Options and impacts of capital improvement financing and planning

Recent evaluations of the state of America’s infrastructure indicate that an exceptional amount of financing is required to repair and replace our aging infrastructure. The United States infrastructure was given a cumulative grade of D+ by the American Society for Civil Engineers, which is an improvement from the D grade it received in 2009. Grades are based on 15 categories of infrastructure including: aviation, bridges, dams, drinking water, energy, hazardous waste, inland waterways, levees, public parks and recreation, rail, roads, schools, solid waste, transit, and wastewater. The report also estimated that to bring America’s existing infrastructure up to a state of good repair by 2020 would require $3.6 trillion in spending over five years. With increasing pressure and urgency to improve public infrastructure, state and local governments will need to increase their capital improvement activities while being aware that government spending is under close public scrutiny.

Increasing capital improvement activity means increasing financing streams to fund projects. There are traditionally three ways to finance capital projects: debt issuance, federal or state grants, and pay-as-you-go (pay-go) financing. A fourth method of public-private partnerships is also emerging. Although some count the use of grant money as pay-go financing, this article will assume that money used in pay-go financing comes from capital reserves, revenue from taxes and fees, and other fund balances. The benefits and drawbacks for both pay-go and debt financing as well as capital improvement planning best practices will be discussed.

Pay-go financing defined

Pay-go financing is the method of using general fund revenues to pay for capital projects in place of or in addition to traditional debt financing. Governments that use the pay-go method will typically pool current revenues after operating expenditures from the general fund into an account reserved for funding capital projects, essentially "saving up" to finance large projects. These accounts are normally referred to as capital reserve accounts, and they often need to be approved by a governing body of a municipality.

A local government client located in the Midwest uses the following methods of pay-go financing to fund capital expenditures:

  • An internal service fund is used to save for capital equipment replacement. Each department is charged based on a calculated amount that takes into account the age of their assets and the replacement value of those assets. Once the capital equipment is due for replacement, the funds are transferred out of the internal service fund to pay for the replacement. This substantially reduces problems with identifying funding and ensures a long-standing commitment to maintenance.
  • A Capital Project fund was created and is supported mainly by the Corporate fund of the government. Since the Capital Project fund is supported mainly by government revenues, the government is able to increase its transfers to the capital fund in excess of the budgeted amount. This allows the government to quickly react to favorable bidding environments for capital improvements. Additionally, having a separate fund for capital expenditures allows the government to save up general fund revenues to help finance large projects.

Pay-as-you-go financing vs. debt financing

Benefits of debt financing

As mentioned previously, when using pay-go financing, governments must save up or already have the money needed to construct capital projects. This presents an obvious drawback to pay-go financing and a benefit to debt financing. Many governments may not have the cash on hand to invest in infrastructure, and saving money, especially for large projects, may take too long. Also, some governments have several capital improvement projects occurring at once or within a short time span. Using pay-go financing for all necessary capital improvement projects could prove impossible. When a government uses debt financing, the lead time before breaking ground on a project can be substantially reduced, and infrastructure improvements or additions can happen when a community needs them. Accumulating large sums of money in a reserve account exposes the government to the opportunity cost of not investing that money elsewhere or using it to fund programs or services for their citizens. Also, there may be some restrictions at either the state or local levels (or both) to a government keeping large sums of money in a capital reserve account to be used for pay-go financing. Finally, maintaining large sums of money in a reserve account may be politically unpopular for entities seeking to increase their tax levy or tax rates.

The most commonly cited positive of debt financing and negative of pay-go financing is intergenerational equity. Intergenerational equity in regards to financing capital projects refers to burdening the appropriate generation(s) with the costs associated with a particular capital project or set of capital projects. In Public Finance in Theory and Practice, Peggy and Richard Musgrave discuss intergenerational equity and state, "…[Public services should be financed on a benefit basis, each generation should pay for its own share in the benefits received" (Musgrave, 1984, p. 691). That is, whoever will be using the infrastructure pays for it. This argument is the main driver of debt financing because interest payments on the debt are made in the future so that current residents not benefitting from the infrastructure do not end up paying for it in the way of increased taxes and fees. Critics of pay-go financing often use this argument to propose that pay-go financing unfairly shifts the burden to current generations.

Benefits of pay-go financing

On the other hand saving up for capital improvements-the same component of pay-go financing that had several drawbacks-also provides many benefits to the governments that use it as a funding tool. For instance, issuing general obligation bonds, depending on who is issuing them, can have many restrictions including: having to hold a referendum to get citizen approval, staying within debt ratio limits, and ensuring that issuing new debt will not affect credit ratings. Pay-go financing has none of these restrictions. In fact, some argue that pay-go financing can improve the credit rating of a government by reducing their debt ratio and other factors. Two of the benefits include a lower debt and improved financial flexibility in the event of reduced revenues or an emergency1. The idea behind increased financial flexibility is that governments would be appropriating revenues to an account to save for capital projects so they would have more cash on hand in case of an emergency.

Also, interest savings are often cited as a benefit to pay-go financing. When a government issues bonds, it has to pay interest on the bonds until they are paid back in full. Pay-go financing relies on cash on hand so there are no interest payments. From the government’s perspective, this can significantly reduce the total project cost. A lack of interest payments may not only lower total project cos,t but it also ensures that the government does not have to budget for interest payments on the debt in future years.

Finally, some small, local governments may have trouble entering into the debt markets because of their small tax bases and inexperience with issuing debt. Using pay-go financing allows them to participate in infrastructure improvements and other capital projects without using debt as a financing tool. 

The CIP as a foundation for responsible financing

As discussed, pay-go and debt financing each have benefits and drawbacks. In light of these questions governments need to continuously explore their options for financing infrastructure projects and engage in responsible financing practices. Debt financing or pay-go financing may not be the right choice for every government while a mix of the two may be a solution.

This discussion also reinforces the importance of long-term capital improvement planning at every level of government. Capital improvement planning adds several layers of responsibility to an infrastructure project including:

  • Long-term planning allows governments to financially plan for future infrastructure improvements including saving-up for projects where pay-go financing will be used.
  • A comprehensive capital plan should be tied into the strategic goals of the community allowing for improved prioritization of capital projects.
  • Long-term feasibility studies should be incorporated in the capital improvement plan to show fiscal impacts of a project on future budgets including debt service payments and any additional operating or maintenance costs associated with the project.

No matter what avenue of financing governments choose to use for their capital projects, employing these best practices for capital improvement planning ensures a strong foundation for the financing and completion of capital projects. Baker Tilly’s state and local government consultants can offer advice on how to maximize the effectiveness of your CIP by prioritizing projects, implementing a priority based budget structure, and increasing the efficiency of your CIP budget implementation.

1Fitch Ratings. (2002). 12 Habits of Highly Successful Finance Officers.