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Press Release · December 10, 1999

Tax Restrictions Such As Prop. 13 Raise Borrowing Costs For States

Unemployment and Unexpected Budget Deficits Also Affect Interest Rates on Bonds

San Francisco, California, December 10, 1999 – The interest rate California will be charged on its bond debt over the next decade will be affected by the state’s fiscal rules, including tax and spending restrictions passed by voters through the initiative process. A new study released today by the Public Policy Institute of California (PPIC) analyzes the difference in borrowing costs between states on general obligation bonds and presents new evidence about what determines the significant disparity between states’ costs.

The study’s authors, James Poterba and Kim Rueben, studied bond market data over the past two decades and found that a number of factors affect a state’s borrowing costs, including fiscal rules set by voters and legislators. The authors found that laws such as California’s Proposition 13, part of which requires a two-thirds majority vote in the Legislature to enact new taxes, put upwards pressure on state borrowing costs.

“States that restrict taxes or that require supermajorities to increase taxes face higher borrowing costs than states without such restrictions,” said Rueben, a PPIC research fellow. “States with these types of requirements are perceived as a greater credit risk because they may have difficulty raising the revenue necessary to meet their debt.”

In contrast to requirements that limit revenue, fiscal rules that limit spending, deficits, or the amount of new debt a state can issue tend to lower borrowing costs, according to the study. “State spending limits – such as California’s Gann Amendment – and deficit limits increase the likelihood that the government will be able to make interest payments,” said Rueben. “The perceived credit risk in such states is lower. Thus, the interest rate on their debt is lower.”

The study, Fiscal Rules and State Borrowing Costs: Evidence from California and Other States, also found that borrowing costs in states with strict fiscal rules limiting spending and deficits were not as sensitive to news of budget deficits. Because unexpected budget deficits make it more difficult for states to pay their debts, they are generally associated with upward revisions in state bond yields (higher yields due to higher interest rates). However, states with tight anti-deficit and fiscal spending rules see bond yields rise less during these periods of financial crisis.

In California, the effect of unexpected deficits is particularly pronounced. This sensitivity can be partially explained by the large amount of outstanding debt in the state and by California’s fiscal rules – the state has spending limits and a supermajority requirement for passing new taxes but does not require that the actual state budget be balanced. “Bond traders seem to be keenly aware of fiscal changes in states with high levels of debt,” said Rueben. “This pattern indicates that accurate budget forecasts are more important for California than many other states.”

With its unique mix of fiscal rules, California’s interest burden, at $76 per capita, is currently lower than the national average of $82 per capita. However, the authors stress the importance of recognizing the unintended effects that revenue limits, spending limits, and deficit rules have on the state’s borrowing costs.

“California expects to issue billions in bonds over the next decade to finance critical infrastructure projects throughout the state,” said Rueben. “The borrowing costs on this debt could affect whether the state is able to keep its fiscal house in order over the long term.”

The Public Policy Institute of California is an independent, nonprofit organization dedicated to nonpartisan research on economic, social, and political issues that affect the lives of Californians. The Institute was established in 1994 with an endowment from William R. Hewlett. David Lyon is President and CEO of PPIC.