Market-oriented subnational debt regimes: empowering the developing world to construct infrastructure.

AuthorYoung, S. Samuel

ABSTRACT

Globally, as national governments continue to decentralize fiscal and governmental responsibility, the sound facilitation of subnational debt markets will play a critical role in the construction of infrastructure. However, sparse scholarship exploring the optimal legal and financial frameworks for encouraging the construction of infrastructure at the subnational level has left a number of open questions. This Note primarily provides a basic overview of subnational debt trends and policies. It first reviews subnational debt regimes, comparing market-oriented regimes with regimes with varying levels of involvement by central governments. Though not always possible, the Note concludes that market-driven incentives generally produce the best subnational debt regimes. Though it has faced some struggles historically, as the largest and most liquid subnational debt market in the world, the United States' municipal bond framework can provide a useful model. The Note then presents a market-oriented proposal for U.S. policy makers. By extending tax-exempt status to the public debt instruments of select subnational entities abroad, the United States could provide a promising investment opportunity for U.S. financial institutions and citizens, facilitate the construction of infrastructure in some of the most desperate areas of the world, and encourage sound international municipal finance practices through the extension of a largely self-regulated system. This market-enabling tax exemption could prove to be far more effective than any sort of direct spending. Finally, the Note argues that a fluid and competitive subnational debt market in developing countries is in the best interest of both investors and humanitarians alike.

TABLE OF CONTENTS I. INTRODUCTION II. DEVELOPING FINANCIAL CHALLENGES FACING THE WORLD'S LOCAL GOVERNMENTS A. Fiscal Decentralization and the Growing Responsibilities of Local Governments III. SUBNATIONAL FINANCIAL MANAGEMENT AND DEBT MARKETS A. The Importance of Sound Municipal Money Management Principles B. What Is a Municipal Infrastructure Investment? C. The Advantages, Disadvantages, and General Categories of Municipal Borrowing D. Bond Market Basics: The Cornerstone of Sound Subnational Debt IV. SUBNATIONAL DEBT MARKETS IN THE UNITED STATES A. Regulatory History of Subnational Debt in the United States B. Notable Subnational Finance Innovations in the United States 1. The Revenue Bond 2. The Bond Bank V. SUBNATIONAL BORROWING IN THE DEVELOPING WORLD A. The Spectrum of Broad Control Regimes for Subnational Debt Markets 1. Monopolistic Subnational Debt Markets 2. Mixed Subnational Debt Markets 3. Competitive Subnational Debt Markets B. Growing Pains in Mexico VI. SUGGESTED GUIDELINES OF SOUND SUBNATIONAL FINANCE A. National Regulation B. Sound Internal Fiscal Policies Within Subnational Entities and Debt Instruments C. The Borrower-Lender Relationship in Case of Default VII. A MARKET-ORIENTED FOREIGN AID PROPOSAL: EXTENDING THE U.S. MUNICIPAL BOND EXEMPTION VIII. CONCLUSION I. INTRODUCTION

The world's population is not only growing, (1) but it is also urbanizing at record levels." (2) In writing the foreword for the 2005 Annual Report of the Cities Alliance, Jeffrey Sachs stated that "too many cities in the developing world are failing to thrive .... [C]ities in low-income and middle-income countries need to draw up bold, long-term strategies for [infrastructure] investments." (3) As national governments worldwide decentralize responsibility for infrastructure investment, the burden is largely falling on subnational governments (4) to finance and construct adequate infrastructure to keep pace with their rapidly urbanizing populations. (5)

Though, as this Note argues, a liquid, transparent, and competitive subnational debt market that matches those with savings to those with capital needs is crucial to building infrastructure, especially in the developing world, the financial and regulatory background is usually tragically absent. (6) Because there has been so little scholarship in the area, questions remain as to what the most efficient legal and financial frameworks are to facilitate a sound subnational debt market. (7) However, the burdens that local governments are facing are increasing worldwide nearly universally, (8) meaning that scholarship exploring these issues and adding perspectives is sorely needed.

