would have had to pay annual interest of 8% over a 30-year period for state employee benefits, a better interest rate could be had if the state used bonds to fund the obligation. Thus, bonds were issued to fund pension and sick leave obligations, and the total 30-year liability was reduced by $324 million.[iv]

While this example illustrates the benefits of bonding for ongoing obligations, there are serious drawbacks, depending on how the bond revenues are utilized. Using one-time bonding revenue for ongoing programs creates a structural deficit that must be filled in the subsequent budget. For instance, the use of one-time bond revenue from securitization of Wisconsin’s tobacco settlement created a large hole in funding in the next biennium.

In the case of the pension and sick leave bonds, Governor Doyle utilized an accounting strategy to save the state short-term money in the 2003-05 budget. The Governor structured the thirty-year bonds such that no interest payments were made from the general fund in the first two years. The budget proposal front-loaded about $70 million in savings from the bonds into the first biennium, leaving 28 years of debt service. Not making those debt service payments in the first two years of the biennium allowed Governor Doyle to spend that $70 million on school aids, payments to local governments, and other general purposes. Since that $70 million saved by not making interest payments wasn’t available in the 2005-07 budget, the state had to come up with new funding sources for general-purpose programs that had been funded by the savings in the previous biennium.

Furthermore, these pension and sick leave bonds set a potentially troubling precedent—allowing general fund-supported borrowing to support an ongoing operational expense. With the creation of these new appropriation bonds, the state now has expanded authority to issue debt for literally any budgetary purpose it sees fit—a far cry from the intent to use debt to finance capital costs.

This strategy of funding ongoing programs with debt is a new phenomenon for Wisconsin state government, and will be discussed in this report. Furthermore, this report will look at some of the benefits and drawbacks of state reliance on debt, and describe the myriad ways that debt is being utilized in state government.

THE HISTORY OF DEBT IN WISCONSIN

The Prohibition on Debt

In the 1830s, nine states defaulted on the long-term general obligations they had contracted for the construction of roads, canals, banks, and railroads. In order to prevent future government loan defaults, between 18 and 20 new states included constitutional provisions that prohibited their state from incurring debt, or greatly inhibited their ability to do so. Generally, these were states that were new to the Union in the 1840s and 1850s, and Wisconsin, admitted to statehood in 1848, was one of them.

During this period, government debt was becoming increasingly unpopular. Illinois and Michigan, two states adjacent to Wisconsin, had saddled themselves with burdensome debts and were struggling to dig themselves out. The trend among states establishing their constitutions at the time was to adopt the 1844 New Jersey standard of a $100,000 debt limit for states.

At the Wisconsin Constitutional Convention, the committee delegated to write the financial provisions of the new constitution recommended a debt limit of $200,000, with a limit of ten years to retire any debt issued. Instead, through negotiation among delegates, a $100,000 limit was adopted, with a five-year debt retirement period. Exceptions to the limits were made to repel invasion, suppress insurrection, or to defend the state in a time of war.[v]

With the constitutional debt limit enacted, Wisconsin began to incur debts below the prescribed limit. In 1852, $50,000 was borrowed to pay off the debt inherited from the territorial government, to build an asylum for the blind, and to operate a state prison. In 1858, $50,000 was borrowed to enlarge the Capitol and to build a “hospital for the insane.”

During the Civil War, Wisconsin borrowed $2.251 million to pay for war expenses under the war exception to the constitutional debt prohibition. These bonds were issued to private investors. It took the state nearly 80 years to pay off the debt on the Civil War borrowing, as debt payments by state government were suspended for decades. In 1903 and 1904, the federal government gave Wisconsin $1.2 million to aid in settling the state’s war claims—but these funds were used for “property tax relief” rather than paying down the Civil War debt. Interestingly, many of the Civil War bonds were purchased from private investors by school trust funds. Thus, if the state paid off the bonds, the interest distributed to school districts may have been less, and the state would then just have to increase school aids to make up for the loss in interest revenue for schools. The bonds were finally retired in 1943.[vi]

Between the Civil War and the end of World War I, Wisconsin constructed buildings on a cash basis. The state saved money and paid for new capital projects with existing funds, which made it increasingly more difficult to keep up with the state’s building needs. By 1910, the introduction of fire-proof construction methods rendered obsolete buildings that had wood as interior support.[vii]

