Replacement Budget Flexibility

The July 2017 edition of Rockefeller Institute of Government’s (RIG) By the Numbers series on state fiscal issues has an especially interesting description of the difficult budget dynamics caused by the time frame of April-May tax revenues and June 30 fiscal-year-end for most states.

The whole thing is worth a read (as ever) but here are the most relevant sections (emphasis mine):

An April income tax shortfall or windfall comes at the worst time of year for three
reasons. First, by the time it is recognized in late April or mid-May, there are just six to
ten weeks before the end of the fiscal year for forty-six states. For states without large
cash balances, April windfalls or shortfalls can create a cash flow crunch or even a cash
flow crisis. There is not enough time to enact and implement new legislation to cut
spending, lay off workers, raise taxes, or otherwise obtain resources sufficient to offset
the lost revenue before the June 30th fiscal year end. As a result, a state without
sufficient cash on hand to pay bills must resort to stopgap measures to “roll” the
problem into the future. For example, states may delay income tax refund payments.
Such actions do not save any money, but they do temporarily avert a cash flow crisis. In
so doing, they increase the budget problem for the fiscal year about to start (by pushing
payment requirements into that year), requiring greater action to close that gap.

This sheds a lot of light on the motivation behind many can-kicking maneuvers. It seems less about conscious political gamesmanship and more related to getting a complex set of numbers to balance in a short period of time – call it ‘bureaucratic expediency’ as opposed to premeditated fiscal mismanagement. I’d guess that most short-term budget-balancing tactics are well-intentioned — and in any case I’m sympathetic to the officials that have to make government work in current economic conditions. Perhaps the bureaucratic aspect of time-pressured tactics also suggests why rainy-day funds don’t get used or expanded as much as you’d expect in the post-2008 world? I could see there might be some additional (and time-consuming) procedural and political hoops to jump through to access a reserve fund, and the fund might be formally or informally restricted to real emergencies or more profound budget shortfalls. If the shortfall is relatively small, unpredictable and has to be dealt with in a hurry, officials might find it easier and effectively more efficient to just quietly kick some maintenance down the road with the sincere intention to make it up later.

Second, an April surprise can have a “double whammy” effect on state revenue in the budget negotiation period. If the shortfall was caused by income that is lower than
had been estimated, then income may be lower in future years, and the state will have
to lower its forecasts for future years as well.[…]

This aspect of the time dynamic – the indications from a bad April surprise about next year’s budget – might explain the choices about which cans to kick. Delaying tax refunds or contractor payments might work for a few weeks or months but not much longer, so repayment has a hard edge in next year’s budget. Deferring maintenance or delaying pension contributions are fuzzier and more forgiving options.

Third, the April income tax shortfalls or windfalls come late not only in the fiscal year but in the budget process too, often as states wrap up their budget negotiations. It takes time for revenue analysts to evaluate the shortfalls or windfalls, and for budget forecasters to revise their forecasts, and for elected officials to come to grips with the magnitude of the new problem they face. The April surprises, whether good or bad, for elected officials can unsettle carefully balanced budget plans already tentatively negotiated.[…]

This kind of negotiation, where after protracted gives-and-takes people are suddenly disappointed or feel they could have got more, is never easy about anything, never mind politically-sensitive spending. The context doesn’t favor careful re-optimization of costs and benefits. Instead, the result is driven by raw power dynamics and horse-trading where the quietest party usually loses. What’s quieter in this sense than infrastructure? Deferred maintenance might indeed cause a lot of life-shortening ‘physical suffering’ to assets, but roads and buildings don’t complain. No surprise they often lose.

I don’t know what a practical solution for the overall April-June budget dilemma might look like. I’m sure that obvious ideas – e.g. just change the fiscal year-end – are equally obvious to public sector officials in the trenches, and they’ve not been pursued for good reasons. And since the RIG report did not mention any discussion of possible overall reform, I’m assuming that nothing is likely to change anytime soon.

So the April-June dilemma can be seen a permanent, highly-specific fiscal constraint in the Value for Funding framework. How much does it matter for infrastructure? I’d guess that a short-term budget scramble actually doesn’t have much effect on decisions to delay major infrastructure investment. These are probably made in the context of “carefully balanced budget plans already tentatively negotiated” by April with respect to longer-term and more predictable constraints like statutory debt capacity, rating agency metrics and overall voter mood.