The peculiar federal structure of the U.S. government has led it to develop one of the most decentralized and market-oriented subnational debt regimes in the world in the form of its municipal bond market. (9) The United States began with a largely decentralized system. (10) Though the U.S. subnational debt regime has endured notable scandals and market struggles, (11) it remains the largest market of its kind in the world. (12) Most applicable to the world's decentralizing governments are the peculiars of the U.S. regime that have enabled the U.S. subnational debt market to become strong, as the real risks in the U.S. system have historically been born by investors and local governments rather than by the country as a whole. (13) Though at times direct involvement by a central government is necessary and efficient, this Note argues that the market-oriented and decentralized U.S. model, with informational and antifraud regulatory oversight, is ideal in many circumstances. (14)

The primary way in which the U.S. federal government has facilitated subnational borrowing without debt guarantees or direct involvement is through an extreme "hands off" approach of merely exempting the interest payments that state and local governments pay on municipal debt from federal income taxation. (15) In other words, the purchasers of state and local debt do not have to pay federal taxes on the interest they received from their investment. (16) This tax-exemption system is largely an accident of the federalist system found in the U.S. Constitution and the expansive power given to its states under the Tenth Amendment. (17) In fact, it was not until the 1988 Supreme Court case of South Carolina v. Baker, that it was even considered constitutional for the federal government to tax state and local debt. (18) This federal anomaly has allowed state and local governments, as well as other tax-exempt entities that the federal government lumped into the tax-exempt category for policy reasons, to have a much lower cost of capital than private entities with comparable credit ratings, as evidenced by Table 1, below.

As a corollary to the subnational regulatory regimes that this Note advocates, the Note also advocates for a specific market-oriented policy proposal for the United States. Encouraging private U.S. investment by selectively extending the tax-exemption given to U.S. state and local governments would not only be far more effective than direct spending, but it would also encourage long-lasting change. (20) As the Note argues in Part VII, such a policy could provide a promising investment opportunity for U.S. financial institutions and citizens, facilitate the construction of infrastructure in some of the most desperate areas of the world, and encourage sound municipal finance within the entities that were chosen to receive the exemption.

In advocating for open and competitive subnational markets, Part II of this Note discusses challenges facing local governments in modernizing cities, and Part III reviews the basics of subnational debt finance. Part IV discusses the regulatory evolution and financial innovations of the U.S. market. Part V then details varying categories of subnational debt regimes and discusses the growing pains faced by one developing nation, Mexico. Part VI makes policy recommendations to facilitate efficient subnational financing in transition economies. Finally, Part VII of this Note advocates for a selective extension of the U.S. municipal bond tax exemption to facilitate U.S. private investment in developing subnational markets.

  1. DEVELOPING FINANCIAL CHALLENGES FACING THE WORLD'S LOCAL GOVERNMENTS

    Local governments around the world face the challenge of keeping cities economically viable by delivering a sufficient level of services while simultaneously keeping taxes low enough so as not to thwart economic growth. (21) Complicating the matter is the fact that, over the past fifty years, urban populations have been increasing at a record pace. (22) By the year 2050, the urban population in developed nations is expected to reach 1.07 billion people, or 86 percent of the total population in those nations; while in the less developed nations, urban dwellers are projected to increase to 5.3 billion people, or 67 percent of the total population. (23) Altogether, the world's urban population is expected to grow to encompass 70 percent of the world's population. (24) For example, Table 2 illustrates the urbanization of India:

    The most alarming statistic in regard to infrastructure investment, however, is that the urban population is expected to

    triple in Africa and double in Asia by the year 2050. (26) Currently, 50 percent of urban residents in Asia and Africa lack adequate water and 60 percent lack adequate sanitation. (27) In Latin America and the Caribbean, 30 percent of the urban population currently lacks adequate water and 40 percent of the urban population lacks proper sanitation. (28) In total, an estimated 840 million people currently live in city slums worldwide. (29)

    A. Fiscal Decentralization and the Growing Responsibilities of Local Governments

    In response to the urban boom, over the last twenty years a number of countries have increased the powers and responsibilities of local governments. (30) The basic transfer of financial responsibilities from central governments to local governments is called fiscal decentralization. (31) Several policy rationales justify the decentralization movement, from democratic principles of local autonomy to a necessary...

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