THE EFFECT OF A CAPITAL BUDGET ON CAPITAL SPENDING IN THE U.S. STATES

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1 THE EFFECT OF A CAPITAL BUDGET ON CAPITAL SPENDING IN THE U.S. STATES Mara Plotnkova Thess submtted to the faculty of the Vrgna Polytechnc Insttute and State Unversty n partal fulfllment of the requrements for the degree of Master of Publc and Internatonal Affars Dr. Dane Zahm, Char Dr. Rchard Zody Dr. Max Stephenson February 28, 2005 Blacksburg, VA Keywords: captal budget, state spendng, state budgetng practces

2 THE EFFECT OF A CAPITAL BUDGET ON CAPITAL SPENDING IN THE U.S. STATES Mara Plotnkova ABSTRACT Ths thess analyzes the mpact of captal budget on captal spendng n the U.S. states. The analyss s based on the James Poterba's 1995 study of the mpact of a captal budget on captal spendng usng 1962 U.S. state-level data. I frst replcate Poterba's model usng the data set that I had constructed for ths study. I then extend Poterba's model to nclude a set of varables that allows exploraton of the specfc effects of the regulatory envronment on spendng outcomes n each state. These are manly categorcal varables that classfy states n accordance wth ther defnton of captal expendture, organzaton of captal plannng process, project selecton and cost estmatng technques and captal fnancng practces. I constructed these varables usng the data of the 1997 NASBO survey after revewng the suggestons of practtoners and polcy makers, as well as those engaged n research n ths feld. The ntroducton of a set of budget rule/budget composton varables nto the analyss s an mportant contrbuton of ths study. Ths study supports the clam that government spendng s determned by a host of causal factors that can be grouped nto four broad categores, (1) demographceconomc factors, representng both demand for publc captal and source of ts fnancng, (2) poltcal decson-makng factors that reflect electorate/party n power preferences for spendng, (3) captal stock varables that relate to the age of nfrastructure and control for spendng culture n a state, and (4) budget composton/spendng rules. The man fndng of ths study s the confrmaton of Poterba (1995) fndng wth respect to the postve effect of captal budget on captal spendng usng a recent data set and longer tme frame of analyss. Another major contrbuton of ths study s a statstcally sgnfcant effect of sxteen spendng rule/ budget composton varables. The results support the basc premse found n the lterature that budget process affects captal spendng.

3 Acknowledgements I would lke to thank my advsor, Dr. Dane Zahm and my Thess Commttee members, Dr. Max Stephenson and Dr. Rchard Zody for ther gudance n the course of ths work. I would also lke to express my enormous grattude to Fran and Gene Carson who made t possble for me to start my academc career at Vrgna Tech. Through ther altrustc effort to brng nternatonal undergraduate students to Vrgna Tech they had set a hgh example of dedcated servce to nternatonal educaton and nternatonal understandng. I would also lke to thank the Blacksburg communty and the people assocated wth the RADVA Corporaton n Radford, VA who have been a source of support throughout my study at Vrgna Tech.

4 Table of Contents LIST OF FIGURES LIST OF TABLES page CHAPTER 1: INTRODUCTION 1 CHAPTER 2: LITERATURE REVIEW The Ratonale for a Captal Budget Understandng Captal Budgetng The Poterba (1995) Model 7 CHAPTER 3: METHODOLOGY Study Varables Dependent Varable - Captal Spendng Explanatory Varables The Captal Budget Control Varables REGRESSION ANALYSIS Models Employed n the Analyss 27 CHAPTER 4: STUDY RESULTS Regresson Results The Effect of Captal Budget Effects of the Control Varables Effect of Demographc and Economc Varables Effect of Captal Stock Varables Effect of Poltcal Control Varables Effect of Captal Budget Composton and Spendng Rules Varables Comparson wth Poterba's (1995) Results 40 CHAPTER 5: CONCLUSION AND RECOMMENDATIONS FOR FUTURE RESEARCH 43 REFERENCES 47 VITA 51 V V v

5 Lst of Fgures page Fgure 1. Rato of Captal Spendng to GSP, , Contnental U.S. States 14 Lst of Tables page Table 1. Varables Used n the Analyss and Ther Expected Effects 10 Table 2. Demographc and Economc Varables: Averages for 48 U.S. States, Table 3. The Basc Model 31 Table 4. The Model wth Captal Stock Varables 32 Table 5. The Model wth Poltcal Preference Varables 33 Table 6. The Model wth Poltcal Preference and Captal Stock Varables 34 Table 7. The Model wth Poltcal Preference, Captal Stock and Budget Varables 35 v

6 THE EFFECT OF A CAPITAL BUDGET ON CAPITAL SPENDING IN THE U.S. STATES Chapter 1: Introducton Ths thess analyzes a relatonshp between a captal budget and captal spendng. Presently the mpact of a captal budget remans an unanswered queston. The lterature on captal budgetng n the publc sector ncludes a number of qualtatve analyses and case studes, but there s a relatve dearth of emprcal work that would determne whether and how the exstence of captal budget affects captal spendng. Many studes (Hush and Peroff, 1988, Thomassen 1990, Natonal Assocaton of State Budget Offcers, 1997) have noted that state governments vary sgnfcantly n ther al practces of budgetng and ther relatve spendng levels and therefore provde a natural laboratory for studyng relatonshps between budgetary practces and polcy outcomes. Ths thess addresses both of these ssues: t ncorporates the dfferences n captal budgetng practces nto the analyss and t contrbutes to the quanttatve lterature on the effects of these practces. The thess s based on a semnal study by Poterba (1995) that analyzed the relatonshp between the level of state captal expendture and the use of captal versus operatng budgets for the year Poterba's central hypothess confrmed by hs fndngs s that the very exstence of captal budget postvely affects non-hghway captal spendng by U.S. states. Ths study frst replcates Poterba's model and then offers a number of mportant extensons of that approach. The most obvous lmtaton of Poterba's model s hs use of crosssectonal data for hs study year. Captal expendtures may vary from year to year because of contngences (one-tme bg expendtures, or natural dsaster relef) or poltcal factors such as a re-electon campagn. Ths "nose" may dstort the underlyng relatonshp between the captal budget and captal spendng. 1

