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Debt and Taxes: Arizona Taxpayers on Hook for $66 Billion Tab Run Up by State, Local Governments

November 19, 2014

George Lee made a comfortable living running a pair of commercial buildings in Prescott Valley, until government debt helped drag him down.

Lee owned and managed the biggest properties in a modest shopping center in a small town. In the mid-2000s the economy was strong, rents were good and the taxes Lee paid on the property were stable. So Lee agreed when city officials approached him and other property owners about forming a special taxing district to spruce up the area and give the businesses direct access to State Highway 69, the main road to Prescott.

The promises made by the town failed to materialize.

The improvements paid for with the $3.4 million in bonds issued by the Parkway Community Facilities District amounted to landscaping and a new parking lot for an area that already had ample parking, Lee said.

There was no direct access to the highway, the critical element in the city’s pitch to property owners. And within a year the property tax rate landowners had to pay was almost twice what the town had claimed it would be. It’s continued to go up.

When the economy soured and rents dropped, Lee was unable to keep up with the taxes and other debt payments he had on the properties. His taxes for the Parkway district alone were about $36,000 per year, almost half of his total property tax bill.

Lee lost both buildings to the bank a year ago. He lost his source of income, his house and his condominium. He and other property owners also lost a court challenge claiming they had been duped into approving the district by the town.

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When districts like Parkway issue bonds, the judge ruled, property taxes must rise to whatever level necessary to make the annual debt payments, regardless of the consequences to the landowners.

“You don’t have to go any farther if you want to see a situation where property owners have really been taking it in the Snuggies,” Lee said. “It’s a travesty is all I can say.”

The amount of government debt that helped drive Lee out business is just a tiny sliver of what taxpayers owe across Arizona. But the risk of financial ruin that Lee faced is shared by all Arizonans as layer upon layer of government adds layer upon layer of debt.

State and local governments in Arizona owe more than $66.5 billion in outstanding debt and unfunded obligations, according to official estimates in disclosure reports scattered across various agencies. That figure is based largely on annual reports from government agencies and pension funds that run through June 2011. Numbers that have been updated since have only gotten worse.

That works out to about $10,258 for every person in Arizona, just for state and local debt and unfunded obligations.

To put that figure in perspective, total personal income in the state is about $232.6 billion per year, or just under $36,000 per person, according to the most recent figures from the U.S. Bureau of Economic Analysis. The state’s operating budget for the current fiscal year is about $8.3 billion.

Nationally, the market for municipal bonds – the primary debt mechanism for state and local governments – is about $3.74 trillion, according to figures through 2011, the most recent available data compiled by the Securities Industry and Financial Markets Association, a private group that represents securities firms, banks and asset managers.

While the $15.6 trillion national debt gets a great deal of attention, the extent of state and local debt in the United States is more difficult to quantify. In 2010, a report by the U.S. Government Accountability Office projected that without major changes in the way state and local governments operate, they will face deficits, debt and unfunded obligations of at least $9.9 trillion over the next 50 years.

To close that gap, the GAO concluded state and local governments will have to raise taxes or cut spending – or both – by a total of about 12.3 percent every year, year after year, until 2058.

More recent projections are not available.

If Arizona’s debt is any indication, things have not improved since the GAO report was issued in July 2010. Money from the federal stimulus bill, which had been masking state and local financial shortfalls, has dried up. The amount of borrowed debt has increased, and so have unfunded pension liabilities.

Some groups have tried to get a fix on current debt and unfunded obligations of state governments. But those studies tend to rely on Comprehensive Annual Financial Reports (CAFRs), which are detailed financial statements that state governments must file every year. The problem with them is that CAFRs tend to be outdated – most run a year or two behind, and state CAFRs do not account for the liabilities of local governments.

Debt Is Not Debt

Understanding state and local government borrowing requires entering a world where debt is not debt, governments are not governments and billions of dollars in obligations are supposedly traded without risk.

No one really knows how much is owed by state and local governments in Arizona. Some of it does not have to be reported. Some of it is significantly under-reported.

There’s not even agreement on what constitutes debt, or what government is.

But whatever the definitions, it all comes with risk to taxpayers, investors and governments themselves.

“Taxpayers should care about it because it’s an obligation that they or their children are going to have,” said Arizona Treasurer Doug Ducey, who advocates paying down the billions in debt owed by the state. “People should be concerned about the amount of debt, the type of debt, and the fact that there is no overall plan to pay down the state debt.

“The trajectory that government writ large is on is that it is taking on too much debt. It’s not living within its means and the only way to change that is to change direction. You do need to make difficult decisions.”

Most of the government debt in Arizona – about $44 billion – is in bonds that have been issued for everything from streets and sewer lines to sports arenas and theaters. In addition, more than $938 million is pledged for lease-purchase agreements, long-term commitments by governments at all levels to buy capital improvements like new buildings or equipment with annual payments rather than bonds.

Government pensions are underfunded by more than $13.6 billion, according to the most recent official estimates. That means they do not have enough assets to cover the expected costs of paying retirement benefits they will owe to government workers. Other benefits to retired public employees, such as guarantees to pay health care premiums, are about $1.3 billion short. Estimates using a more conservative market-based approach published by the Goldwater Institute in 2010 put the unfunded liability for the four state pension funds alone at more than $50 billion.

