Rule-Based Financing Versus Political Competition in the Municipal Bond Market

We study the link between the choice of rule-based financing instruments and political competition using the municipal bond market. Cities, counties, and states issue municipal bonds to raise money for public projects. These securities comprise a substantial fraction of the overall American securities market. In 2015, the municipal bond market accounted for $3.7 trillion, roughly 10% of the American public debt. Is the choice of municipal financing instruments driven solely by efficiency factors as in private corporations? At the risk of oversimplification, municipal bonds can be categorized in two main types: general obligation (G.O.) bonds and revenue bonds. These two types of bonds have different contractual characteristics. G.O. pledge to all forms of city finances (including general tax revenues) and their proceeds can be used at the discretion of the elected official. G.O. bond issues must be approved in referenda and, in most jurisdictions, are subject to legislated debt limits (Rugh and Trounstine 2011). In contrast, revenue bond proceeds are earmarked for specific purposes and are backed by specific revenue streams, normally from the investment project they finance. Revenue bond issues do not require approval in referenda and are excluded from debt ceiling calculations. Due to their restricted collateral, however, revenue bonds are more expensive (must pay higher interest rate) than comparable G.O. bonds (Edwards 2008). Therefore, tradeoffs emerge between disbursement discretion, financial cost, and political oversight. For example, by selecting revenue bond financing and accepting the cost of higher bond yields, a politician can self-restrict the scope of her discretion to avoid public scrutiny through a contested referendum and insulate herself from a charge of improper use of public monies