7 My data set ncludes the perod Replcatng the results of an earler study usng a recent data set provdes a robustness check for the valdty of the prevous study s assertons. The panel data also allow me to verfy whether Poterba s results are consstent when consdered over several years, nstead of just at a fxed pont n tme. In addton to usng panel as opposed to cross-sectonal data, I extend Poterba's model to nclude a set of varables that allows exploraton of the specfc effects of the regulatory envronment on spendng outcomes n each state. These are manly categorcal varables that classfy states n accordance wth ther defnton of captal expendture, organzaton of captal plannng process, project selecton and cost estmatng technques and captal fnancng practces. I also ntroduce addtonal control varables used n the studes descrbed n the lterature revew. The remander of ths study s organzed as follows: Chapter 2 s devoted to a revew of the relevant lterature. Chapter 3 ntroduces the dfferent varables that can affect captal spendng and sets up the emprcal regresson models. The results of the regresson are presented n Chapter 4, ncludng a comparson wth Poterba's 1962 results. I also ndcate the lmtatons of ths study and conclude wth suggestons for further research. 2

8 Chapter 2: Lterature Revew 2.1 The Ratonale for a Captal Budget Separaton of captal and operatng budgets has been a contentous ssue and dates back to the early work of Rchard Musgrave (1939) who argued n favor of separaton. The often-cted argument for nsttutng a captal budget (Kng, 1995, Darr, 1998, Poterba, 1996) s that nsttutng a separate budget provdes for greater transparency n such spendng allocatons. Ths transparency n turn results n more effcent allocaton of resources and greater effectveness of captal spendng. Another argument espoused by proponents of a captal budget s that t leads to ncreased captal spendng (Aschauer, 1989, 1990, Gramlch, 1990). Implct n ths argument s the assumpton that more captal s better, whch n turn s grounded n dfferent theores of economc growth. The Keynesan School of economcs suggests that publc captal has a multpler effect on prvate output. The Neo-Classcal school of thought vews captal - both publc and prvate - as elements n the producton functon for economc output. In ths vew publc captal s complementary to prvate captal. Emprcal work by Aschauer (1989) has demonstrated the postve lnk between aggregate productvty and nfrastructure nvestment for the U.S. and several other countres. At the same tme, as Button (1998) ponts out, the drecton of causalty n the relatonshp between economc performance and publc nfrastructure has not been suffcently analyzed,.e., t s not obvous whether nfrastructure enhances output (neo-classcal) or greater output leads to greater nfrastructure provson (Keynesan) whch then has a multpler effect on the output. A related argument states that publc captal can be seen as a strategc polcy tool n the hands of the government to provde thrusts to dfferent sectors of the economy. For example, constructon of the nterstate system gave a bg boost to the automoble ndustry. Consequently, such growth theorsts would vew a captal budget as a necessty. 3

9 Ths argument s renforced by clams that, beng a publc good and necessary for producton of output, publc captal may be underprovded f left to the prvate sector. Peterson (1990), among others, has argued that nfrastructure s under-suppled. One of the arguments used to support ths clam s a hgh (80%) rate of approval of captal nvestment bond referenda. In other words taxpayers/consumers are often wllng to buy more nfrastructure captal than has been provded by publc authortes. Thus, contrary to the arguments gven earler, unmet consumer demand s posted as the cause of ncreased captal spendng. Ths has led researchers to examne whether publc captal ndeed s under-provded n comparson to ts demand. Gramlch (1994) provdes an account of methods to evaluate whether nfrastructure s undersuppled (engneerng assessments of nfrastructure needs, poltcal measures based on votng outcomes, economc measures of rates of return, econometrc estmates of productvty mpacts). The evdence wth respect to under-provson s not conclusve. However, the author ponts out that " at any gven tme there could well be, or have been, shortages of partcular types of nfrastructure captal" (Gramlch, 1994, pg. 1185). However, a number of scholars have also argued aganst the posted relatonshp between the captal budget and captal spendng. Crtcs of the captal budget contend that t s not an effectve nstrument. They argue that t does not lead to greater allocaton of funds dedcated to captal spendng, nor does t mprove the effcency of the budgetary allocaton process. Consequently, a captal budget does not help n makng better decsons. Ths (pessmstc) vew has been expressed n the qualtatve research of Henry Thomassen (1990): "States today use only captal lstngs; they have no bona fde captal budgets wth revenues and costs that can be evaluated n a comprehensve framework to ad decson-makng." Fnally, stll others contend that havng a captal budget s bad because t shfts the emphass n state spendng from more mportant sectors lke health and educaton. Qute asde from normatve arguments concernng the desrablty of captal budgets, nsttutonal economcs suggests that nsttutons such as budget agences have real effects on the economy. What are the venues through whch a captal budget can have allocatve effects on captal spendng? Conybeare (1984) ponts out that adopton of a captal budget s generally accompaned by the creaton of an organzaton or an admnstratve agency to oversee the 4