Industrial Development Authorities, creations of state and local governments that have the power to issue tax-free bonds for certain commercial purposes, have more than $5 billion in outstanding debt.

In addition to those costs, there are intangibles such as $1.3 billion in accounting tricks used by state lawmakers to balance recent budgets, and civil litigation claims that are owed but not tallied in government debt reports.

Full Faith and Credit

The usual way for governments to go into debt is to issue bonds that are repaid through some type of taxes or fees. Usually the interest paid on government bonds is not taxed, making them attractive to investors who buy them on the open market. That allows governments to pay lower rates to borrow money.

Government bonds often amount to a full pledge of taxpayers’ wealth. The debt becomes the first lien on any money that is pledged to repay it, regardless of the consequences to taxpayers or the agencies that borrow the money. Standard language in bond documents tied to land values requires property taxes to increase to whatever level is necessary to make the annual principal and interest payments. As in Lee’s case, if one property owner goes broke, the cost is simply shifted to those who remain.

Similar guarantees are made when sales taxes or other fees are pledged to back bonds. Debt service is the first claim to the money. Anything left over is what can be used to run the rest of government. If money falls short, either taxes must be raised or services must be cut.

That is happening in Glendale, which has pledged so much of its sales taxes and other revenues that would normally fund day-to-day operations toward debt payments that bond rating agencies are raising fears the city may not be able to meet all of its obligations.

About a fourth of the money Glendale takes in for general operations goes to pay debt. In addition, the city is paying the National Hockey League $25 million a year to keep the Phoenix Coyotes playing at the arena, built with $180 million in bonds that were supposed to be paid for with stadium rent payments.

But the Coyotes went bankrupt in 2009. Since then, Glendale officials have struggled to keep the team playing there, last year offering to issue $100 million in new bonds to help finance the purchase of the team from the NHL by a private investor. That deal fell through when the Goldwater Institute raised concerns that it would violate state constitutional prohibitions against using public funds to subsidize a private business.

Glendale is paying a heavy price. Last year Moody’s Investors Service downgraded the city’s bonds, citing its high debt burden and “high leverage” of the city’s operating fund that pays for general city services like police and fire protection.

In some instances, bonds issued either directly through Glendale or through special districts created by the city are backed by second and third liens on sales taxes and other revenues normally reserved for operational spending, essentially meaning the same money is being used to back two or three different sets of bonds.

“Of continued concern, Moody’s notes that the amount of debt service supported by the general fund is substantial, reflective of management’s decision to highly leverage the city’s primary operating resources,” the report stated.

Glendale’s debt was downgraded again in January, and the outlook was changed from stable to negative, with Moody’s continuing to raise concerns that so much operating revenue was pledged to repay bonds.

Analysts for the ratings agency warned city officials faced tough choices to deal with the debt:

“The outlook also reflects budgetary pressures over the near-term that may require politically challenging revenue raising measures or cuts to city services,” the most recent report warned.

Diane Goke, chief financial officer for the city, said Glendale has not had to resort to tax increases or cuts in services through the sour economy of the last few years. However, as the council prepares the budget for next fiscal year, “all options are on the table,” she said.

Glendale did commit a large portion of its sales tax revenues to economic development projects, such as the arena and other projects in the area, when times were good, Goke said. When the economy tanked, those revenues declined sharply, creating pressure on the general fund, she said. When the economy was strong, Glendale also set up a fund balance, essentially a reserve account, of $72 million that it has used to bridge gaps as sales taxes have declined, Goke said.

That balance is down to less than $12 million.

“We do face some challenges ahead,” Goke said. “We do have some debt. The council has some really tough decisions to make, but in the past they have made some really tough decisions and done what they need to do. Given what we know now, would we do it all over again? I can’t answer that question. But we do certainly have some challenges ahead of us. We’re going to weather those challenges.”

Rating the Risk

Bond ratings reflect the risk to investors, not the risk to taxpayers, said David Jacobson, a communications strategist in the public finance group at Moody’s. So high ratings mean there is great certainty that the government that issues the bonds will be able to repay them. Part of that equation is the expectation that governments will do what is necessary to make their debt payments, even if it means raising taxes or cutting services, he said. Some governments, including Glendale, commit multiple sources of revenue to a bond issue to drive up the rating.

“We’re not in the prescriptive business,” Jacobson said. “We’re kind of agnostic as to how they do it. If they do it by raising taxes, and it works, that’s fine. If they do it by cutting expenses, that works; or some combination of the two.”

Lower bond ratings raise the city’s cost of borrowing money when it issues new debt and makes those bonds already trading less attractive to investors. In February, Glendale attempted to market $58 million in bonds backed by sales taxes and other general fund revenues. It only managed to sell about $8.7 million.

“The market said ‘look Glendale, you need to get some of your things in order before we’re going to go any farther,’” Goke said.

Glendale has about $1 billion in outstanding bonds.

Pay As You Go

Max Wilson, chairman of the Maricopa County Board of Supervisors, said what is playing out in Glendale and other cities with heavy debt burdens shows why it is dangerous for governments to rely heavily on borrowed money.

“Debt is not free,” Wilson said. “Debt kills you. It’s not good in any economy.”

