UNDERGROUND GOVERNMENT: THE OFF-BUDGET PUBLIC SECTOR (Public Choice)

Politicians and bureaucrats have a great disaffinity for constraints placed on their discretionary behavior, particularly with regard to their ability to spend and to borrow. Government spending permits politicians to direct benefits to their constituents in general and especially to their political supporters. Debt is favored because repayment occurs in the future (perhaps while others are in office) while the benefits of the expenditures are reaped in the present period. In the United States, both statutory and constitutional restraints on government spending and indebtedness greatly limit the abilities of politicians and bureaucrats at the state and local levels of government to spend and to incur debt. These restrictions historically arose because of the egregious fiscal excesses during the nineteenth century when canals and railroads were under construction. In the heady days of the "robber barons," bonds were issued by state and local governments to attract the railroads, and defaults were not uncommon. To restore fiscal integrity — and the faith of investors, many of whom were foreign — statutory and constitutional restraints were imposed on the fiscal actions of governments. For example, at the state level of government, forty-five states now have either a constitutional or statutory requirement that the governor must submit a balanced budget; forty require the legislature to enact a balanced budget; and thirty-seven states mandate that the budget signed by the governor must be balanced (Council of State Governments, 2001, p. 260, table 6.3). Thus, the ability of politicians and bureaucrats to spend and borrow are markedly constrained.

In response to fiscal constraints on their behavior, public officials have devised a means to move government activities "off the books" or "underground" by creating "off-budget enterprises" (OBEs) which permit them to evade statutory and constitutional constraints on borrowing. An OBE is a corporation established by a charter from the federal or a state or local government that has significant ties to the governmental entity that charters it. Typically, the members of the board of directors of the OBE are appointed by elected officials in the jurisdiction that established the OBE, so politicians ultimately control the OBE. Because the OBE is an entity separate from the governmental unit that established it, its financial operations are not subject to the statutory or constitutional restraints imposed on government itself. OBEs spend, borrow, hire and fire, contract for services, and engage in all sorts of activities free from the limitations imposed on governments.

As Bennett and DiLorenzo (1983, p. 35) discuss, the first attempt at off-budget activity occurred in the city of Waterville, Maine at the close of the nineteenth century when the city fathers wanted to build a new city hall, but taxpayers rejected the bond inititative required to finance it. Undeterred, the politicians established the Waterville New City Hall Commission, a corporate entity, donated a building lot to the Commission, and hired a contractor who was to be paid from the proceeds of a bond offering made by the Commission. Debt service on the bonds was to be provided from rent paid by the city to the Commission for use of the building. But, because the source of the rent was taxes, "the Commission was held unconstitutional in 1898, because the court ruled that the arrangement was a disguised mortgage that violated the debt limitation imposed on the city by the Maine constitution." Waterville politicians then regrouped to evade the constitutional debt limits that limited their actions. The next year, 1899, the Kennebec Water District was established as a separate corporation — the nation’s first OBE — that would issue its own bonds to purchase the private water companies operating in the area. Revenues from providing water services to residents would pay the interest, retire the debt, and finance the corporation’s operations. The Supreme Judicial Court of Maine held that this debt was not the obligation of the city or the taxpayers, so the constitutional restriction on borrowing did not apply, and the scheme passed judicial scrutiny (Morris, 1958).

From this modest beginning, OBEs have proliferated in both numbers and activities. The most comprehensive census of these entities is reported in the Census of Governments (U.S. Census Bureau, 1997, p. vii) where OBEs are called "special district governments" (excluding school districts) "that exist as separate entities with substantial administrative and fiscal independence from general purpose local governments … [These] entities must possess three attributes: existence as an organized entity, governmental character, and substantial autonomy." According to the Census of Governments (pp. vii-viii), the number of OBEs has increased dramatically: "As a group, special district governements are by far the most rapidly growing type of government, rising to a total of 34,683 [in 1997], an increase of about 3,128, or 9.9 percent, since the 1992 Census of Governments. … [T]he number of special district governments reported in 1997 is almost three times the number … reported in 1952."

Of significance is the Census Bureau’s admission that the reason for the dramatic growth of OBEs is motivated by financial constraints on government: "The increasing number of special districts often reflects financial considerations. As new programs are initiated, or new services required, the establishment of special districts may reduce the need to increase the burden on general purpose governments which may be unable to meet the fiscal requirements necessary to implement these new programs. Debt and tax limitations are further stimulants for creating special districts for raising both capital construction and operating expenditure funds." (Ibid., emphasis added.)