10 captal budget process. Ths agency becomes, n effect, a lobbyng group for captal spendng. A number of other such arguments have also been proposed. The captal budget can also become a facltatng venue for pro-captal nterest groups at large (Poterba, 1995). 2.2 Understandng Captal Budgetng In recent years a number of studes have specfcally addressed the relatonshp between budgetary procedures and outcomes usng quanttatve tools. They dd not specfcally address captal spendng; nevertheless, the models developed n these studes provded a contextual foundaton for ths research. Holtz-Eakn, Rosen and Tlly (1994) provde a theoretcal foundaton and an mportant motvaton for emprcal studes such as ths one. The authors tested the permanent ncome hypothess for state and local governments. When appled to the U.S. states, ths means that state spendng patterns reflect total or long-term resources avalable to the state. They reject the permanent ncome hypothess by fndng that state and local spendng s determned by current as opposed to long-term resources. Ths result suggests that current sources of ncome are a crtcal varable n explanng state spendng. Cran and Mller (1990) explored the relatonshp between state legslatve budget agences and state spendng growth for the years They found that the lne-tem veto, budget bll format, and other legslatve rules affected spendng growth rates. Cran and Cran (1998) establshed that a current servces budget baselne ncreased state spendng for In a smlar ven, Cran and Oakley (1995) explored the effects of procedural and poltcal factors such as bennal budget cycle, gubernatoral term lmts, state bond ratng, and separate captal budget on state government captal stock for They found that states wth unlmted gubernatoral terms have lower stocks of publc captal, separate captal budgets are negatvely related to publc captal stock and better bond ratngs are postvely related to publc captal stocks. Alt and Lowry (1994) have analyzed a related queston. They examned the relatonshp between state spendng and a host of varables reflectng the structure of the government. They 5

11 found that varous forms of dvded government, such as party-splt branch and party-splt legslature affect state spendng. Whle unfed governments are quck to adjust spendng to (revenue) changes, dvded governments tend to make smaller adjustments, and to do so more slowly. Bohn and Inman (1996) nvestgated the effect of state Consttutonal mtatons on state defcts. Consttutonal lmtatons nclude balanced budget rules, the lne tem veto and debtssue restrctons. They found that balanced budget rules, when appled to an end-of-year General Fund balance, reduced the extent of defcts. They also found that long-term restrctons dscourage captal spendng and publc debt. Fnally, ther study s unque wth respect to ts scope as t looked at a comparatvely large number of agency structure and procedural varables. A number of studes (Clngermayer and Wood, 1995, Kewert and Szakaly, 1996) have analyzed the effect of poltcal nstruments and budget structure on state debt. A prmary ratonale for ncurrng debt s that when benefts from a project extend far nto the future, the future benefcares of the project should also help to pay for those benefts. Hence t s justfable to borrow funds that future benefcares can help to repay. Moreover, current taxpayers may be unwllng to pay for future benefts that they wll not enjoy. Snce benefts of captal projects extend nto the future, captal tems are often purchased wth debt. Hence the fndngs of studes of state debt are especally mportant for ths research. Usng tme seres data, Clngermayer and Wood (1995) have analyzed the patterns n state ndebtedness used to fnance the provson of long-lastng nfrastructure. They found that tax, expendture and debt lmtatons do not sgnfcantly alter the growth of debt, and suggested that state governments were not mmune to the so-called "debt-culture" prevalng at the natonal level. Kewert and Szakaly (1996) analyzed the effect of consttutonal lmtatons on state borrowng. They found that a number of lmtatons such as publc referendum approval requrements are effectve n constranng state debt. Two studes have drectly analyzed captal spendng: Holtz-Eakn (1988), and Poterba (1995). Holtz-Eakn, (1988) examned the effects of the gubernatoral lne tem veto on several categores of state revenues and expendtures ncludng captal expendtures. The results of hs study ndcate that the lne tem veto does not lmt the average level of state expendtures. In the short run, however, the lne tem veto may affect spendng contngent upon the poltcal settng, 6

12 .e. when governors face a legslature controlled by the rval poltcal party. In such stuatons captal outlays tend to be reduced under Republcan governors. Poterba (1995) analyzed the relatonshp between the level of state captal expendtures and the use of captal versus operatng budgets n Snce the model used n ths study frst replcates and then extends Poterba s (1995) model, hs study s descrbed n some detal below The Poterba (1995) Model Poterba s central hypothess s that a captal budget has a postve effect on captal spendng. Poterba also hypotheszed that the practce of borrowng s assocated wth a hgher level of nvestment, and the no-borrowng rule wth a lower level of nvestment. Poterba s model s a cross-secton regresson of non-hghway per-capta captal expendture on a dchotomous varable for captal budget, a dchotomous varable ndcatng borrowng funds to fnance captal projects, and a set of control varables reflectng state-specfc demographc and economc characterstcs. Poterba also ncluded dchotomous control varables for a Republcan-controlled Congress, Senate and gubernatoral ncumbent, as well as the percent of the popular vote for presdental canddate Barry Goldwater, who was the Republcan Party Presdental nomnee n These varables were amed at capturng dfferences n spendng preferences along party lnes. Poterba suggested that the very exstence of a captal budget postvely affects captal spendng. He defned a captal budget as an nvestment plan that specfes nvestment amounts and targets. The hgher the level of nvestment, the greater the need for a captal budget n order to coordnate and smplfy the nvestment process. He also suggested that these varables are possbly endogenously determned. Ths endogenety s corrected for by usng an nstrumental varable for whether the captal budget exsted n The captal budget and borrowng rules data used n Poterba s study was taken from a survey of captal budgetng practces n 1962 conducted by Hllhouse and Howard n The 1962 captal outlay data used n Poterba s study came from the Compendum of State 7