Aside from direct appropriations for building projects, the state used other methods to fund capital projects. Profits from state programs such as sales from the binder twine factory at the state prison were used to fund construction projects at the prison. The state borrowed funds from the state insurance fund and the teachers’ retirement fund to pay for the State Office Building and the Memorial Union at the University of Wisconsin. Funds raised by the Wisconsin Alumni Research Foundation were also used, among other revenue sources.[viii]

Building Corporations

In order to alleviate the pressure to fund new building projects, the state constructed a way to legally circumvent the constitutional restriction on issuing debt. State government began issuing debt on the basis of the “special fund doctrine,” which states that there is a difference between debts based on the full faith and credit of the state and debts that are paid for with revenues derived from use of the structure.

In order to issue this debt, the state proceeded to set up extra-governmental corporations, which would receive state government assistance to construct buildings. Under this arrangement, the state would lease state-owned land to a corporation, which would then agree to erect a building on the land for state use. Revenues from the use of the building were then used to pay off debt service. When the building was paid for, it was then transferred to the state.[ix]

In 1923, the state set up the first extra-governmental corporation to issue debt. The University Building Corporation was created to acquire land and construct buildings for the benefit of the University of Wisconsin. For 14 years, the University Corporation was the only such “dummy corporation,” until a series of authorities were created to erect buildings at the Grand Army at King, at Stout Institute, and at other state colleges. In 1949, a corporation to erect general state office buildings was created and authorized to issue debt for that purpose. By 1957, four principal building corporations had been authorized by the Wisconsin legislature.

The state continued to fund construction through a mix of bonding and existing revenues. In 1949, Wisconsin created the State Building Trust Fund, which set aside 1% of the replacement cost of the state’s buildings per year in a separate fund. Also in 1949, the state increased the cigarette tax by one cent and set aside $6.3 million of the revenues from that tax increase for building projects. In 1952, the set-aside amount for the State Building Trust Fund was increased to 2% and made retroactive to 1949. In 1943, the state created the Post-War Construction and Improvement Fund, which set aside 10% of all income taxes collected in a two-year period for building projects.[x] By 1952, Wisconsin had accrued $5 million in debt through its corporations, thereby finding ways to work around the debt restriction.

Despite creation of both the borrowing and cash-based construction funding mechanisms, Wisconsin government facilities weren’t adequately prepared for the post-World War II population explosion. The state’s population increased from 3.1 million to 3.9 million between 1940 and 1960, which necessitated more schools, colleges, roads, and human service infrastructure. While the Post-War Construction Fund had accumulated $192 million between 1949 and 1965, it wasn’t nearly enough to fund Wisconsin’s capital needs.

In 1954, the Wisconsin Supreme Court addressed the state law that authorized private corporations to authorize loans to build state buildings. In State ex rel. Thomson v. Giessel, 267 Wis. 331, the Court held:

Where the objective of a lease of an addition to the state office building by the state from the Wisconsin State Public Building Corporation, a private corporation, was to benefit the state, and the arrangement was one highly advantageous to the state, the obligation of the state to pay future rentals to the corporations until the corporation’s loan to provide funds with which to construct the new addition should be paid, thereby enabling the corporation to obtain the loan, did not constitute giving or loaning the credit of the state or the benefit of the corporation in violation of the provision in sec. 3, art. VIII, Const., prohibiting the giving or loaning of the state in aid of any individual, association, or corporation.[xi]

This report examines the increased use of debt by state government, and how the growing reliance on bonding can be traced to pressures to find short-term answers to the state’s fiscal problems.

Amending the Constitution

Frequent attempts were made during Wisconsin’s history to allow direct borrowing by the state. However, in the late 1960s, the movement to amend the Wisconsin Constitution to allow the state to issue debt began to pick up steam.

In the 1963 session, the legislature created a special panel dubbed the “Committee of 25” to “survey appropriate measures by which the people of Wisconsin can be assured that the expenditures for state and local government will remain within the capacity of the taxpayer and will be used most efficiently.” The Committee’s final report, issued in March 1965, recommended “the Wisconsin Constitution should be amended to permit the full faith and credit of the State of Wisconsin to be used in borrowing funds for building purposes.” The report also recommended limiting the total debt that may be incurred.

Proponents of direct borrowing by the state argued that using the full faith and credit of state government would allow debt to be issued at a much lower interest rate, which would save a great deal of money in the long run. Furthermore, supporters of a constitutional amendment to allow borrowing argued that the state would have more control over the debt it would incur if that debt had to be issued via specific legislative approval.

