The spending of other people's money is always open to abuse. That is why what government does with taxpayers' money is best guided by good economic principles. One such principle is that governments should invest in goods that taxpayers want but the market will not provide. Falling under the general heading of infrastructure, these investments include education and research, roads and bridges, water and sewage systems, and public health and safety. According to economic theory, if the government did not intervene in the market, these goods would be produced in quantities far smaller than their value to society. And that value is considerable: Research shows that government's investment in infrastructure has consistently bolstered long-term economic growth.
In recent years, something other than this economic principle has been guiding state and local government investments--the idea that government should invest in private businesses that create jobs. These investments often take the form of low-interest government loans to new or expanding businesses, and the option of investing in job creation this way is seductive. Unlike investing in infrastructure, investing in job creation appears to have small costs and highly visible returns that accrue in a relatively short period of time. A closer examination, however, reveals that in fact the costs can be great and the returns are illusions. Therefore, constraints on these investments need to be strengthened.
State and local governments finance private businesses with tax-exempt bonds known as industrial development bonds (IDBs). The bonds are converted into low-interest private business loans by using the proceeds to buy or build some desired capital (an office building or a factory, for example) and leasing the capital to the business. The rental income generated by the lease agreement is used to service the debt, and the capital secures the loan.
Both parties appear to benefit from these transactions. Of course, the private business that receives the government loan is better off because it is able to finance a significant part of its capital at a rate much lower than it could get on its own. The local economy is presumably better off because it now has more jobs. Its out-of-pocket expenses are negligible, and its revenue loss is small. Furthermore, if the business is successful, the local government could eventually end up with more revenue than it would have otherwise.
As the numbers show, state and local governments have taken advantage of this form of financial aid to their economies. In a recent 10-year period, close to $400 billion worth of private-activity IDBs were issued, $99 billion alone in 1985. The big numbers, however, have not translated into big benefits because the returns on such loans are nothing more than illusions.
To see what I mean, consider the following example. A hypothetical firm has decided to borrow $10 million at the market rate--say, at 17 percent--in order to expand its local operations and create 100 new jobs. Learning of the firm's plans, some outside community offers a low-interest loan to the firm--say, at 14 percent--because it can issue federally tax- exempt IDBs. The local community, concerned about losing these new jobs, counters with the same offer. The firm decides to expand as originally planned and saves three percentage points on its capital expenses.
Has the local government created any new jobs? Probably not. From the local view, one might argue that the loan brought new jobs to the community. If the counteroffer had not been made, the jobs would have gone elsewhere. But clearly, from a national view, jobs were neither lost nor created; the financial aid just helped to determine where the new jobs would be located.
What about the possibility that the firm might not have expanded its operations without government assistance? If that is true, then the government has created 100 jobs. But governments shouldn't be creating jobs this way. They have no inherent advantage over private credit markets in predicting which firms will succeed and which will fail. The Eastern Europeans, for example, have demonstrated how costly it can be to let governments determine which firms receive financial support, rather than leave these decisions to private markets.
Congress has been well aware of this fruitless competition among state and local governments for new jobs. Since the late 1960s, Congress has been trying to control the growth of tax-exempt bonds that are issued to finance private activities. In 1986, it strengthened its controls by imposing volume caps on these types of IDBs. Today a state and its local governments can issue each year only $150 million worth of private-activity, tax-exempt IDBs, or $50 per capita, whichever is greater.
State and local governments, however, have found a loophole that they are beginning to use aggressively. Some are now offering federally tax- exempt general obligation IDBs as a way to get around the caps. These IDBs are backed by the full faith and credit of the issuing government, rather than being revenue bonds (bonds secured by the revenue of the business receiving the loan). And there are no federal limits on the amount of general obligation bonds that state and local governments can issue.
In some ways, the option of issuing general obligation bonds to create jobs is even more seductive than issuing revenue bonds. Not only are general obligation bonds tax exempt, they also have a very low risk of default because the issuing state or local government guarantees the debt service. The bonds, therefore, sell well below market rates, and private businesses get an even lower-rate loan than those financed by revenue bonds. Again, both parties appear to gain, and only the federal government loses.
But there is an illusion here too, this time covering up the cost to the local taxpayers. Local taxpayers, rather than the bondholders, now bear the risk of business failure. Remember our hypothetical firm that would have had to pay 17 percent to borrow in the market but managed to save three percentage points by borrowing from a community issuing tax-exempt revenue bonds? Suppose it instead were to receive the proceeds from the issue of general obligation bonds, for which the local government would probably have to pay only a 7 percent rate (roughly the going rate on such bonds today). Our hypothetical firm would now save 10 percentage points, 3 percentage points because the bonds are tax exempt and 7 percentage points because the bonds are secured by the full faith and credit of the issuing government. The 7 percentage points represent the cost of the credit risk which is borne by the local taxpayers. The implicit annual subsidy to the firm, therefore, is 7 percent of our original $10 million, which is $700,000, or $7,000 per job. If such costs were made explicit, I suspect taxpayers would have doubts about such an investment, especially those taxpayers who never received such assistance when they expanded or started their businesses.
As we have seen, Congress already had such doubts. In 1986, convinced that allowing state and local governments to compete for jobs with IDBs was a mistake, it acted to severely limit such competition. But Congress succeeded in limiting only one type of competition. Over the last five years, state and local governments have found a new and costlier way to compete for jobs--tax-exempt general obligation bonds. Congress needs to close this loophole by eliminating the tax-exempt status on all bonds issued for private activities.
As for state and local governments that may still want to issue taxable general obligation bonds to promote job creation, they should be required to make local taxpayers aware of the hidden costs. Once taxpayers are fully informed, state and local governments will likely return to competing for business by offering more and better types of infrastructure. At least the return on these investments will be no illusion.