Dysfunctional or Optimal Institutions

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Dysfunctional or Optimal Institutions?
State Debt Limitations, the Structure of State
and Local Governments, and the Finance of
American Infrastructure

• John Wallis and Barry Weingast

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• Interpreting whether fiscal rules really work is
  bedeviled by endogeniety
• and endogeniety implies that the structure of
  governments and their rules evolve over time in
  response to one another.
• The big question is the effect of the rules on
  outcomes more important than the effect of the
  outcomes on rules?

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Our Bottom Line

• The changing structure of American state and
  local fiscal institutions is, in large part, a
  response to changing constitutional restrictions
  on the way state and local governments borrow.
• The net effect of all these changes is good.

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Subversion

• The ability of governments to subvert the
  spirit and intention of debt restrictions is
  accomplished by shifting government activity to
  different levels of government.
• So subverting debt limits has a direct effect on
  government structure.

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Millions of dollars
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Three Cycles

• 1800 to 1850
• In the 1830s States borrowed and in the 1840s
  states defaulted. States placed procedural
  restrictions on their own debt issue.
• 1850 to 1880
• Local Governments began to borrow, and a wave of
  local defaults in the 1870s led to procedural
  restrictions on local debts.

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• 1880s to 1930s
• State and local governments responded to tighter
  restrictions by creating special governments
• States responded in by making special districts
  strictly responsible for their debts, i.e. by
  restricting their ability to issue full faith and
  credit debt.

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Infrastructure

• The largest share of state and local borrowing is
  to finance infrastructure investment, not to
  finance current budget shortfalls.
• 19th century infrastructure was characterized by
  geographically specific benefits canals,
  railroads, water and sewer systems, and utilities.

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• How does a majoritarian democracy finance
  geographically specific infrastructure when
  taxation is geographically diffuse?
• The simple answer is that it cannot.
• There are four fiscal options

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• Normal taxation
• Something for everyone
• Benefit Taxation (Property taxes and user fees)
• Taxless Finance
• TF typically involves the assumption of a
  contingent liability by taxpayers. If the
  project fails, the taxpayers service the bonds.
• The procedural restrictions imposed in the 1840s
  on state debts were intended to eliminate taxless
  finance, not to eliminate infrastructure
  investment.

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• State procedural restrictions did lower state
  borrowing.
• Between 1841 and 1860, states with debt
  restrictions had 8,000,000 less in total debt
  and 13.26 in per capita debt, at a time when per
  capita income was less than 200.
• States with debt restrictions also increased
  their debts by much smaller amounts during the
  Civil War.

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In a panel of data covering 1870 to 1902

• States with debt restrictions had 5 less debt
  per capita, when average state debt per capita
  was 5.
• Local governments in states with state debt
  restrictions had 2 more local debt per capita,
  when average local debt per capita was 21.
• Local governments in states with local debt
  restrictions had 2.85 less local debt per capita.

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• State and local debt restrictions, particularly
  state restrictions, really worked in the 19th
  century.
• But they had the effect, just as they would in
  the 20th century, of shifting government activity
  to local levels.
• Is this good or bad?

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• First Generation Fiscal Federalism (FGFF)
• Second Generation Fiscal Fedm (SGFF)
• A range of recent work
• Here how to align incentives of political
  officials so they do not saddle citizens with
  huge debts that bought value?

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SGFF Incentive Problems in Debt Finance

• Problems with state finance of local projects.
• Problems of local government debt backed by a
  general government.
• Normative properties of current rules.

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• Under-unappreciated role of debt finance in
  structuring state and local governments.
• The Substitution Hypothesis Explaining the
  shift from 91 statelocal debt to 18
• Some evidence