In 1967, the Wisconsin legislature passed the first consideration of a constitutional amendment to allow direct state borrowing. As required by the Wisconsin Constitution, it would need to be passed by the next legislature and approved by popular vote of the public in order to take effect.

The proposed amendment contained a provision that limited the amount of debt the state can offer to the lesser of:

1.      0.75% of the aggregate value of all taxable property in the state; or

2.      5% of the aggregate value of all taxable property in the state, less the state’s net indebtedness as of January 1 of the current year.

During the time the legislature debated the new constitutional amendment, it was unclear what the effect the change would have. In June 1967, Representatives Harold Froelich and Frank Schaeffer, Jr. wrote a letter to Attorney General Bronson La Follette, asking how the amendment might legally be applied. In their questions, the two representatives anticipated the possibility that bonding may someday be issued for “general anticipated requirements.”

In his response to the legislators, Attorney General La Follette stated clearly that “general” programs could not be funded with debt issued by the state. He said,

The constitutional provisions do not permit borrowing for the payment of ordinary current expenses. The language of the proposed amendment and of other constitutional provisions must be adhered to. Borrowing can be only for those purposes which are specifically stated or necessarily implied. . . . Borrowing could not be for general purposes, or for generally anticipated but uncertain requirements in those areas for which borrowing would be permissible.[xii]

In 1969, the legislature passed the second consideration of the constitutional amendment by overwhelming votes (89-to-11 in the Assembly and 23-to-8 in the Senate). On April 1 of that year, Wisconsin voters approved of the measure by a 61% to 39% vote. Shortly thereafter, the legislature created the Building Commission, which was given the responsibility of overseeing all public debt. The Commission was headed by the governor, and included six legislators and one citizen member.

In 1975, the Constitution was again amended, this time to allow the state to borrow money to fund a veterans housing loan program. Under the program, the state would borrow funds to pay for veterans’ home loans, and the debt service would be paid back with the interest paid by the veterans. This amendment passed more narrowly, with 56% of the state’s voters casting their ballot in favor of the new program.

In the same election voters were asked to expand the state’s bonding authority for veterans’ mortgage loans, they were also asked to add “transportation facilities” to the list of permissible uses of bonding. Despite initially narrowly passing, a recount of the vote showed the amendment actually failed. Amid controversy, the legislature rescheduled the vote on the amendment for November 2, 1976. The second time around, this constitutional expansion for transportation was resoundingly voted down 56.5% to 43.5%.

While the public rejected the expansion of state indebtedness for transportation purposes, the state legislature wasn’t deterred in its quest to use bonding for other purposes. In 1971, the legislature created the Wisconsin Housing Finance Authority, which was intended to act as a funding vehicle for the development of housing for low-and moderate-income families. Funds to cover the bonds would be raised through rents and interest on investments. Much like the building corporations in previous years, the Authority was created as an extra-governmental authority to circumvent constitutional limits on the amount and purpose of bonding. The Authority was allowed to issue notes and bonds which were solely the obligation of the Authority—however, if obligations outpaced revenues, the legislature was required by law to appropriate funds to make the Authority solvent. The initial law passed by the legislature applied a moral obligation to funds issued by the authority for both housing acquisition and rehabilitation. This moral obligation provided bond purchasers with more comfort, since taxpayers would be required to pay the bonds off should the Authority default.

The 1969 constitutional amendment allowing state debt issuance specifically prohibited the use of extra-governmental corporations for the construction of state buildings. Given that the new Housing Finance Authority looked very much like a corporation, its constitutionality was tested in court. In 1973, the Wisconsin Supreme Court ruled that since the Finance Authority was not designed to provide any buildings for state agency occupancy, the constitutional prohibition on public corporations did not apply.

In 1973, the legislature created the Wisconsin Health Facilities Authority, which provided funding for the development of new hospitals, nursing homes, and other health-related facilities. The new law creating the Health Facilities Authority stated specifically that the bonds they issued were payable only by the Authority, and there was no moral obligation provision for the state.

Given the new bonding authority via constitutional amendment, the state quickly began issuing debt. In 1970, Wisconsin issued $126.7 million in general obligation debt. By 1980, the state had $458 million in GPR-funded, GO bonds outstanding.

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