13 Government Fnances produced by the U.S. Department of Commerce. Demographc data for 1962 was taken from the annual Statstcal Abstract of the Unted States. Poterba found a statstcally sgnfcant postve effect of a captal budget on captal spendng, and a sgnfcant negatve effect of a no-borrowng rule. Other statstcally sgnfcant fndngs nclude a negatve effect of per-capta ncome, and a postve effect of federal grants per capta on state captal spendng. 8

14 Chapter 3: Methodology Ths chapter descrbes the dependent varable and all the dfferent explanatory varables used n the study. I start wth the economc and demographc varables, and utlze a large number of ndcator varables to capture the poltcal culture as well as budgetary agences and procedures n the states. Ths s followed by a bref dscusson of the data set and the dfferent regresson models used n the study. Whle, as noted, I begn wth the basc model suggested by Poterba (1995), I augment t by ncludng varables accountng for budget composton and practces to postulate more detaled models than that offered by Poterba. Chapter 4 begns wth the results of the fve dfferent regresson models, followed by a comparson wth Poterba's fndngs. 3.1 Study Varables Ths secton ntroduces the varables and the data used n the analyss. I construct a data set smlar to that of Poterba (1995). The demographc and per-capta ncome data and data on captal outlay and ntergovernmental revenue for are from the U.S. Statstcal Abstract and the Bureau of the Census. Per-capta ncome was adjusted for nflaton by multplyng each annual fgure by the respectve Consumer Prce Indces. Data for each of the years was adjusted to the level of Smlar adjustments were performed for the captal outlay and the ntergovernmental revenue annual fgures. Captal outlay was adjusted usng the government ndex for captal goods and ntergovernmental revenue was adjusted usng the general Government Purchases Index. Smlar to other studes of U.S. states, the varables used n the analyss are n per-capta terms. The budget composton varables and varables accountng for spendng practces were constructed usng data from the survey of state budgetary practces conducted by the Natonal Assocaton of State Budget Offcers (NASBO) and publshed n The am of the survey was to comple nformaton about each state s captal budgetng practces and contrbute towards establshng a set of recommended practces n captal budgetng. The bnary (yes/no) responses of the survey are coded as dchotomous varables. 9

15 Table 1 lsts the varables and ther expected effects. Each s descrbed n greater detal n the sectons below. Table 1. Varables Used n the Analyss and ther Expected Effects (Dependent Varable: Per-Capta Captal Spendng) Independent Varable Expected Effect Captal Budget + or - Net n-mgraton + Metropoltan area - Populaton under 18 + Populaton over 65 + Personal ncome + or - Homeowners + Intergovernmental revenue + Populaton Densty + or - Control for annual effects - Control for regonal effects + or - Government Captal Stock + or - Descrpton/type of varable Dchotomous varable: captal budget=1 Contnuous: % of populaton Contnuous: % of area Contnuous: % of populaton Contnuous: % of populaton Contnuous: $ per capta Source/other studes usng the varable Poterba 1995, Cran and Oakley 1995 Poterba 1995 Poterba 1995 Poterba 1995; Cran & Cran 1998 Poterba 1995 Poterba 1995, Holtz- Eakn 1988, Clngenmayer and Wood 1995, Alt and Lowry 1994 Contnuous: % of households Poterba 1995 Contnuous: $ per capta Contnuous: persons/sq. mle Dchotomous varable for 1993, 1994, 1995 Dchotomous varable for West, North-East, South Contnuous: $ per capta Poterba 1995, Holtz- Eakn 1988, Clngenmayer and Wood 1995, Alt and Lowry 1994 Poterba 1995 Poterba 1995 Cran and Oakley

16 Table 1. Varables Used n the Analyss and ther Expected Effects (Dependent Varable: Per-Capta Captal Spendng) Independent Varable Rato of publc to prvate captal stock Government Debt Stock % vote for democratc presdent n 1996 Expected Effect + or - + Descrpton/type of varable Contnuous: $ per capta Contnuous: $ per capta Source/other studes usng the varable Cran and Oakley 1995 Holtz-Eakn, or - Contnuous Poterba 1995 % of democrats n the House + or - Contnuous Poterba 1995 % democrats n the Senate + or - Contnuous Poterba 1995 Governor party afflaton + or - System to prortze nvestment projects Exstence of mechansm for settng asde funds to preserve facltes Excluson of mantenance from the captal budget Avalablty of other mechansms for allocatng mantenance. Treatment of long-term leases as operatng versus captal expense Exstence of lease versus own polcy Incluson of educaton and hosptals n the captal budget Mnmum expendture requrement for ncluson n the captal budget Dchotomous: 1=Democrat Holtz-Eakn 1988, Alt and Lowry Dchotomous NASBO survey, Dchotomous NASBO survey, Dchotomous NASBO survey, Dchotomous NASBO survey, Dchotomous NASBO survey, or - Dchotomous NASBO survey, Dchotomous NASBO survey, Dchotomous NASBO survey, 1997 Jont boards for captal revew - Dchotomous NASBO survey, 1997 Sngle state agency to oversee and manage projects Multple versus sngle entty requests for fundng Exstence of wrtten gudelnes for use of bonds versus cash + Dchotomous NASBO survey, Dchotomous NASBO survey, Dchotomous NASBO survey,

