Skip Navigation

Innovative Financing of Highways: An Analysis of Proposals January 1998

Motorists want better, safer, less congested highways, but the money to build them is scarce. Transportation officials strain to juggle limited resources to meet the demands. Elected representatives could raise taxes, but voters resist. How then can transportation planners secure funding for new highway projects? To augment money raised in traditional ways, highway officials are exploring the use of innovative financing techniques.

In the past and in large part today, states have financed roads primarily through a combination of state revenues and federal aid. States have raised their share of the funds by taxing motor fuels and charging user fees--for example, for motor vehicle registration and driver's licenses and, to a lesser extent, tolls. The federal program of aid to the states for highways is also financed through motor fuel taxes and other levies on highway users. Federal aid for highways is entirely on a cash basis from the Highway Trust Fund. At the state level, most highway spending is in the form of cash raised from taxes and user fees that are accumulated in designated highway accounts. Debt financing constitutes only about 6 percent of the revenues states use for highways.

Transportation officials at all levels of government have recognized in recent years that funding from traditional sources is not keeping pace with demands for new, expanded, or improved highways. As a result, they have begun to explore new sources of highway financing. Highway officials use the term "innovative financing" to refer broadly to any funding measures other than the traditional pay-as-you-go approach. Most of the innovative measures currently under consideration entail debt financing. Although most financial experts would not consider debt financing innovative, the term is used to contrast that approach with traditional methods of funding highway projects.

The 1990s have seen significant innovation in highway financing. Encouraged by measures that the Congress adopted in the Intermodal Surface Transportation Efficiency Act of 1991 (ISTEA), new ideas have been proposed, discussed, tried on an experimental basis, and in some cases enacted into law. Most such measures are linked closely to an individual project, in many instances, a toll facility; they do not cover a state's overall highway program. Although they may enable state and local governments to get important projects built sooner than traditional financing would allow, they are unlikely to replace pay-as-you-go user taxes for the bulk of roadway needs. The reason is that as long as most roads are toll-free, new toll projects will be at a disadvantage in competing with them.

To some observers, "innovative" has a positive connotation suggesting a new and better approach. To others, especially when it is used to describe methods of financing, the term raises the specters of gimmickry and smoke and mirrors. Each side has some justification for its view. Some innovative techniques can work well to finance specific projects without imposing additional, unanticipated, and unwanted cost burdens. But careful scrutiny of some financing proposals may reveal that they cost more than they appear to at first glance and they shift the cost burden in hidden and unfavorable ways.

Innovative financing may enable states to increase the incomes, wealth, and well-being of their residents by building highway projects sooner than would be possible with traditional financing. Like other investments, judiciously selected highway projects have the potential to yield benefits over many years. If the benefits exceed the costs of a project, after factoring in the cost of capital that could have been used for alternative income-generating ventures, the project is a worthwhile investment for the community. Borrowing money to build it enables people to enjoy its benefits sooner.

Borrowing has risks, however, and those risks may be greater for public projects than for private investments. And even if the risks are not greater, they are, at the very least, different and thus continue to raise concerns for policymakers. Observers who brand innovative measures as gimmickry worry that the risks and costs associated with debt financing may be hidden or downplayed by enthusiasts who are eager to get a project built. For example, if a public project receives a subsidy in its borrowing (perhaps by obtaining a below-market interest rate), the subsidy should be factored into the cost of the project. Also requiring consideration are indirect subsidies, such as making the interest on bonds issued by state and local governments exempt from federal income taxes. Such subsidies impose costs on federal taxpayers that may be obscured in analyzing the merits of any individual highway project.

In the end, money to pay for highways can come only from general taxpayers or from users or other beneficiaries of highways. Innovative financing measures generally shift the burden of costs from current users of highways in general--that is, payers of taxes on motor fuels and other taxes and fees imposed on motorists--to future general taxpayers, motorists in general, and users of the specific projects built with innovative financing. Some shifting may also occur between taxpayers at the state and federal levels.