OBEs engage in a wide range of activities, including (but not limited to) operating airports, fire protection, cemeteries, hospitals, industrial development, mortgage credit and housing, parking facilities, recreation and parks, electricity generation and distribution, gas and water supply, sewerage, mass transit, and the construction and maintenance of highways. They are generally designated as authorities, commissions, or districts by the governmental body that creates them. OBEs tend to be concentrated in the most populous states: in 1997, 11 states had more than 1,000 OBEs, with California (3,010), Illinois (3,068), Texas (2,182), and Pennsylvania (1,919) having the most. Four states (Alaska, 14; Hawaii, 15; Louisiana, 39; and Rhode Island, 76) and the District of Columbia (1) had fewer than one hundred OBEs (U.S. Census Bureau, p. 13 table 9). A small number of OBEs have been chartered by the federal government, because their operations involve more than one state; most notable is the Port of New York Authority which operates transportation facilities for metropolitan New York City, an area that includes New Jersey.

Another indicator of the economic significance of OBEs is their debt. For state and local governments, two types of debt exist: full-faith-and-credit debt which is approved by the taxpayers in a bond referendum and "nonguaranteed" debt incurred by OBEs. The term full faith and credit indicates that taxpayers have agreed to tax increases if needed to guarantee payment of principal and interest. For OBEs, revenues from operations are pledged in the bond indenture to cover principal and interest payments; the taxpayer does not guarantee repayment, and taxpayer approval is not sought when OBEs issue bonds. Interest payments on both full-faith-and-credit and nonguaranteed debt are exempt from federal taxation.

As shown in Table 1, at the state level of government, nonguaranteed debt issued by OBEs outstanding was a small fraction of voter-approved debt in 1942, the earliest date for which information is available. In 1942, $5.80 in full-faith-and-credit debt existed for each $1 of nonguaran-teed debt at the state level. By 1970, however, the amounts of the two types of debt outstanding were roughly equal. Since 1980, nonguaranteed debt outstanding has risen by roughly a factor of five while full-faith-and-credit debt outstanding has only increased by a factor of about 2.4. At the local level of government, a similar pattern emerges. The amount of nonguaranteed debt issued by OBEs was nearly equal in 1980 to the amount of voter-approved debt outstanding, approximately $100 billion. Since that time, however, nonguaranteed debt has risen by a factor of 4.5 while full-faith-and-credit debt outstanding went up only by a factor of three. These trends since 1980 reflect that "Since 1978 … activists have proposed and passed initiatives limiting taxing and spending by state governments in the United States" (New, 2001, p. 1). Off-budget activities conducted by OBEs, that is underground government, was the natural response of politicians and bureaucrats to these tax and expenditure limitations (Bennett and DiLorenzo, 1982).

A number of disquieting public policy issues arise in the context of off-budget enterprises. First, if the activities of OBEs are truly in the public interest, why does the public not vote on the bonds issued by these entities? Indeed, full-faith-and-credit debt always carries a lower interest rate than does nonguaranteed debt, for lenders demand compensation for the higher risk of default of nonguaranteed bonds. Thus, capital cost considerations favor the elimination of OBEs and the movement of their activities on-budget. Of course, the sticking point is the constitutional and statutory limitations on government debt which lead to the creation of OBEs in the first place. But those restraints raise an important issue: If these contraints are no longer relevant, shouldn’t they be repealed? And, if the constraints are still relevant, should OBEs be used to evade them?

Second, politicians assert that OBEs provide superior service to the public because they are far less bureaucratic and offer much greater flexibility than traditional government agencies that are supposedly hamstrung by red tape, civil service regulations, and bidding requirements. Rather than being an argument in favor of OBEs, however, such claims are a clarion call for the reform of bureaucratic red tape and regulations. If regulations and red tape hamper government operations without compensating benefits, reform is essential. Much closer to the truth is that OBEs offer politicians greater opportunities for nepotism and favoritism in rewarding their supporters than does on-budget government agencies where freedom-of-information legislation typically mandates an openness and transparency from which OBEs are exempted as "private" corporations.

Third, a persuasive argument can be made that OBEs should be disbanded and their actitivities turned over to private firms. OBEs obtain revenues from providing goods or services, so the eclusivity criterion so crucial to the concept of public goods is not applicable. In short, those who do not pay for the electric service or the highway tolls, for example, can easily be denied such services. Thus, virtually all of the activities of OBEs could be conducted by private firms, even if government subsidies were required (as might be the case for mass transit). A large and growing literature on privatization of public services shows unequivocally that private provision is typically far more efficient than government provision, so taxpayers would benefit from higher quality services at less cost.

Table 1: State and local government debt by type, selected years, 1942-1997 ($ millions)

Finally, scholars and researchers should be aware that the public sector, particularly at the state and local level of government in the United States, is much larger in terms of revenues, expenditures, and employment than is generally reported — OBEs are extensions of government. In terms of both numbers and outstanding debt, OBEs are clearly important components of the public enterprise broadly conceived. Off-budget enterprises are not unique to the United States by any means, but exist in Britain and other countries where they are called "quangos," an acronym for quasi-autonomous nongovernmental organizations. Underground government and off-the-books operations are prominent features of the political landscape that benefit politicians more than their constituents.