Maricopa County has had a policy since the mid-1990s of paying up front for capital improvements, such as new buildings, out of the regular operating budgets rather than issuing long-term bonds. That means for the most part if the county does not have the cash, the project does not get built, Wilson said.

The county was teetering on bankruptcy in the early 1990s, said David Smith, who was brought in as county manager to help the board of supervisors dig out of the debt and overspending that had driven it to near ruin. Since then, the board has limited the growth of county government and set money aside every year so it would not have to use bonds for most large construction projects, said Smith, who recently retired.

More than $1 billion worth of capital projects have been financed without issuing debt by Maricopa County. That includes a new $340 million court building, and almost a half-billion dollars in jail improvements that were financed by a quarter-cent per dollar sales tax approved by voters. By paying for the improvements with year-to-year revenue rather than by issuing bonds, the county saved about $350 million over the last 10 years in interest charges, according to county estimates. Paying cash for the new courthouse alone saved about $191 million.

As other levels of government have cut services and raised taxes to cope with the economic downturn, Maricopa County has remained relatively stable and this year reduced property taxes by about $22 million, Wilson said.

“It’s pretty simple economics,” he said. “If you go into debt you are paying more for your money than if you don’t go into debt, and you can do more with your dollars if you do not go into debt. The people are the ones that have to pay for the debt. They’re the ones that elected us and the ones we’re serving. Nothing is accidental when it comes to money. Either you’re good money managers or you’re not.”

Arizona law actually encourages governments to go into debt because it limits how much a local government’s general operations budget can increase from year to year, an attempt to control spending. Maricopa County has issued debt for projects it would have otherwise paid cash for to avoid violating that spending limit, Smith said.

“These laws are blunt instruments,” Smith said.

Maricopa County, where about 60 percent of the state’s population lives, does owe about $134 million in bond debt, most of it left over from old issues. Per-capita debt for county government in Maricopa County is about $35. Pima County, the state’s second largest in terms of population, owes almost $1 billion on outstanding bonds, about $1,016 per person. Five Arizona counties have no debt themselves, though some have created special districts that do owe money. For instance, Yuma County has no bonded debt itself. The Yuma County Library District, technically a separate entity, owes about $48 million on bonds.

Good Debt and Bad Debt

Not all debt is bad, said Scottsdale Mayor Jim Lane. Paying for infrastructure like water and sewer treatment plants that will be used for decades with long-term bonds makes sense, especially when the debt is repaid for through specific revenues such as water and sewer fees.

Scottsdale has about $1.15 billion in outstanding bonds. That works out to about $4,719 per resident, the most of any major Arizona city. About $350 million of that was to pay for water and sewer lines and treatment facilities, Lane said. Another $277 million is owed for nature preserve efforts in the McDowell Mountains, authorized by voters in 1995 and 2004.

“The appropriate use of debt is to build the infrastructure that the city relies upon, whether it’s streets and sidewalks, or it’s water lines and treatment facilities or a public safety building or city hall; any of your hard assets,” Lane said. “You are talking about a long-term asset. You generally match a long-term asset with long-term debt so you have an even matching the useful life of it with a steady stream of income over a longer period of time.”

It is dangerous for governments to commit general operating revenues like sales taxes to long-term debt, said Lane. That is something Scottsdale did in the past.

About two years ago Scottsdale adopted a policy of not obligating sales taxes and other money used for day-to-day operations toward debt, Lane said.

Dollars and Debt

The most definitive source about bonded government debt in Arizona is an annual report by the state Department of Revenue. Cities account for the biggest chunk of the $44 billion in total bonded debt, with about $16.6 billion still owed. State agencies and universities add about $13.7 billion and school districts $4.7 billion. Counties, community colleges and special taxing districts combined add up to about $3.9 billion.

The rest – about $5 billion – comes from what are called “other jurisdictions” because they are stand-alone regional taxing authorities not chartered by another level of government. The bulk of that debt was issued by Salt River Project, a water and power improvement district that owes about $4.4 billion on outstanding bonds.

SRP is a “political subdivision” of the state that operates like a private company. It is treated in state law much like a city, and has the power to tax, acquire private property through eminent domain, and issue tax-free government bonds.

Yet company officials do not view the district as a traditional government, and say the bonds they issue are the responsibility of rate payers, not taxpayers.

“We’ve never considered ourselves an agency of the state,” said Russell Smoldon, senior director of government relations for SRP. “The bonds that we use are revenue bonds that don’t involve any taxpayer dollars. So we’ve always argued we are not subject to the whims and fancies of the government. We don’t typically think of ourselves as (issuing) governmental debt.”

Also in the category of regional authorities are things like the Arizona Sports and Tourism Authority, which financed the University of Phoenix stadium in Glendale and Cactus League baseball parks throughout the state. The sports authority still owes about $291 million.

There are a dozen government entities in Arizona that each owes more than $1 billion in outstanding debt, including cities, universities and state agencies. Almost 50 owe more than $100 million each.

Last year state and local governments paid about $1.6 billion in interest on the bonds they owe. The total interest that has been paid on bonds that are still outstanding is almost $10 billion.

The total outstanding debt being carried by state and local governments in Arizona has doubled since 2003.

