State and Local Government Debt and COVID-19

State and Local Government Debt and COVID-19

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April 10, 2020
State and Local Government Debt and COVID-19
Debt (often in the form of bonds) represents a promise by
(or maturity), and general economic conditions. The tax
the issuer (borrower) to pay interest income to lenders on
exemption on interest income lowers the cost of debt for
the principal (the amount of money borrowed) until that
state and local governments by reducing their interest costs.
principal is repaid. In light of the economic downturn
All else equal, a lender in the 35% marginal income tax
accompanying the COVID-19 outbreak, there are growing
bracket would be indifferent between a taxable (or
concerns about state and local governments’ ability to make
corporate) bond with an interest rate of 5.00% and a tax-
payments on outstanding debt, and general concern about
exempt bond with an interest rate of 3.25%, because the
the fiscal capacity of those governments. The CARES Act
bonds’ after-tax income would be identical. State and local
(P.L. 116-136), signed into law on March 27, 2020,
governmental bonds, or those that meet the statutory
included provisions that may offer fiscal relief to state and
definition of having a “public purpose,” receive this tax
local governments. This In Focus briefly describes the
exemption without restriction.
nature and characteristics of state and local debt issuances
in light of recent economic and legislative developments.
Nongovernmental (or private activity) state and local bonds
also receive a federal tax exemption if they are included in
Mechanics and Federal Support
the statutory list of activities eligible for qualified private
State and local governments typically issue debt to finance
activity bonds. Tax credit bonds, which provided a federal
the construction of capital facilities (e.g., buildings, roads,
tax credit or direct payment in lieu of the tax exemption,
and airports). Because capital facilities provide benefits
were a former alternative to the federal tax exemption for
over a long period of time, debt instruments may allow the
state and local debt. Authority to issue tax credit bonds was
timing of payments to better match those benefits. Debt
repealed by P.L. 115-97 (commonly referred to as the
may also be used for cash-management purposes, though
“TCJA”) beginning in 2018, though some previously issued
the capacity to respond to unexpected budgetary
tax credit bonds are still outstanding. Current law prohibits
developments is typically limited.
the federal government from providing loan guarantees
(wherein the government assumes responsibility for debt
Unlike the federal government, which has no enforceable
should the borrower be unable to make payments) on any
balanced budget restriction, state and local governments
tax-exempt bond.
generally must balance their operating budgets every one or
two years. Though debt issuances are typically accounted
Current Characteristics
for in capital budgets not subject to balanced budget
Federal Reserve data indicate that in September 2019, state
restrictions, budget shortfalls can force state and local
and local governments had approximately $3.05 trillion in
governments to choose between sudden spending decreases,
outstanding debt. Much of that debt remains outstanding for
tax increases, or breaching contractual payments on debt
several years, as data from the Municipal Securities
issuances (described as being in default). This is one reason
Rulemaking Board (MSRB) show state and local
why state and local debt may be perceived as riskier than
governments issued $0.46 trillion in new debt (roughly 15%
federal debt to lenders. For more information, see CRS
of the total stock) in 2019. Debt instruments finance
Report RL30638, Tax-Exempt Bonds: A Description of
projects across a variety of policy areas. MSRB data on
State and Local Government Debt.
issuances from 2009 through 2018 show significant
resources devoted to education (26% of all debt issued),
The federal government subsidizes the cost of many state
transportation (13%), utilities (10%), and health care (8%),
and local bonds by exempting any interest income they earn
with an additional 31% in issuances for general purpose
from federal income taxation. Certain goods and services,
projects (including broad capital improvement initiatives).
including capital projects, provided by state or local
governments benefit both residents, who pay local taxes,
Figure 1 (next page) shows the level of combined state and
and nonresidents, who pay little to no local taxes. Because
local government debt recorded in 2017, measured as a
state and local taxpayers are unlikely to provide these
percentage of total annual state and local revenues
services to nonresidents without compensation, certain state
(including intergovernmental transfers); in other words, it
and local services may be underprovided without outside
shows what those governments owe as a share of their
intervention. In theory, the exemption of interest income
annual “income.” Nationwide, state and local government
compensates state and local taxpayers for benefits provided
debt issuances equal 78% of annual revenues, and state
to nonresidents and residents alike, and encourages
figures range from 20% (Wyoming) to 105% (Texas).
increased provision of borrowing-financed projects.
Local governments (98%) generally have a larger ratio of
debt to annual revenues than state governments (46%).
Interest rates vary with the creditworthiness of the
State and local debt is smaller than the federal debt burden
borrower, the terms of repayment, the length of repayment
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State and Local Government Debt and COVID-19
of $16.80 trillion in publicly held debt at the end of
businesses—but did not require it. Support may be
FY2019, or 485% of annual revenues.
provided through purchases of debt issuances from outside
creditors or the issuance of new loans to borrowers that will
State and local government debt generally involves higher
allow for debt repayments. Oversight of the loan program is
interest rates than comparable federal debt. March 2020
tasked to the Federal Reserve and Treasury. For more on
data from The Bond Buyer showed 30-year yields (interest
this provision, see CRS Report R46301, Title IV Provisions
rate benchmarks) of 1.46% for Treasury securities (federal
of the CARES Act (P.L. 116-136).
debt) and 3.40% for municipal securities. Distinctions in
how projects are financed and reduced monetary policy
On April 9, 2020, Treasury and the Federal Reserve
influence are other reasons states and localities may be
announced that, through CARES Act authorities, they had
charged higher interest rates than the federal government.
established a Municipal Lending Facility (MLF) that would
Recent Developments
provide direct financing to states, counties, and city
governments. The announcement stated that Treasury
There has been a sudden decline in economic output amid
would make a $35 billion equity investment into the MLF
the COVID-19 outbreak. State and local government
that would support up to $500 billion in direct financing.
revenues tend to decrease as economic growth declines
(because taxes are paid on economic activity, such as sales).
Section 5001 of the CARES Act established the
Moreover, the COVID-19 crisis is likely to lead to
Coronavirus Relief Fund, which provides $150 billion in
additional demand for spending programs, particularly in
federal payments to state, local, tribal, and territorial
the health sector. That combination is expected to increase
governments. Most of those payments are initially provided
the frequency and intensity of state and local budget
to state governments, though local governments with
deficits, which may lead to a decline in state and local
underlying populations of at least 500,000 people may
spending and a rise in default rates as policymakers attempt
apply for some direct federal assistance. Fund payments
to comply with statutory balanced budget restrictions. More
must be used for necessary and unexpected expenses in
information on this issue is found in CRS Insight IN11258,
2020 related to the COVID-19 emergency. While such
State and Local Fiscal Conditions and Economic Shocks.
funds cannot directly be used to alleviate the state and local
debt burden, they may indirectly allow government
The CARES Act included two provisions offering federal
revenues that would otherwise have been used for COVID-
assistance to state and local governments that, depending on
19 to be used for debt repayment. For more information, see
their implementation, may ease their debt burden in the
CRS Report R46298, The Coronavirus Relief Fund (CARES
current economic climate. Section 4003 of the CARES Act
Act, Title V): Background and State and Local Allocations.
provided at least $454 billion to the Federal Reserve to
support state governments, local governments, and eligible
Figure 1. 2017 Combined State and Local Government Debt
As a percentage of annual state and local revenues

Source: U.S. Census Bureau. CRS calculations.

IF11502
Grant A. Driessen, Analyst in Public Finance
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State and Local Government Debt and COVID-19

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