 |  Money and Capital Markets: Financial Institutions and Instruments in a Global Marketplace, 8/e Peter Rose,
Texas A & M University
State and Local Governments in the Financial Markets
Chapter SummaryThe borrowing and spending activities of state and local governments have proven to be
one of the most rapidly growing segments of the financial system and the economy in recent
years.- State and local governments in the United States borrow billions of dollars each year to
fund the construction of public facilities and to supply themselves with working capital
to cover daily operations in providing government services to their citizens.
- The borrowing of these units of government are specially privileged under the U.S.
Constitution and U.S. Treasury Department regulations. Their interest earnings are exempt
from federal income taxation and many states also exempt the interest earnings on
their own debt from state and local taxes. The tax-exemption feature makes these financial
instruments (called municipals) uniquely attractive to investors occupying the highest
tax brackets (including wealthy individuals, banks, and certain insurance firms).
- By the end of the twentieth century state and local government debt outstanding exceeded
a trillion dollars, growing rapidly after World War II and especially during the
1980s and 1990s. Major factors driving local debt growth have been rapid population
and income growth, the upgrading of citizen expectations, and a shifting of responsibility
for funding many local services from the federal government to state and local units
of government.
- Key revenue sources for state and local governments include sales and income taxes,
property taxes, user fees, and funds transfers among governmental units. The largest categories
of state and local government expenditures include education, social services,
transportation services, health services, and construction spending.
- Inadequate revenues, rapid area growth, short-term cash needs, long-term capital investments,
and advance refundings represent major motivations for state and local governments
to borrow money.
- Many different types of securities are issued by states and local governments. Short-term
municipals include tax-anticipation notes (TANs), revenue-anticipation notes
(RANs), and bond-anticipation notes (BANs). Each of these instruments is issued in the
expectation that revenues to pay them off will subsequently appear.
- Long-term security issues include general obligation (GO) bonds and revenue bonds.
The latter depend for their repayment on the revenues generated by a specific municipal
project, such as toll roads, toll bridges, and other revenue-generating ventures. There has
been a tendency in recent years to develop many new types of state and local government
securities such as floaters, securitized bonds, and lottery bonds.
- Among the many significant features of municipal securities are their tax-exempt feature
and their subsidization of high-tax-bracket investors—both of which tend to create a rel-tively
volatile market for municipal securities. State and local obligations are also usually
serialized or broken up into a range of maturities in order to appeal to a wider
variety of potential buyers and minimize the risk of misuse of public funds.
- State and local government securities are generally of high credit quality with low perceived
default risk. However, over the past two decades a few notable failures have appeared,
causing investors at those times to rapidly move their funds to investments of
higher quality (such as U.S. Treasury securities). Recent failures have also spurred the
expanded use of municipal bond insurance even though it slightly lowers a municipal
investor’s expected yield.
- Municipals are generally marketed through security dealers under competitive bidding.
However, there are some signs of taxpayer resistance to the continuing issuance of a
growing volume of state and local debt obligations and the higher taxes that usually follow
their sale to investors in the money and capital markets.
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2003 McGraw-Hill Higher Education