17 Table 1. Varables Used n the Analyss and ther Expected Effects (Dependent Varable: Per-Capta Captal Spendng) Independent Varable Legslatve approval as prmary determnant to usng bonds versus cash Comparson of debt servce to revenues and expendtures Expected Effect Descrpton/type of varable Source/other studes usng the varable - Dchotomous NASBO survey, Dchotomous NASBO survey, 1997 Exstence of nventory data base + or - Dchotomous NASBO survey, 1997 Number of cost-estmatng methods for captal expendture Exstence of polcy to lmt debt servce, such as balanced budget rules - Categorcal NASBO survey, Dchotomous Bond ratngs + or - Categorcal Use of Treasury loans for project fnancng Determnants of the extent of general fund use for project fnancng NASBO survey 1997; Clngenmayer and Wood 1995 NASBO survey 1997, Cran and Oakley 1995, Clngenmayer and Wood Dchotomous NASBO survey, Dchotomous NASBO survey, 1997 Prvate sector partcpaton - Dchotomous NASBO survey, 1997 Avalablty of alternatve fnancng - Dchotomous NASBO survey, 1997 User fee fnancng - Dchotomous NASBO survey, 1997 User-pad debt servce - Dchotomous NASBO survey, 1997 Provson for nterm project fnancng + Dchotomous NASBO survey,

18 3.2 Dependent Varable - Captal Spendng A startng pont for ths analyss s a closer look at the dependent varable. I wll begn by descrbng the captal spendng trends that are common to all states. Captal spendng comprsed a larger porton of the GNP n the 1960s, the tme analyzed n Poterba's study, than at present. The Natonal Councl on Publc Works Improvement (1988) reported a drop n publc works captal outlays by all levels of government from 2.5% of GNP n 1963 to 1 % n The calculaton for the state data used n ths research appears to confrm the decreasng trend. 1 The rato of state captal spendng to gross state product has been steadly decreasng from 0.19% n 1992 to 0.17% n 1996 (see Graph 1 n the Appendx). Rubn (1990), who descrbes fscal trends n state and local governments, suggests that lower captal spendng can be partly explaned by lower revenues - lower tax collectons n late 1980s and early 1990s and federal cutbacks throughout the 1980s. She also notes that when states experence revenue shortfalls, they may dvert resources from captal to current operatons (for example, reactng to lower world ol prces n the late 1980s, the ol-producng U.S. states of Colorado, Lousana, Oklahoma and Wyomng curtaled ther constructon spendng). To sum up, captal spendng seems to have two features: varablty from year to year, whle exhbtng an overall declnng trend. Both of these facts llustrate the need for usng data for several years rather than a sngle year n the analyss. 1 Although one could argue that fve years s not a suffcently long tme frame to assert ths wth certanty. 13

19 Fgure 1. Rato of Captal Spendng to GSP, , Contnental U.S. States Wth respect to the composton of the dependent varable, captal spendng, ths analyss uses values that were (self) reported by the states for the years Many authors (e.g., Poterba, 1995, Thomassen, 1990) report dfferences n how states defne captal, whch results n dfferences n the composton of the captal spendng varable. Whle all states nclude expendture on buldngs and constructon, some states nclude transportaton expendture as captal, whle the majorty of the states exclude t. Accordng to a survey by Hush and Peroff (1986), "25 out of 42 states exclude transportaton programs fnanced by state current revenues such as gasolne tax... even though the functon by tself accounts for more than half of captal spendng at the state level on a natonal bass." It s mportant to note that states do not nclude transportaton expendture fnanced by federal grants n the captal budget. 14

20 Other dfferences n the composton of the captal-spendng varable across states are due to the ncluson versus excluson of mantenance, equpment, long-term leases of structures, and captal expendtures on educaton and hosptals. A number of states nclude only "major" repars, whle others nclude all repars or provde a specfc dollar benchmark. Whle two states may be spendng smlar amounts on mantenance, they may be reportng t dfferently. In some states mantenance expendture s allocated prmarly to the captal budget and n others to the operatng budget. The dfferences wth respect to ncluson of tems n the captal budget ntroduce a bas n the form of a measurement error. Another source of measurement error s any temporary reallocaton from captal to operatng budgets, for example, n order to balance the budget wthout alterng the actual amount of spendng. Ths s the problem of "relabelng" emphaszed by Poterba (1995). Dependng on prevalng consttuent preferences, a porton of captal spendng may be passed on as operatng costs or vce versa (Shepsle and Wengast, 1984). Re-labelng would present the same problems for research desgn as measurement error. Ths dscusson underscores the need to control for dfferences n defnng captal expendtures. Ths study tackles the problem by groupng the states accordng to categores - usng dchotomous varables reflectng dfferences n how each state defnes captal expendture and budget composton. 3.3 Explanatory Varables Explanatory varables nclude the man varable of nterest, captal versus operatng budget, and a number of control varables. Bohn and Inman (1995) suggest that a comprehensve set of control varables s needed to analyze state spendng. Falure to do ths wll lead to the omtted varable bas problem gvng mprecse or ncorrect estmates. In order to obtan better estmates three sets of varables are used. These are 1) economc and demographc varables that control for nter-state dfferences, 2) varables that control for party afflaton to account for varaton n state poltcal structures and 3) past value of debt to control for spendng preferences. In addton, a fourth set of explanatory varables accountng for budget composton and spendng rules s ncluded. Incluson of these varables n the analyss s one of the orgnal contrbutons of ths study as these varables are more comprehensve than those used n other studes. 15