The revenue department’s report is a good starting point for figuring government debt. But it does not account for all of the government bonds or obligations that residents and business owners must pay.

Virtually all state and local government entities that have the power to issue bonds are supposed to report their outstanding balance every year. But the Department of Revenue only collects the reports. It does not compel other agencies to file them, and every year some do not.

‘The Big Lie’

Then there is the question of what is debt.

One popular financing mechanism is lease-purchase, an agreement in which a government buys a building or other asset with annual payments and ends up owning it at the end of a certain period of time.

Government officials interviewed by the Goldwater Institute claim lease-purchase contracts are not debt because no long-term bonds are issued and the lease payments are appropriated every year, regardless of the length of the contract. So for instance, the thinking goes, if a city finances a new fire station through a 20-year lease-purchase agreement, it could get out of the obligation by simply stopping the payments and vacating the building.

In theory, since lease-purchase contracts only call for annual payments, they are not multi-year obligations that would qualify as debt.

Reality is far different, said Kevin McCarthy, president of the Arizona Tax Research Association, a non-profit watchdog group that tracks government debt and taxation. First, if a new building was financed through lease-purchase, then the space is presumably needed and moving out of a new facility would be impractical. But even more important, a government agency that backs out of a lease-purchase deal would jeopardize its credit rating on more traditional bond financing, McCarthy said.

“The big lie that is told is that when they write the verbiage to make it an annually renewable lease payment, that it’s not a debt of the city, it’s not a debt of the county or it’s not a debt of the state,” McCarthy said. “The implications of a city or a county walking away from a debt instrument like that are huge. They would never be able to sell another debt instrument on the market for the foreseeable future. So the black mark left on them is pretty significant. You could write it all day long that it’s not a debt and we can walk away from it. But the truth is that it is a debt.”

Lease purchase agreements do have to be reported to the Department of Revenue, but they are tallied separately from other government debt and not counted in the total. The amount owed on those agreements is about $938.6 million.

Industrial Development Authorities (IDAs) are government creations that issue government bonds. But they do not have to report their outstanding balances to the state.

IDA officials insist the billions in government bonds they have issued to benefit private industries and non-profits are not really government debt. The reason, they say, is that bonds are repaid by the private company that ends up receiving the money, not by the IDA which has no taxing authority. Documents used to market the bonds make it clear that if the beneficiary defaults neither the authority nor the city or county that created it is liable for the debt.

So, the thinking goes, IDA bonds are not really government debt, even though they are government bonds issued by a political subdivision of the state.

Officials at most of the IDAs contacted by the Goldwater Institute say they don’t know how much is still owed on the bonds they issued. The state stopped requiring IDAs to report their outstanding debt in 2005. At that time, it was $6.6 billion. Since then, most IDAs have stopped tracking that information.

Some of the larger IDAs were able to provide their current balances, which totaled about $5.3 billion.

Shifting the Debt

Just as there is no clear agreement on what debt is, there is no clear picture as to how many government entities there are in Arizona that have the power to tax and issue debt, or who is responsible if that debt goes bad.

The number of counties, cities and school districts is known. So is the number of state agencies, though accounting for some large issuers of state debt is complicated because of mergers, spinoffs and debt issued by one level of government to benefit another, according to the revenue department report.

But those are not the only entities that can tax and issue debt.

Cities can create municipal property corporations, semi-private non-profit entities with the power to issue bonds for municipal projects. The corporations use the bonds to make capital improvements and then lease them back to the city with annual appropriations, often with a dedicated revenue stream such as water fees.

The City of Phoenix, which has more debt than any single government entity in Arizona, has used its municipal corporations to issue about $5.6 billion in bonds. The city’s total reported debt is $7.2 billion, including corporation bonds.

Technically, the bonds issued by a municipal corporation are not considered debts of the city, according to the revenue department. They normally are not subject to the same legal limits that cities must abide by.

Jeff DeWitt
Jeff DeWitt, Phoenix finance director

Most of the debt issued by the Phoenix property corporation was to pay for improvements in the water and sewer system, and improvements at the airport, said Jeff DeWitt, the city’s finance director.  The corporation is generally used to finance projects that will have a long life and a fixed source of income, such as a water treatment plant paid for through water rates or airport terminal improvements paid by rental fees.

The bonds issued by the corporation are not a debt owed by the city, DeWitt said. If they default, the city is not legally bound to pay them with its general tax revenues. But realistically the city does have to make sure debt is repaid. Bond documents are written to limit the city’s financial exposure if the fees pledged to pay the corporation’s bonds do not generate enough money to make annual debt payments, DeWitt said. But the city could not realistically allow the corporation’s bonds to default, especially on assets like the water system or the airport.

“It’s not a debt of the city,” DeWitt said. “It is a debt of the corporation, but the city is obligated to pay it.”

McCarthy calls municipal property corporations the “ultimate ruse” used by cities to mask their true debt from taxpayers, and to avoid state constitutional requirements for voter approval.

Franchise Debt

Then there are special districts, which have specific powers to tax or issue debt for everything from electrical service and flood control to building amusement parks and providing television service to rural areas.

