MORTGAGING OUR FUTURE

The Need for a Debt Limit in California

Carl DeMaio,
DeMaio, President,
President, The Performance Institute
On November 7, 2006 voters in California will be asked to decide on five ballot measures
(Propositions 1B, 1C, 1D, 1E and 84) that would total $42.7 billion in new general obligation bond
debt if approved. On their face, each bond proposition looks enticing, promising funds will go to a
number of politically popular purposes.

There is no doubt that the State of California needs to invest in infrastructure -- and needs investments
in many of the areas addressed by the propositions on the November ballot. Unfortunately, all too
often in government, what you pay for is not always what you get. Government loves to throw good
money after bad. Recent analysis on each of the bond propositions released by the Reason Foundation
raises serious concerns over how efficiently and effectively the funds authorized by these measures will
be used.

Even if you buy into the idea that all the monies raised from these bonds will go to important
infrastructure projects, the monumental amount of debt created by the bond package should be a
cause of great concern. As voters once again go to the polls, one must ask: how much debt is too
much? Will approval of the bond package on November 7th push our state past a healthy limit?

Current and Projected Levels of Debt

Even before the November bond package is included, the State of California has more than $45 billion
in outstanding General Obligation Bond and Lease-Revenue bond debt being financed from the state’s
general fund. General Obligation Bonds and Lease-Revenue bonds must be financed each year
through appropriations from the state budget—meaning the more debt that is issued today, the less
monies are available in the state’s annual budget in future years for other popular programs.
Moreover, an additional $30.5 billion in infrastructure funding is still waiting to be issued—dealing with
many of the popular program areas being addressed by the November bond package.
There are five general obligation bond measures on this ballot, totaling $42.7 billion in new
authorizations. These include:

Proposition 1B, which would authorize the state to issue $19.9 billion of bonds to finance
[infrastructure, i.e.] highway safety, traffic reduction, air quality, and port security.

Proposition 1C, which would authorize the state to issue $2.85 billion of bonds for housing
and development programs.

Proposition 1D, which would authorize the state to issue $10.4 billion of bonds to finance
kindergarten through university education facilities.

Proposition 1E, which would authorize the state to issue $4.1 billion of bonds for flood control
projects.

Proposition 84, which would authorize the state to issue $5.4 billion of bonds to fund various
resource-related projects.

Prop Amount
Amount Total cost Per year Cost per household
1B 19.9b 38.9b 1.3b $3,400
1C 2.85b 6.1b 204m $500
1D 10.4b 20.3b 680m $1,800
1E 4.1b 8b 266m $700
84 5.4b 10.5b 350m $900
TOTAL 42.65b 84b 2.83b $7,300

In addition to the sizable level of indebtedness

at the state level, local governments
throughout the state have issued their own
General Obligation Bond debt. Much of that
debt has gone to finance infrastructure projects
in the same program areas as addressed on
the November ballot.

Supporters of the November bond package will

correctly point out that local government debt
is financed by those local governments and
should be seen as separate from the debt
incurred at the state level. While this is
technically accurate, at the end of the day, the
same taxpayers are left holding the bag and on
the hook for debt service payments for debt
incurred today.

One final category of debt is not included in any of the discussion or fiscal impact analysis of the
November bonds: the debt represented by the unfunded liabilities in California state and local pension
funds. As is only now coming to public light, pension benefits and retiree health insurance packages
promised to state and local government employees pose significant liabilities to California taxpayers. In
fact, the total cost of unfunded pension benefits and retiree health insurance is estimated at least $110
billion statewide—although
statewide this figure could rise as California state and local governments implement
GASB Rule 43/45. Unlike a state-issued bond, taxpayers do not get to vote on the liabilities created
by the granting of state and local government pension and health benefits. Nevertheless, taxpayers
must service the debt created by these obligations in the same manner they service bonded debt.

Establishing a Prudent Limit: How Much Debt is Too Much Debt?

Common sense tells us that at some point a

individual or an entity (in this case the state
government) can take on too much debt. What
common sense does not tell us clearly is when do
you cross the line from sustainable levels of
indebtedness to unsustainable levels.

In setting a prudent “debt limit,” creditors look at a

number of financial, managerial, and economic
factors at play in a state or local government. One
of the primary factors examined is the whether the
borrower can “service” the debt long term given
revenue projections. The “debt service ratio”
examines what percentage share of annual
spending is required to service the debt—today and
in the future.

The vast majority of creditors and financial analysts advise that no more than 6% of state revenues
should be consumed by debt service—though some argue for a lower number, some for a higher
number, and some for no “set” number at all. The state’s non-partisan Legislative Analyst’s Office
recommends a reasonable debt service ratio is 6 percent or less.

Proponents of the November bond package seem to accept the 6% figure implicitly, and make the
claim that even if all the bonds were approved and sold, the total debt-to-spending ratio would “peak”
at 5.9% in 2010-11. Of course, these estimates are coming from the same state bureaucrats who
projected dot-com revenues from the late 1990s would be sustainable.