21 3.3.1 The Captal Budget The use of a captal budget s the man varable of nterest. Accordng to a Natonal Assocaton of State Budget Offcers 1997 survey of state captal budgetng practces, out of forty-eght contguous states, thrty-two have separate captal budgets and sxteen do not. It s nterestng to note that there has been lttle temporal varaton n the number of states wth captal budgets. Hush and Peroff (1986) conducted a comprehensve survey of captal budgetng practces among the U.S. states. They found that n 1985 the same thrty-two states had captal budgets. A survey by Hllhouse and Howard (1963) cted n Poterba, 1995, reports twenty-nne states as havng a captal budget n Poterba hypotheszed that captal budget s conducve to captal spendng. Hs hypothess was confrmed by hs emprcal fndngs of statstcally sgnfcant effect on captal spendng of a dchotomous varable for exstence of captal budget. One can also argue that the transparency nduced by a separate captal budget results n greater effcency and therefore that the relatonshp between spendng and a captal budget wll be negatve. 2 Moreover, many authors, n partcular Hush and Peroff (1986) pont to the dffculty of precsely defnng the captal budget because the degree of separaton between captal and operatng budget dffers across the states. The degree of separaton between captal and operatng budget s the potental source of dfference n allocatng expendture between captal and operatng budgets. The dchotomous formulaton (captal budget/no captal budget) may mss what n actualty s "captal budget for a narrow defnton of captal" or "captal budget ntegrated n the operatng budget" for some states. To address ths problem ths study uses a more detaled framework, whch takes nto account the structure of the captal budget. The ntent s also to delneate further research venues to address questons relatng to the qualty of a captal budget and ts effects on captal spendng by the states. Ths wll be accomplshed by expandng the set of budget-rule varables descrbed later n the chapter. The functon of the many control varables and especally budget- rule control varables s to explcate the relatonshp between the captal budget and captal spendng. 2 Though Poterba fnds a postve relatonshp, a thrd possblty s that the exstence of a captal budget may have no effect on captal spendng cannot be ruled out. 16

22 3.3.2 Control Varables I begn by assessng the mpact of dfferent populaton and economc parameters on captal spendng Demographc and Economc Varables () Per-capta ncome -- Income s an mportant explanatory varable because t represents both the demand for servces and s the source of fnancng government expendture. State captal spendng and state per-capta ncome may be nversely or drectly related. The drect relatonshp may be explaned by government spendng on nfrastructure beng a "luxury" good so that ncreases n per-capta ncome nduce ncreases n the share of spendng devoted to nfrastructure uses as argued n Aschauer (1990). Or, smply stated, hgher spendng may be due to hgher tax revenues n the affluent state. Also, f nfrastructure s under-suppled, the state government may channel hgher ncome per-capta tax revenue to captal spendng. On the other hand, the state may take on a more nterventonst role and spend more n poorer states n areas that n rcher states may reman n purvew of the prvate sector (hence an nverse relatonshp). That s a possble explanaton for the nverse relatonshp between captal spendng and ncome found by Poterba for hs 1962 data. () Fracton of populaton below 18 and Fracton of populaton above In states wth a hgher fracton of populaton below 18 years spendng on schools may be hgher n response to hgher populaton projectons. States mght also spend more on state hosptals, or on nursng homes when they have a hgher proporton of ther populaton over 65. These varables have been used by Poterba (1995), and Cran and Cran (1998). () Fracton of home-owners n total households -- The antcpated effect of the homeownershp varable s expected to be postve because of the homeowners demand for nfrastructure and ncome level (source of fundng for supply of nfrastructure). Home-ownershp may requre more nfrastructure, such as roads and utlty lnes because of lower populaton densty of settlements wth greater sngle home ownershp than wth apartment-type dwellngs. The supply of nfrastructure s determned by government polcy and avalablty of funds. 17

23 (v) Percent of populaton lvng n metropoltan area -- The reason for ths varable s the supposton that captal spendng n metropoltan areas s dfferent from that n nonmetropoltan areas. For example, more concentrated nfrastructure needs may account for less captal spendng. Also, states wth large ctes can have lower per- capta state spendng because the cty authortes do captal spendng n the ctes. The percentage of metropoltan populaton s used n ths study nstead of Poterba's "percent urbanzed" varable. The "Percent lvng n metropoltan area" varable allows for greater varaton of data than the percent urbanzed varable and s therefore preferred from a statstcal pont of vew. (v) Populaton densty -- Populaton densty may affect captal spendng n a number of dfferent ways. One the one hand, more concentrated nfrastructure needs may account for less captal spendng per capta due to economes of scale n the delvery of government servces ncludng captal outlays. On the other hand, a more concentrated populaton may be ndcatve of agglomeraton economes wth hgher levels of per-capta ncome (Aschauer, 1990) and possbly hgher demand for government servces. One can also postulate that a threshold populaton densty level may be requred to justfy publc spendng. Poterba (1995) fnds no effect of populaton densty. (v) Net mgraton -- Poterba ncludes net mgraton as a control varable because t accounts for consttuents' unwllngness to vote for captal projects that brng future benefts but have to be pad for by current tax revenues (Poterba, 1995). It also controls for the overall economc clmate of the state: f there s sgnfcant n-mgraton, the state s dong well economcally and captal spendng s correlated wth good economc performance. (v) Indcator varables for Census geographc regons: northeast, south, west, md-west -- Regonal ndcator varables are necessary to solate trends that are common to geographcal regons. They are used n all econometrc models n the lterature n the form of dummy varables. Wheat and Crown, who undertook a longtudnal study of U.S. state ncome changes argue that "per-capta ncome varaton s essentally a regonal phenomenon" (1995, pg.2). States wthn regons tend to be smlar n terms of agrculture, urbanzaton, manufacturng, employment and transportaton costs. In addton, there may be unobserved regon-specfc factors that can be captured by controllng for the regons. For example, South 18