Arizona law has provisions for at least 40 different types of special districts. Almost all of them have the power to tax and issue debt. Most have the power of eminent domain, meaning they can seize private property for their own use. The Department of Revenue report says there are 587 “known” special districts in the state.  Those districts that did report to the state have issued bonds with a current outstanding balance of almost $1.7 billion, according to the revenue department.

Local governments often use special districts to franchise debt. Some counties, for instance, have separate districts for things like flood control, libraries and jail construction.

Some districts are set up to benefit private interests. Land developers can petition cities to form community facilities districts to pay their infrastructure costs, not just for traditional public services like roads and water lines, but also for things like parks, equestrian trails and jogging paths. The bonds are repaid through property taxes.

Usually the initial debt payments are made by the developer. But as the raw land is developed, the people who buy homes or businesses there pick up the tab. The Parkway district in Prescott Valley that caused Lee so much financial trouble is a community facilities district.

Community facilities districts are considered political subdivisions of the state. They have the power to issue bonds, impose property taxes and condemn property.

Bond documents say the city that creates a community facilities district is not liable for its debt. But some city officials acknowledge they don’t know what could happen if a developer goes bankrupt and district bonds default. General taxpayer revenues could be at risk. At a minimum, allowing a facilities district that is created, staffed and governed by the city to fail could negatively affect investors’ confidence in bonds issued by the city itself, even if there is no legal liability, according to several sources familiar with those bonds. That would lower credit ratings and drive up future borrowing costs for taxpayers.

“If there was a failure, could there be some connection drawn by bond rating agencies to the town’s ability to service debt? There could be. We don’t know,” said Larry Tarkowski, town manager in Prescott Valley, which has seven community facilities districts.

The original developers in three of the Prescott Valley districts went out of business, but new buyers were found to take over two the projects and the debt of the facilities districts before the bonds defaulted, according to town officials. Property owners in the third district were forced to pick up the developer’s share of repaying the bonds.

There are dangers beyond financial obligations with so many special districts that have so much power, said Clint Bolick, vice president for litigation at the Goldwater Institute. The people who run special districts typically are not directly accountable to voters, said Bolick, who wrote about abuses by these quasi-governments in his book Leviathan. Yet they have tremendous power over peoples’ lives.

“We’ve gotten to the point in our society where we’re governed by a multiplicity of governments and we don’t even know who most of them are,” Bolick said. “We have a tradition that government closest to home is the most preferable. These governments are literally in our backyards, and yet we don’t even know they exist, and they are completely insulated from democratic processes or accountability.”

Legal Limits

Arizona’s constitution is supposed to limit the amount of debt the state can incur to no more than $350,000. It also imposes limits on counties, cities and school districts as to how much debt they can issue and how much they can tax.

Click image to enlarge
Rising Debt

But Arizona courts have interpreted that provision to limit only general obligation debt, which pledges the full faith and credit of the issuer for repayment. General obligation debt is usually paid back through property taxes. If debt is paid for through a different source of revenue, then the limits for the most part come off, under court interpretations.

Among the earliest cases was a 1935 decision that allowed universities to issue bonds that were to be repaid by student tuition and fees. In 1969, the state Supreme Court ruled that bonds paid for through highway user fees like gas taxes can be issued without running afoul of the constitutional debt limit.

As a result, the state does not have general obligation debt. It does have about $13.7 billion in other types of debt if universities are included in the total.

General obligation bonds are considered the most stable and least objectionable form of government debt. They are secured by the general taxing power of the district that issues them, which almost always means they are repaid by property taxes.

The reason general obligation bonds are considered so safe, both to investors and to the governments that issue them, is because they amount to the first lien on all of the land within the jurisdiction. Tax rates are set mathematically to generate whatever amount of revenue is necessary to make the annual debt payments. They also require voter approval, which has grown more problematic in recent years.

The amount of total general obligation debt that can be issued by a county, city or school district also is limited based on the total value of the property within the jurisdiction.

Of the $44 billion currently owed on bonds by state and local governments in Arizona, about $11 billion is in general obligation debt, according to the revenue department’s report. That number is skewed because school districts, a major issuer of public debt, have limited ability to issue anything other than general obligation bonds. As a result, all but about $38.2 million of the $4.75 billion in bonds issued by school districts is in the form of general obligation bonds.

Because of the restrictions on general obligation debt, they are more difficult for governments to issue, said McCarthy of the Arizona Tax Research Association. Local governments tend to use general obligation bonds for projects they can easily sell to voters, things like new police or fire stations, parks and libraries. For less popular projects, other types of debt are easier to issue because they bypass the requirements for voter approval and constitutional limits.

“Its intent is to be able to dress up a debt instrument that doesn’t require voter approval,” McCarthy said. “It’s hands down the most pernicious thing that goes on in public finance. The only way taxpayers control government spending is to have a close, direct relationship with government and know what they’re paying for services. If you have a real close link between the amount of taxes people are paying and the taxpayers paying it, and the elected officials spending it, you’re going to have clarity on how much government we want.”

Instruments and Options

There are any number of ways governments can incur debt without calling it debt subject to restrictions in the state constitution. The most common is revenue bonds. They are normally paid back through a specific funding source. That might be sales taxes, water and sewer fees or gasoline taxes that are pledged to repay the debt.

