It’s Time to Limit City Borrowing

City Controller Rick Tuttle has asked the mayor and City Council to adopt a debt policy that would limit the city’s ability to borrow. Tuttle is concerned about the level of city debt and its projected growth. He fears that if current trends continue, Los Angeles’ bond credit rating may suffer, increasing borrowing costs.

Beyond concern over the city’s credit rating, there is an additional reason to cap borrowing: There is evidence that instituting a legal cap will directly lower a city’s borrowing costs. Taking this even one step further--to provide residents with additional protection against excessive city borrowing--the city charter should be revised to subject all future borrowing to voter approval. And if the San Fernando Valley breaks away from the city, the new government charter should also embrace these debt policies.

Los Angeles has accumulated about $14 billion in debt, more than half incurred without specific voter approval. The service of this debt requires payments equal to 9% of the city’s general revenues. Tuttle projects the total debt service figure will exceed 10% in two years, a level bond rating agencies consider undesirable and risky. Clearly, Los Angeles’ bond rating will decline if current trends continue, increasing borrowing costs.

Tuttle has proposed a total debt service limit of 10% of general revenues. Debt service not approved by voters would be capped at 6%. City Administrative Officer Keith Comrie has suggested a 7.5% limit on such debt to be accompanied by a similar limit on voter-approved debt.

The interest rate paid on the city’s debt reflects national credit conditions and a Los Angeles-specific risk premium. The size of the risk premium paid depends primarily on how well the city controls its spending and borrowing. As Los Angeles’s debt continues to grow, the chance of default increases, especially if the economy sours. As a result, lenders will require a higher interest rate as compensation for the greater risk. Although Los Angeles cannot control macroeconomic conditions, it can manage its budget and borrowing prudently.

Governments that pass spending and borrowing rules are rewarded by financial markets with lower interest rates. Debt limits reduce the chance of fiscal mismanagement, reassure financial markets and therefore reduce borrowing costs. Even if the city manages to slow debt accumulation so as not to jeopardize its bond rating, a legal debt ceiling would still be a valuable asset.

Economists have investigated the impact of budget rules, including legal debt limits, on the interest paid on borrowing and debt accumulation at the state level. These studies show that state governments with strict debt limits pay lower interest rates. Specifically, the studies show that strict state debt limits can lower interest costs up to one-half of a percentage point. This result is strengthened when states place limits on the growth of expenditures. Lenders reward limits on spending, but not taxation, because they want a government to have the flexibility to raise taxes if needed to service debt.

There is also evidence that states that require voter approval for borrowing tend to accumulate debt more slowly. So in addition to limits on total borrowing, tough explicit limits on borrowing not approved by voters are an important component of any debt policy. Both the Tuttle and Comrie proposals include limits on debt not approved by voters.

Voter-approved borrowing is important because debt limits alone are not foolproof. Judging from some state experiences, politicians work around debt limits by creating off-budget public authorities that can issue revenue bonds to finance their activities. As a result, government and debt continue grow, against the public will. Voter approval of all borrowing must be included as an important component of any debt policy reform. It is the best way to be sure that any borrowing the city undertakes will be for public capital projects that voters want, rather than for projects benefiting special-interest groups.

Politicians may argue that broad debt policy reforms are unnecessary and will have a constraining effect on “good government.” They’ll tell us to let the elected officials do their jobs. However, the evidence is in and Los Angeles’ debt is growing too fast. A 10% debt limit is prudent and will save the city millions of dollars over time. Rick Tuttle’s proposal should be approved. Adding voter approval for all future borrowing will constrain politicians from cutting through the debt limit by creating off-budget authorities to issue bonds.

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