The definition of overlapping debt is simple: Overlapping debt refers to financial obligations of political subdivisions and neighboring special districts that a municipality is responsible for. In other words, it is the debt that is issued to fund various capital projects and activities that fall across different political jurisdictions.
It occurs when several authorities in the same geographical area are eligible to tax the same residents. It is common in the US as the states are divided amongst different jurisdictions for different purposes. The purposes include building a new hospital, a school, or a new airport.
Understanding overlapping debt in detail
To understand overlapping debt, you first need to know why governments issue municipal bonds. They do so to finance particular projects, part of the larger plan to maintain and upgrade infrastructure.
The significant reasons for overlapping debt include:
- A neighboring special district that issues its bonds is eligible for tax exemptions under US law. It can thus compete with your local government for tax revenue.
- The state has the power to tax a particular activity regardless of where it is located. For instance, if the form collects taxes for building an airport, you might not be in control to make one or not even use its tax revenue for your own needs.
- Capital projects are expensive, and knowing whether there will be enough tax revenue in the future can be difficult in some cases. A municipality can borrow money to finance a costly project on behalf of the taxpayer. Future tax revenues later pay it off.
- There are sometimes overlapping authorities, making it difficult for local governments to identify all potential funders of their plans. This results in fragmented strategy and several applications for funding at different agencies, which increases overall costs
Why are municipal bonds and why are they issued?
Municipal bonds are debt securities issued by the states and other government entities to finance capital projects, such as highways, roads, hospitals, and public schools. A municipal bond is considered a good way of preserving capital by generating interest.
For over 200 years, governments have relied on municipal bonds to finance various development projects. You can think of a municipal bond as a critical source of financing for local governments.
So, municipalities issue debt to raise money to finance projects that benefit the residents. Sometimes, two municipal governments have overlapping jurisdictions. An overlapping jurisdiction can be in the form of a city, state, or county.
Overlapping debt is the debt of a municipal authority shared with another government. In some cases, overlapping debt may also be issued to the neighboring town when both towns benefit from the same project.
Pros and cons of municipal bonds
There are quite a few benefits of investing in municipal bonds. Municipal bonds are a safe investment option that carries low default risk. They are free from state, local, and federal taxes. They are highly liquid and provide a steady stream of income.
However, when the interest rises, the current bonds lose value. One more disadvantage to investing in municipal bonds is that they are no different from other investment options and thus carry the risk of capital loss.
While discussing Municipal bonds, it’s also essential to know the types of municipal bonds.
What is a general obligation bond?
A general obligation bond is one of the most common types of municipal bonds in which bond repayments are guaranteed by the total revenue generated by the government. They are considered a safe investment option as they are backed by general tax revenues, complete faith, and credit of the issuing municipality. They are considered safer than revenue bonds.
What is a revenue bond?
A revenue bond is a municipal bond issued to find public projects in which the repayments of the obligation are guaranteed solely from specified revenues. A general obligation bond and a revenue bond are that general obligation bonds that depend on taxation. In contrast, a revenue bond is guaranteed by the revenue generated by the issuer. Revenue bonds are riskier than general obligation bonds.
What Is a Moral Obligation Bond?
A moral obligation bond is when the issuer’s guaranty of repayment is not backed by actual revenue or assets but by its ethical commitment to repay them on time. Moral obligation bonds are typically used for projects that do not generate enough tax revenue to repay investors.
What is a subordinate obligation bond?
A subordinate obligation bond is when the issuer’s guaranty of repayment is not backed by any specific revenue source and has a lower priority than other types of bonds, such as general and moral obligation bonds.
What is a pay-as-you-go bond?
A Pay-As-You-Go Bond (PAYG) is a municipal bond in which the interest and redemption payments are made annually. Unlike other types of bonds, pay-as-you-go bonds are discontinuous; they do not receive all of their principal upfronts. Instead, they accept some on each payment date while the remaining principal is added to future payments.
Held by many investment agencies due to its minimal risk, PAYG investors maintain continued access to cash flow generated through interest payments.
Although minuscule in denomination size compared to most other types of debt securities available for purchase, considering that municipalities account for nearly two-thirds of local government expenditures nationwide, these securities carry significant weight concerning financing projects and initiatives.
What Is a Letter of Credit?
A letter of credit is a guarantee from an issuing bank to pay the holder of a bill, bond, or note if the maker fails to pay as agreed.
Banks ‘ letters of credit may be used as margin guarantees on securities not traded in public exchanges. Similarly, letters of recognition can also be used in banking-related transactions.
In this case, a bank may issue a letter of credit to a foreign buyer that stipulates that the bank will pay the exporter if he cannot repay his customer.
In both examples, banks buy liquidity but at a premium.
Why do government and citizens care about the amount of overlapping debt reported?
Apart from general obligation, it also includes debt supported by general fund revenues, sales tax debt, and tourism tax debt. A government is concerned about the amount of overlapping debt reported because it affects the borrowing cost of a municipal government and can affect a government’s ability to issue debt. It also affects the credit rating of the government.
Citizens are concerned about the amount of overlapping debt reported because it can affect their taxes.
A final word
Overlapping debt is a debt issued by municipalities that have overlapping geographical boundaries. For example, if both the city and the State of Colorado have issued bonds to pay for their development projects, both the state and the city have overlapping debt. The amount of overlapping debt is considered essential for the government as it affects the rating and the government’s ability to issue debt.