Sometimes revenue bonds are used for traditional public improvements. The Arizona Department of Transportation uses gas taxes and vehicle-registration fees to pay the $2.87 billion it still owes on revenue bonds that were issued to build and maintain the state’s highways.

But revenue bonds are also used for riskier ventures.

In 2005, Phoenix used a municipal property corporation to issue $350 million in revenue bonds to build the 1,000-room Sheraton hotel downtown. The bonds, issued without voter approval, are supposed to be repaid by earnings from the hotel. Some also carry additional security from pledges of other revenue sources, including hotel and car-rental taxes. The bonds secured only with hotel revenues, comprising about $157 million of the issue, are trading at junk status because hotel room charges and occupancy rates have failed to meet expectations. The others have better ratings, and are considered medium investment risks by bond rating agencies.

The negative ratings do not affect the city, said DeWitt, Phoenix’s finance director. The bonds were issued by the non-profit hotel corporation set up by the city, and Phoenix taxpayers are not obligated to repay them out of general revenues. It was made clear to investors that the hotel project was to stand on its own. No city money beyond the limited amounts pledged is at risk, DeWitt said. Unlike water and sewer bonds issued through a different municipal corporation, the hotel is not viewed as a vital service, so there would not be the same kind of pressure on the city to backstop the debt, he said.

“The city has no obligation to step in,” DeWitt said.  “If the revenues of the hotel are insufficient, the city has no obligation to, nor do I believe it would, step in to bail out the senior bond holders of the hotel. It’s a stand-alone credit, solely backed by the revenues of the hotel. It was designed that way so the city would not be at risk in the event that it was not successful.”

Jacobson of Moody’s said investors would not expect the city to help pay the $157 million in bonds secured only by hotel revenues because those were sold as a stand-alone debt. Still, there could be consequences to letting them default, he said.

“If the city walks away from the senior revenue bonds, it may not directly impact the city’s rating, as the city is not expected to backstop the debt,” Jacobson said. “That is not to say that it may not have an indirect effect.”

As to the bonds secured by hotel and car rental taxes, the city is obligated to use those sources as needed to ensure repayment, Jacobson said. As a result, those bonds have a higher rating.

Revenue bonds also are popular for building things like sports arenas. The Arizona Sports and Tourism Authority issued almost $400 million in revenue bonds to finance the University of Phoenix Stadium and other sports venues around the state. It still owes about $291 million.

Revenue bonds are the most popular type of debt among governments in Arizona, accounting for about two-thirds of what is currently owed, according to the state revenue department.

Phoenix has issued more than $1 billion in revenue bonds over the past five years to finance water treatment facilities, including $200 million in unfunded federal mandates requiring the city to add filtration equipment. Water rates in Phoenix have increased sharply in recent years to meet annual principal and interest payments on the bonds.

Exotic Debt

There are even more exotic ways for governments to go into debt. The State of Arizona used most of them two years ago.

State government faced a shortfall of almost $5 billion that bled over two years in January 2010. The deficit for the 2010 fiscal year, already more than half over by then, was about $1.5 billion. At the same time, lawmakers had to grapple with the 2011 budget, which put the state $3.4 billion farther in the hole.

The solution lawmakers came up with was to raise taxes and plunge the state deeper into debt.

More than $1 billion was raised by essentially mortgaging state buildings, using them as collateral to sell certificates of participation to private investors. Similar to lease-purchase agreements, the certificates are sold to investors with the understanding that payments of principal and interest will be appropriated every year for the 20-year life of the deal. That will cost the state more than $85 million per year in lease payments, money that will come from the general operating fund. By the time interest is factored in, it will cost the state about $1.6 billion to repay the billion dollars it borrowed through the certificates.

Technically, the state is not obligated to repay the money, according to documents used to market the certificates of participation to investors. If the Legislature opts not to make the payments, the buildings that were pledged to back the loans could essentially be repossessed and state agencies that use them could be evicted. Therefore, the certificates are not counted as a debt by the state.

Among the assets the state used to secure the certificates are the buildings that house the Legislature, the governor’s office and other executive agencies, the Department of Public Safety and state prisoners.

Even the way the certificates were structured obscured their true cost. The two issues both carried an “original-issue premium,” which essentially allows a government agency issuing a bond to get more money up front with the promise to pay a higher-than-market interest rate.

The face value of the certificates issued by the state when it mortgaged its buildings was almost $999 million. When the original-issue premium is included, the total proceeds from the sale were almost $1.05 billion, a difference of about $47.5 million that the state will have to make up with higher payments during the 20-year life of the debt.

Original-issue premiums were common in the dozens of government bond transactions reviewed by the Goldwater Institute.

Issuing the certificates also was not cheap for the state. It cost almost $11 million in fees, insurance premiums and other costs to sell the certificates on the municipal bond market. That’s money that came off the top before the proceeds of the sale went into the general fund. About $3.9 million of that went to the discounts given to bond underwriters that financed the transactions, essentially the fees that they receive for handling the initial purchase of the certificates which are then sold to other investors.

Aside from mortgaging its buildings through the certificates, lawmakers raised another $450 million by pledging lottery profits for the next 20 years, money that would otherwise have gone into the state’s general operating fund.

