Some U.S. debt instruments better than others

U.S. municipalities have tapped debt markets to a much greater extent than their Canadian counterparts, with US$1.9 trillion in bonds outstanding vis-a-vis only about C$30 billion in Canada. This larger borrowing appetite reflects in part higher overall financing needs, as cities south of the border were required to invest large amounts in the 1970s and 1980s in order to stem growing urban decline. However, it is also owing to a number of debt instruments that are at U.S. municipalities' disposal, but are either unavailable or not used widely in Canada. No doubt, any talk of increased use of borrowing is likely to come hand-in-hand with requests for provinces to allow these U.S.-style vehicles. Still, some of them warrant greater consideration than do others.

Tax-exempt bonds (TEBs) - an approach used widely in the United States for financing urban infrastructure (see Annex 1). These debt instruments provide a particularly cheap form of borrowing for local governments, since interest income is exempt from federal and state income tax, and hence borrowers will accept a lower rate from the municipality. Yet, TEBs have deep flaws. For one, as we show in an example in Annex 1, they're regressive in nature, with most of the benefits accruing to those with above average marginal income tax rates. Second, a sizeable share of the benefits are leaked, as the money saved by state and local authorities in lower interest payments is considerably less than the level of foregone revenues. In Canada, this leakage would be larger than in other countries, given the importance in the bond market of non-taxable entities such as foreigners and pensions. And, if that isn't enough, TEBs are weak on accountability, because one area receives the benefits but another foots the bill in terms of a lower tax take.

Among Canada's provinces, only Ontario has moved to adopt TEBs, issuing the first tranche of bonds exempt from provincial income tax in May 2003 through its Ontario Municipal Economic Infrastructure Financing Authority (OMEIFA). By topping up the interest-relief grant with an additional subsidy, the Authority will lend the funds to municipalities for infrastructure investments at half the going market interest rate. Only residents of the province can purchase these instruments which are labelled Opportunity Bonds.

State Infrastructure Banks - state infrastructure banks (SIBs) offer another inexpensive borrowing option for municipalities free of many of the inherent problems of TEBs. Created by federal grants, SIBs are state-run institutions in the U.S that operate like private banks, providing municipalities with seed funding to start a project and a range of low-rate loan and credit enhancement products.26 A feature of the SIB is the continual "recycling of funds". In other words, as the assistance is repaid, funds are then used for other purposes. These vehicles have been used extensively in the United States to finance transportation, environmental and water and wastewater projects. Moreover, they have proved to be useful in leveraging private sector funds. In Canada, the Green Municipal Investment Fund, established by the federal government in its 2000 budget, is one of the few examples of a permanent revolving fund for capital project financing.

In many respects, these institutions operate like the provincially-administered Canadian municipal finance authorities that have been established in both Ontario and B.C., since they borrow on behalf of a number of local governments in order to secure lower interest loans and provide expertise, particularly to smaller communities. In contrast, however, SIB loans are guaranteed by the bank's reserves rather than the credit of the municipality.

Revenue bonds - along with TEBs, revenue bonds have been used increasingly by municipalities Stateside. These instruments, also referred to as limited obligation bonds, are legally secured by a specified revenue source. Accordingly, in the event that the revenue source is not sufficient to service the debt, the state is not legally obligated to appropriate other revenues for debt repayment, thus allowing revenue bonds to get around constitutional debt limitations imposed in many states. On the plus side, these bonds promote full-cost pricing of services and shift the economic risk to investors without any loss of ownership or control. However, given that these instruments are not backed by the government's overall revenue source, interest rates are often higher than for general obligation bonds.