A closer look at the proponent’s 5.9 percent figure reveals just how unreliable it is—and that the true
percentage of the state budget consumed by debt payments will likely be far higher. Several factors
have been excluded, such as:

o Bonds In 2004, state voters were asked to approve a one-time Economic

Budget Deficit Bonds:
Recovery Package of bonds to finance the state’s budget deficit. At the time, Governor
Schwarzenneger and legislative leaders asked for the one-time approval of a bond to cover an
“inherited” deficit, with a promise to “tear up the credit card” if the massive bond was
approved. Debt service on this outstanding $10.7 billion bond is NOT included in proponent’s
debt service ratio projections. According to the Legislative Analysts’ Office, including this bond
in the debt service ratio would push the state government’s debt service ratios “above 7
percent from 2007-2008 until after 2010.”1

o Fluctuations Should interest rates increase (and lately, as anyone

Interest Rate and Revenue Fluctuations:
with a mortgage can tell they are), or should state revenues soften (as has happened
repeatedly in California’s notorious boom-bust budget cycles) the percentage of the general
fund used to service debt can increase dramatically. Since service on debt takes first priority in
annual appropriations, other important programs can be devastated by any significant
fluctuations in state revenues.

1
http://www.ppic.org/content/pubs/jtf/JTF_FinancingInfrastructureJTF.pdf
 o Pension Fund Obligations: As noted above, proponents fail to factor in the debt service
required of pension and health benefits for state workers—which continues to consume a
greater share of the state’s annual general fund budget.

Other measures outside of the debt service ratio raise concerns that even the existing level of general
obligation debt is high. The percentage of personal income of state residents required to service state
government debt stands at 8% of resident’s personal income—one full percentage point about the
national average of 7%. Finally, on a per-capita basis, California has the second largest long-term
debt of any state in the nation.2

Reforming the Bond Approval Process: A State Debt Limit

By any measure, the State of California is already at its limit when it comes to debt. Not all of this can
be blamed on out-of-control politicians in Sacramento. In fact, the voters of California themselves
share in the responsibility for the high level of debt.

Over the past three decades, California voters have been unable to resist authorizing more state debt
by approving a variety of feel-good bond measures. In fact, 86% of all bonded debt put up for a
public vote has been approved since 1970. Since 1980, voters have approved more than $97 billion
in debt through more than 60 bond measures.

Ballot-box budgeting can be dangerous, particularly when the spending in question is being financed by
debt that will have to be paid by future generations. If California voters cannot exercise restraint on a
case-by-case basis, a reform to the system of voter approval of bonds is needed.

Many have argued that the State Constitution should be amended to include a debt limit. Studies show
that states that utilize a debt limit are more effective in controlling the granting of state debt.3 Even
Governor Schwarzenegger endorsed the idea of a debt limit when he initially proposed the massive
November bond package. Unfortunately, the debt limit was left of the cutting room floor when the final
package was placed on the ballot by the state legislature.

How would a debt limit work? A debt limit would establish a set percentage of the general fund budget
(say that 6% figure experts keep referring to) that could be used for debt service. Based on reviews of
debt limits used in other states, as well as from input from a variety of fiscal experts in California, the
Performance Institute has devised specific language that could be included in the State Constitution to
serve as a debt limit:

SECTION 16. Section X of Article XIII B is added to read:

Sec X. Whenever, based on the most recent estimates by the Controller, and based on
laws then in effect, the estimated total amount of debt service on non-self-liquidating
general obligation bonds and General Fund-supported lease revenue bonds exceed 6
percent of the estimated General Fund revenues, exclusive of transfers from other funds,
for either the current fiscal year or any of the succeeding four fiscal years, the Treasurer
may not sell any additional non-self-liquidating general obligation bonds or General
Fund-supported lease revenue bonds. If that percentage is 6 percent or less, the
Treasurer may sell those bonds to the extent that, based on the most recent estimates
from the Controller, and based on laws then in effect, the additional debt service will not
cause the percentage to exceed 6 percent in the current fiscal year or any of the

2
Financing California’s Infrastructure, Michael Semler, Sacramento State University, December 2005
3
D. Roderick Kiewiet & Kristin Szakaly, Constitutional Limitations on Borrowing: An Analysis of State
Bonded Indebtedness, 12 J.L. Econ. & Org. 62, 1996
 succeeding four fiscal years. During any time that the debt service exceeds 6 percent, no
measure to authorize additional general obligation bonds may be submitted to the
voter. For the purposes of this section, the Controller, at the time of publication of the
Governor’s Budget in January, at the time of publication of the May Revision, and after
the enactment of the Budget Act, shall publish estimates, for the current fiscal year and
each of the succeeding four fiscal years, of debt service and General Fund revenues,
excluding transfers, based on the law in effect at the time each estimate is made.

This provision would create a check-and-balance system to control the growth of state debt. If the State
Constitution did contain a debt limit, voters would still be able approve any individual bond measure
they want—up to a point. Voters would still pick and choose from bonds placed on the ballot, but there
would exist and overall “check” to ensure the level of debt does not get out of hand. Moreover, if
voters approved debt in excess of the limit, it would not be sold until the state had room within its debt
limit.

Another benefit is gained from a debt limit—a control on legislative borrowing. In recent years, the
legislature has stretched the definition of what constitutes “voter-approved” debt vehicles, particularly in
regards to their use of Pension Obligation Bonds. A debt limit acts as an additional check against
“excessive” legislative borrowing in addition to the voter approval process.4

Even if you accept the debt service projections of bond proponents as accurate, one issue is not in
doubt: should all the bonds in the November 7th package be approved, the state of California would be
completely tapped out. Any additional bonds approved in 2008 pushing the state past the limits that
even proponents of the November bonds have proposed. Without a debt limit, it is highly unlikely that
state politicians and even the voters themselves can resist incurring more debt past the 2006 election.

4
Anita S. Krishnakumar. In Defense of the Debt Limit Statute. Harvard Journal on Legislation, Volume
42, Number 1, Winter 2005