They also devised a series of accounting tricks, such as either delaying or simply not making required payments to local schools, universities and agencies that deliver health care and other services to the poor. Those maneuvers add up to about $1.3 billion still owed to local schools and state agencies, according to Ducey, the state treasurer. However, they do not count as debt. Ducey recommends the obligations either be paid or wiped off the books. Instead, lawmakers thus far have simply continued to carry the obligations over from year to year.

The final piece of the budget balancing act was to ask voters to raise sales taxes by one cent per dollar, an 18 percent hike, which they did in May 2010. The tax raises close to a billion dollars annually. But it expires in May 2013, creating what is being called a “financial cliff” the Legislature will have to contend with if the state’s anemic economic recovery continues.

Clark Partridge
Clark Partridge, Arizona state comptroller

Gov. Jan Brewer, who championed the tax increase as necessary to save local schools and universities from deep budget cuts, has said she will not seek its renewal. A coalition of advocacy groups is trying to organize a ballot initiative that would extend the tax.

Once the decision is made to issue debt, it’s tough to get out from under it, even if the money to pay it off becomes available.  Brewer asked that legislation to buy back the capitol be passed in time for the state’s 100th anniversary in February. That didn’t happen.

The state is obligated to pay interest on the bonds for at least 10 years, a mechanism to ensure investors could count on their earnings over the long term, said comptroller Clark Partridge. State officials were advised to put the money into an interest-bearing account that would be used to gradually pay the principal and some of the interest that would accrue over the life of the certificates. That deposit would become collateral for the debt, allowing the lien on the capitol to be cleared.

Positive Cash Flow

The tactics used to balance the budgets came with consequences. Mortgaging state buildings made Arizona the butt of jokes from late-night comics. More importantly, credit agencies responded by downgrading the state’s debt, raising the cost of future borrowing.

Only two states now have a worse credit rating than Arizona.

Moody’s and Standard & Poor’s have both upgraded the state’s outlook from “negative” to “stable” since December. Both credit ratings agencies cited improved state finances and projections that with revenues inching upwards, the state is anticipating a surplus of about $600 million in the current fiscal year.

Treasurer Ducey said Arizona does not have a surplus. It merely has positive cash flow and needs to begin paying down some of its debt. Ducey also wants the state to establish an emergency reserve account so it will not have to resort to new debt and accounting tricks to weather future rough patches in the economy. The Legislature also needs to develop a long-term plan to pay down state debt and publish it on the Internet, Ducey said. It would not bind future legislatures, he said. But it would create political pressure for them to deal with the unpaid balances rather than use money in good times to expand the government.

“The only difficulty about paying down debt at the government level is the temptation from politicians who want to please constituents by spending money on their behalf,” Ducey said. “That’s the only disincentive to paying down debt, and it’s the wrong incentive.”

Arizona’s bond rating, while low among the states, is still considered high quality and safe for investors, said Jacobson of Moody’s. When rating government bonds, Moody’s considers a variety of factors in addition to debt, including the long-term strength of the area’s economy, budget history and debt levels. It also looks at how well a jurisdiction manages its long-term finances, not just how it is doing at any given point in time, he said.

So while state or local governments may use unusual methods of balancing their budgets in any given year, what is important for ratings agencies is whether investors can count on being paid back over the long term, he said.

Risks Rising

Municipal bond defaults remain extremely rare, according to recent studies by Moody’s and other credit rating agencies. The riskiest government debt was used to help finance things like hospitals and low-income housing complexes, both of which make up a large share of the portfolio issued by industrial development authorities in Arizona.

But there have been some high-profile government bankruptcies and dire warnings about the future of the municipal bond market over the past few years. Jefferson County, Ala., filed for bankruptcy last year in large part because it could not repay more than $3 billion in bonds it issued to pay for upgrades to its sewer system. So did Harrisburg, Pennsylvania’s capital, when it could not keep up with payments for a trash incinerator it bought by issuing debt. Stockton, Calif., and Detroit are teetering on the brink of bankruptcy because their debts are deemed unsustainable. In the last couple of years there was speculation that Los Angeles might have to declare bankruptcy to restructure its finances.

Federal law does not allow states to go bankrupt, though there has been some talk in Congress about allowing them to do so.

No local governments in Arizona have declared bankruptcy.

In February, Moody’s maintained a negative outlook for most of the state and local bonds it rates, meaning they faced the likelihood of having their ratings downgraded. It is the fourth year in a row that local debt has been deemed to have a negative outlook, the fifth year in a row for state debt.

Governments in general are under stress because of the overall economy, Moody’s concluded. Some regions, including Arizona, are especially hard-hit because of the collapse of the housing industry.

Another troubling sign from Moody’s is that downgrades of state and local debt significantly outnumber upgrades, an indication of eroding confidence in municipal bonds. The reasons for the gloomy forecast include the nation’s overall struggling economy, sluggish sales and property tax collections, and the fact that many governments have used up most of the reserve funds they built when the economy was strong, according to Moody’s.

As a result, “budgetary tradeoff decisions are getting tougher,” Moody’s noted in its February, 2012, report on local governments.

“Many local governments will be forced to choose between cutting core services, raising taxes, or significantly depleting their remaining financial cushions,” the report says. “Spending priorities and levels that were once considered inflexible are now on the table for cutback.”