Not so for deferred maintenance and delayed minor capex. In fact, from RIG’s detailed description, the mechanics of an April-June budget problem almost paint a target on these aspects of infrastructure spending as exactly the type of temporary solution that’s consistent with bureaucratic expediency. These cans may be kicked quickly and quietly as minor adjustments, without apparent immediate impact on the infrastructure itself or any obvious budget metrics, and the affected ‘constituents’ suffer their degraded efficiency and shortened lives in silence.

Obviously the cumulative effect of deferred maintenance and delayed capex is insidiously expensive and dangerously hidden, often emerging from the sub-budget depths only when it’s a serious problem. But in the heat of the budget process, this long-term result is easy enough to forget, especially because the cost of many other last-minute alternatives (failed budget process, skipped pension contribution, etc.) is just as bad or worse.

In the real-world budget environment of time pressure and bad options described in the RIG report, I don’t think that ‘just say no’ is a practical proposal to reduce deferred maintenance and delayed capex. But in effect, this is what P3 availability-payment (AP) proponents are suggesting by pointing out that the third-party AP contractual obligation requires adherence to (and regular payment for) an optimal whole-life maintenance and capex schedule. That’s clearly better in the long run – something I’m pretty sure most public sector officials already know. But if the solution was so simple why wouldn’t they have done it themselves – either as a matter of practice or perhaps by putting maintenance and capex in a restricted fund that was difficult to access for any other purpose? The fact that they haven’t is best explained I think, not by ignorance or political cynicism, but by the idea that the budget process needs some informal flexibility to function in an uncertain world – and the ability to defer some infrastructure spending is among the least bad options to accomplish this.

If this perspective is correct (and I think it’s worth some empirical work to find out), then proposals to keep infrastructure maintenance and capex on a whole-life schedule must include some way to replace the budget flexibility that’s lost by doing so. This is more subtle than it sounds. An effective replacement needs to provide the same features that made deferring maintenance such a ‘bureaucratically-expedient’ option in the first place:

*  Cash is available on short notice and without further procedures if the April/May numbers come up short

* The source of cash is informal (i.e. from delayed spending, not formal indebtedness) but still relatively certain to be there

* The source is outside the scope of formal budget negotiations and can be flexibly applied to last-minute adjustments

* Repayment does not automatically impinge on next year’s budget

The ‘built-in rainy-day financing facility’ (RDF) seems to dovetail into these requirements pretty well, at least on the surface. The basic idea of the RDF is to act as a generalized budget ‘shock absorber’ built into an infrastructure project financing in order to mitigate the effect of long-term fixed commitments in an environment of revenue volatility. But it might work even more precisely to provide replacement flexibility for April-June budget issues if (as should always be the case) deferred maintenance and delayed capex are not allowed in a Public Project Financing:

The RDF revenue index would be tied to the surplus or shortfall of the actual April/May results vs. official forecasts. If a shortfall occurs, scheduled project payments would be automatically reduced for the last payment of the current fiscal year and all but the last for the next. The last scheduled payment could be customized to be much larger than all the others – so a reduction makes a bigger impact for the June 30 numbers. That would free up cash for officials to work with in their efforts to make everything else balance, but it’s not a formal request from a reserve and it’s outside the budget process.

Project costs under the reduced schedule are financed with a built-in line of credit. That will need to amortize per a contractual schedule – no open-ended can-kicking allowed – but repayment via higher project payments won’t start until the end of the next fiscal year. And maybe not even then, if another unexpected shortfall occurs. Beyond two or three years of reduced payments triggered by shortfalls, I think some sort of trend line can be assumed – and so higher expected project payments can be included in the main budget process.

I’m sure there are many devils in all these details. Maybe some other approach would work as well or better. But one thing I remain convinced about – and even more so after reading the latest RIG paper – innovative alternative financing for infrastructure should focus as closely as possible on actual fiscal and budget realities for the US state and local public sector. If the ‘customer’ has a problem, the ‘product’ has to provide a practical solution – or it will simply stay on the shelf.