State and Local Governments

Since public capital facilities provide services over a long period of time, it makes financial and economic sense to pay for the facilities over a similarly long period of time. This is particularly true for state and local governments, whose taxpayers lay claim to the benefits from these facilities by dint of residency and relinquish their claim to benefits when they move. Given the demands a market-oriented society places on labor mobility, taxpayers are reluctant to pay today for state and local capital services to be received in the future. The state or local official concerned with satisfying the preferences of constituents may therefore elect to match the timing of the payments to the flow of services, precisely the function served by long-term bond financing. An attempt to pay for capital facilities "up front" is likely to result in a less than optimal rate of public capital formation.

State and local governments are also faced with the necessity of planning their budget one to two years in advance. This requires a balancing of revenue forecasts against forecasts of the demand for services and spending. Not infrequently, unforeseen circumstances can undermine the forecast and cause a revenue shortfall, which must be financed with short-term borrowing, or "notes". In addition, even when the forecasts are met, the timing of expenditures may precede the arrival of revenues, creating the necessity to borrow within an otherwise balanced fiscal year. Finally, temporarily high interest rates that prevail at the time bonds are issued to finance a capital project may induce short-term borrowing in anticipation of a drop in rates.