The report goes on to warn that “we could see an increase in the number of municipalities that file for bankruptcy, although we still expect this will be a very small number.”

Pension Predicament

As volatile as government bonds are, they are only one part of the debt that state and local governments will eventually have to pay. Governments also face billions more in other shortfalls. But they are harder to calculate than bonded debt, where it is relatively easy to figure how much will have to be paid back at any given time.

As with revenue bonds, lease-purchase, certificates of participation and budget rollovers, those other obligations do not meet the constitutional definition of debt.

The most significant is pensions for government workers.

Most government workers in Arizona pay into one of four state pension plans: one for public safety personnel like police and firefighters; one for regular government workers and teachers; one for corrections officers, and one for judges and elected officials. Phoenix and Tucson also have their own pension plans for general city workers, though both cities use the state retirement funds for public safety employees.

Technically pension plans do not have debt. They do have unfunded obligations. That figure is calculated by taking the current value of each plan’s assets, figuring out how much it will grow in the future as it is invested; then comparing it to the benefits that will have to be paid out to retirees over a given period of time, typically 30 years.

The difference is reported in comprehensive financial reports as unfunded actuarial liabilities.

Officially, the four state pension accounts are underfunded by about $12.5 billion, according to the most recent Comprehensive Annual Financial Reports, which give a snapshot of the funds through the 2011 fiscal year that ended in June.

Other retiree benefits, mainly health insurance premiums the pension funds will pay, add another $769 million in unfunded obligations, for a total of $13.2 billion.

Ducey said more recent figures put the unfunded obligations of the four state pension funds at more than $16 billion.

The combined deficiency of the Phoenix and Tucson pension funds, including post-employment benefits, is about $1.7 billion.

So the total unfunded balance of the six funds is almost $15 billion, according to their own financial reports; $18 billion if the newer numbers cited by Ducey for the four state funds are used.

Government pension funds have come under greater scrutiny in recent years because of the optimistic assumptions used to calculate unfunded liabilities. Because there is no firm figure as to what is owed – as there is with bond debt – pension fund debt is figured using estimates as to how much their current assets can be expected to make through investments in the future. All of the government pension funds in Arizona assume an annual earnings rate of 8 to 9 percent.

Unrealistic Expectations

That is unrealistic, said Byron Schlomach, director of the Goldwater Institute’s Center for Economic Prosperity.

Since the prediction of unfunded liabilities can rise or fall based on the assumptions of how much interest will be earned over the next 30 years, changing the expected earnings rate a few percentage points can alter the predicted revenues by billions of dollars.

Because pension benefits are guaranteed, the rate of return used to calculate the value of current investments should be based on what the market is paying for low risk debt instruments such as treasury bills, Schlomach said.

“You have a highly certain, guaranteed promise to pay people in the future with an extremely uncertain asset base,” Schlomach said. “They have constantly lost ground, year after year, basically since 2000; demonstrably so and pretty extremely so.”

The volatility of the investments made by state pension funds is evident in their earnings history. Over the last 10 years, the average rate of return for the Arizona State Retirement System, the largest public pension fund in the state, is 5.2 percent; not the 8 percent used by fund managers to calculate unfunded obligations. Last fiscal year, it was 24.6 percent. Year-by-year figures show the fund’s earnings over the last decade have varied from last year’s high to a low of losing 18.1 percent in the 2009 fiscal year.

A study published by the Goldwater Institute in 2010 recalculated the reported unfunded obligations of the state’s four pension funds using the rate of return realized on treasury bills. At the time, the pension funds were reporting unfunded liabilities of about $10 billion using the normal rate of investment return of 8 percent annually or more. Applying the U.S. Treasury bond rate increased that unfunded debt to more than $50 billion.

The Governmental Accounting Standards Board (GASB), a private organization partly funded by government which sets financial accounting standards for state and local governments, has proposed new guidelines aimed at forcing a more realistic assessment of unfunded pension liabilities.

Fund shortfalls would be calculated in part by using the yields of high-quality, tax-exempt municipal bonds rather than only the more arbitrary 8 to 9 percent figure used now.

The GASB board is currently reviewing public comments. New rules could be issued in July.

Burden on Taxpayers

In the end, it doesn’t matter whether government debt comes through bonds, certificates of participation, lease-purchase, unfunded pension obligations or accounting tricks. It doesn’t matter whether it is issued directly through a city or county, a municipal property corporation or some other type of special district.

Taxpayers have to pay it back one way or another.

“It is recognized that all debt, regardless of the source of revenue pledged for repayment, represents some sort of cost to taxpayers and ratepayers,” a recent debt management plan published by Glendale reads. “While lease-secured and certificates of participation obligations may not be debt under strict legal definitions, future appropriations are still required if the underlying transaction is to continue.”

For people like George Lee, who lost his buildings in Prescott Valley, the level of government that issued the debt is not what was important. What mattered was that when the economy soured, the taxes he was paying did not leave him flexibility to save his business, and he ended up losing everything he’d worked a lifetime to build.

“The problem is the jurisdiction for those districts, the president of the United States couldn’t change it,” Lee said. “They are unto their own. They are their own law and nobody can touch them.”

>> Read Debt and Taxes: Recommendations for Reform




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