24 has been growng at a relatvely faster rate and catchng up wth other regons of the naton n recent decades. Munnell (1990) notes that the South had the hghest rate of publc nvestment durng the 1970s and was the only regon to ncrease ts publc captal stock n the 1980s. Bohn and Inman (1995), who explore the relatonshp between publc defcts and state budget composton, nclude regonal varable for the South because they expect southern states to be more fscally conservatve. Ther expectatons are confrmed by ther results. (x) Intergovernmental revenue per capta -- Intergovernmental revenue s a drect source of revenue to the state and t conssts of federal and local transfers. In contrast to Poterba, who ncludes only federal ad, ncluson of ths varable enables accountng for revenues receved from the local government, as well as non-governmentally funded gfts and donatons. However, the proporton of revenue comng from the local governments for captal expendture s relatvely small, beng around 10-20%, wth federal support beng the man source of ntergovernmental revenue for state governments. A certan porton of state ntergovernmental revenue gets dstrbuted to captal spendng. States do not have the freedom to use ntergovernmental revenue as they please, as funds are n many nstances allocated for specfc uses. Because of ths, ntergovernmental revenue s an mperfect varable - part of t reflects the composton of the dependent varable. There s an addtonal caveat that also apples to federal fundng: whle federal ad s a sgnfcant component of captal spendng, t may be to a certan extent endogenously determned wth captal spendng because some grants are matchng and federal ad s a functon of state spendng (Oates, 1968). Hence a smlar crtcsm can also be appled to Poterba's analyss. On a related note, Clngenmayer and Wood (1995) suggest that besdes beng a mere component of spendng, ntergovernmental ad also drectly mpacts spendng because the federal matchng grant system propels more spendng ntatves from state governments. For all these reasons ntergovernmental revenue s stll a better explanatory varable than pure federal ad. 19

25 Table 2 shows the mean values for ths set of economc and demographc varables. Table 2. Demographc and Economc Varables: Means for 48 U.S. states, 1994 Varable Mean Standard devaton Net n-mgraton, % of populaton Populaton growth, % Captal Spendng, $ per capta Metropoltan area, % Populaton under 18, % Populaton over 65, % Personal ncome, $ Homeowners, % of households Intergovernmental revenue per capta, $ Populaton Densty, persons/sq. mle Past values of Debt and Captal Stock Contemporaneous explanatory varables capture the effect of current dfferences across the states. Current spendng s also the result of long-run adjustments to changes n the economy. Hence there s a need to control for past decson-makng usng varables such as captal and debt stock whch represent the total value of state captal and debt. () Debt stocks -- There are several ways debt stock may affect spendng on captal. For example states wth hgher debt stock spend more on debt servce thus rasng spendng on captal n these states. What then s the ratonale for ncurrng debt? Taxpayers-voters nherently prefer borrowng snce they favor current benefts and dslke current taxes (Buchanan, 1962). Debt stocks dffer wdely across states and the varaton s greater than that of captal spendng levels. The coeffcent of varaton (standard devaton dvded by the mean) for the 48 states n 1993 s 0.36 for captal spendng and 0.68 for the stock of debt. A hgher value of the coeffcent of varaton ndcates greater varaton n magntudes across the data. The varaton may be due to dfferences n "debt culture", or readness to ncur debt. Some states may dslke ncurrng debt and set-up varous debt-lmtaton measures to guard aganst the ncentve to ncur debt. (These spendng rules are addressed later n ths chapter). To solate the effect of the captal budget and 20

26 varous other budget structures, ncludng enacted debt-lmtatons, t s necessary to control for the "debt culture". So the debt stock varable s ncluded to control for the debt culture and for dfferences n debt servce across the states. The relatonshp should however, be nterpreted wth cauton because of endogenety between captal spendng and debt stock: not only does debt nfluence spendng on captal but spendng on captal contrbutes to the stock of debt as well. To avod the latter, the 1984 stock of debt value s used. () Publc captal stock -- The publc captal stock varable controls for captal spendng preferences: states that used to spend more on captal may carry on spendng more n the future. On the other hand, the states that have already accumulated captal may be spendng less than states that are stll n the process of captal accumulaton. Because of these two conflctng tendences the expected effect of the publc captal stock varable on captal spendng s uncertan. Ths varable may be correlated wth the debt stock varable because captal s partly debt-fnanced. () Prvate Captal stock -- Prvate captal may be a substtute or a complement for publc captal. If they are substtutes, then states wth greater prvate captal may have lower captal spendng. Substtutablty s related to the noton of "crowdng out". Some authors suggested that publc captal mght be crowdng out prvate captal: successve ncreases n publc captal result n prvate captal beng replaced by publc captal. If prvate and publc captal are complements, then hgher prvate captal may be assocated wth greater publc captal spendng. Munnell (1990) suggests that certan publc captal, such as roads, water and sewer facltes are complements to prvate captal, whle others, such as hosptals, are substtutes. It s very dffcult to precsely measure prvate captal and ths study reles on estmates provded by Munnell (1990). The rato of prvate captal stock to publc captal stock s used because only the rato was avalable from the Munnell study Varables controllng for Poltcal Preferences of the State Populaton Poterba (1995) ponts out the possblty of endogenety between budget agences, spendng procedures and consttuents' preferences. Ths mples that states wth greater captal spendng have dfferent captal budget processes from other states but these dfferences n spendng and budget processes may be a reflecton of consttuents preferences mplyng that 21

27 captal budget exerts no ndependent effect on captal spendng. Here I follow Poterba (1995) by ncludng varables for the party composton of the legslature (Democratc/Republcan Senate and Democratc/Republcan House), Governor party afflaton and State percentage vote for the elected presdent n Budget Composton varables After economc and poltcal varables have been accounted for, the supposton of ths study s that the rest of the varaton n the dependent varable can be explaned by dfferences n budget composton. The budget composton varables are grouped by ther functons, n partcular what knd of spendng s ncluded n the captal budget n each state, use of analyss for project selecton, centralzed versus decentralzed features of spendng decson-makng, debtfnance and alternatve fnance. () Captal expendture tems ncluded n the captal budget I used a number of ndcator varables to capture the ncluson of captal expendture tems n the captal budget: Incluson of educaton and hosptals n the captal budget; mnmum expendture requrement for ncluson n the captal budget; ncluson versus excluson of mantenance from the captal budget; avalablty of other mechansms for allocatng mantenance; treatment of long-term leases as operatng versus captal expense; exstence of a lease versus own polcy. Hush and Peroff, 1988 as well as other authors report that what s ncluded as captal vares across the states. For example, accordng to Hush and Peroff, only three states nclude vehcle purchases, whle thrty-sx states nclude major mantenance. Snce ncluson of educaton and hosptals n the captal budget wll reflect hgher level of spendng, t s necessary to control for t. Another mportant captal budget composton ndcator varable Mnmum expendture requrement for ncluson n the captal budget (Expendtures below the requrement amount are ncluded n the operatng budget). States wthout such a requrement should have hgher captal spendng than states wth such a requrement, whch s the ratonale for controllng for mnmum expendture requrements. Snce ncluson of mantenance n the captal budget wll reflect hgher spendng, t s necessary to account for the ncluson of mantenance n the 22

28 regresson. If other mechansms for allocatng mantenance (that s not through the captal budget) are used, the lnk between the captal budget and captal spendng wll be weaker and we would expect to have a negatve effect for ths varable. Treatng long-term leases as operatng expenses wll decrease the level of captal spendng, whch s why t s necessary to control for t. Exstence of lease versus own polcy specfes what tems are for lease and whch ones have to be purchased so whle the drecton of the effect on spendng s not obvous, we would expect there to be a more systematc relatonshp between captal budget and captal spendng,.e. less nose. Bunch (1996) notes that allocaton of long-term leases s a source of sgnfcant dfferences n budget allocatons across states. () Use of analytc technques and mechansms for prorty project selecton The followng s a lst of ndcator varables that reflect the states' effort to provde nformaton for captal decson-makng: System to rank nvestment projects; exstence of mechansm for settng asde funds to preserve facltes; exstence of nventory data base; number of cost-estmatng methods for captal expendtures; comparson of debt servce to revenues and expendtures. The objectve of a system to rank order nvestment projects s to commt resources to the most mportant nvestments. Lee (1991) notes that prorty rankng s one of the newer practces n the budgetary process that became common after The ratonale behnd havng a mechansm for settng asde funds to preserve facltes s to avod sharp ncreases n spendng that may ental unantcpated debt servce. Settng asde funds s a form of precautonary savng that s more lkely to take place n states wth more strngent budget constrants (Bohn and Inman, 1995). The exstence of the nventory data base (for captal assets) may be ndcatve of a more judcous decson-makng that s based on better nformaton than n the states wthout nventory data base. Ths varable may exert ether postve or negatve nfluence on captal spendng. 23

29 Whle use of analyss n budgetary decson-makng has become standard practce (Lee, 1991), the greater number of cost-estmatng methods for captal expendture analyss reflects greater use of analyss or use of more sophstcated analyss. It s lkely to be an ndcator of greater precson n decson-makng and the expected effect s negatve or ndetermnate. Comparson of debt servce to revenues and expendtures s another practce that may be ndcatve of judcous decson-makng. A closer look at the NASBO survey reveals that states that compare debt servce to revenues and expendtures do so for both ther captal and operatng budgets. The drecton of the antcpated effect s suggested n Rubn (1990) who notes that the practce of comparson of revenues and expendtures tends to allocate spendng outsde of the operatng budget, specfcally to the captal budget; therefore ths should have a postve effect on captal spendng. () Centralzed versus decentralzed decson-makng The ssue of centralzed versus decentralzed decson-makng wth respect to budgetng n the states has been rased by Darr (1999) and Lee (1981). The ndcator varables used for ths purpose nclude: jont boards for captal revew; multple versus sngle entty requests for fundng; and, a sngle state agency to oversee and manage projects. Wth respect to the varables above, jont boards for captal revew and multple entty requests for fundng can be nterpreted as lesser centralzaton, as both mply multplcty of decson-makers. Sngle state agency to oversee and manage projects can be nterpreted as greater centralzaton. Clngenmayer and Wood (1995) hypothesze that centralzed polcy responsbltes could result n hgher state debt whch s used to fnance captal expendtures. Accordng to ther hypothess, sngle state agency to manage projects would result n greater spendng on captal. Conversely, jont boards for captal revew and multple versus sngle entty request for fundng ndcator varables should have a negatve effect on captal spendng (v) Debt fnancng and Bonds There s a large body of lterature on Pay-As-You-Use (debt) versus Pay-As-You-Go (no debt) fnancng of captal and other expendtures. Consttutonal or statutory debt lmtatons are frequently mposed n the states to constran the growth of debt. If these constrants are effectve, 24