Innovative financing can affect how efficiently resources are allocated in both making and using an investment. Ventures that must attract financing from lenders or equity investors face intense scrutiny, which raises the likelihood that the investment will be a sound one. It does not, however, ensure a profitable outcome. Tight controls over costs are often critical to the success of such projects.

To the extent that they impose user fees to repay debt, projects financed by innovative means have greater potential for allocating resources efficiently than do tax-financed, toll-free highways. Tolls that reflect the marginal social cost of use of a roadway provide incentives for efficiency. In congested corridors, tolls that take into account the costs of traffic delays are a way of allocating use to motorists who place the greatest value on avoiding those delays. But highway operators do not necessarily set user fees at the efficient level. If a highway is not congested, the cost of one additional vehicle--the efficient toll rate--may be so low that revenues from a toll set at that level will not cover debt service, operations and maintenance, and other costs. In those cases, the sponsors of the project may need to charge tolls that are higher than the economically efficient level to cover their costs.

Although innovative financing is unlikely to replace the current system of pay-as-you-go financing, it can augment traditional sources of funding in specific cases and enable state and local governments to proceed with major projects sooner than they might otherwise. This study analyzes several innovative measures that have been tried or proposed in recent years. It describes the way they would raise money to accelerate projects and discusses their potential effects on the allocation and distribution of resources. It also analyzes the implications such approaches have for the federal budget.

Innovative financing measures for highways fall into several broad categories: relaxing financial restrictions on the use of federal aid, establishing financing institutions at the state level, providing federal credit assistance, and tapping private-sector resources for investment in highway projects.
 

Relaxing Restrictions on Federal Aid

The federal-aid highway program is characterized by a maze of requirements that states must fulfill as a condition of receiving grants. In recent years, the federal government has removed some long-standing restrictions on highway aid and given states greater latitude in their use of it. Those reforms, which help states stretch the value of federal aid, have provided greater flexibility in three major areas: sponsoring toll roads, providing financial assistance to transportation projects built by public/private partnerships, and engaging in debt financing. The federal government has also modified the matching-share requirement, a move that states have found especially helpful. The changes have enabled states to launch highly valued projects more quickly than would have been possible under the standard funding approach. In addition, the reforms have broadened the set of projects that are eligible for federal assistance.

The federal budget is unlikely to be much affected by relaxing financial restrictions on federal highway aid. Of course, the relaxation might lead to somewhat faster spendout rates if states drew on every dollar of aid as soon as it became available instead of amassing enough money to pay up front for a large, new project. But even if federal outlays accelerated initially, over time they would probably resume a steady rate.
 

State Infrastructure Banks

State infrastructure banks (SIBs) are investment funds that provide loans or other forms of financial assistance to public or combined public/private sponsors of transportation projects. As loans are repaid, the proceeds can be re-lent to fund additional projects. In the National Highway System Designation Act of 1995, the Congress established a SIB pilot program and authorized the Secretary of Transportation to enter into agreements with up to 10 states to form such banks. Subsequently, the Congress opened the SIB pilot program to all states. The Department of Transportation has given definite or conditional approval for SIBs in 38 states and Puerto Rico.

SIBs give states greater flexibility in financing transportation projects than they have under the standard financial regulations of the federal-aid highway program. Such rules impose constraints on the timing and use of aid and the types of projects eligible for it. By providing flexibility, SIBs can help states get projects under way sooner. SIBs may also aid states in another aspect of highway ventures. Besides the financial rules of the federal highway program, the government imposes conditions on federal aid that may increase a project's cost. For example, a project built with federal aid must meet the prevailing-wage requirements of the Davis-Bacon Act. Under current interpretation of the law, those requirements would apply only to the first round of projects financed by SIBs and not to projects financed with recycled funds.

In addition to flexibility in financing, SIBs can offer credit enhancements to attract private investment. In making loans rather than grants, SIB financing makes federal highway aid go farther because loan repayments are available for additional highway projects. How much additional money SIBs will make available, and when, depends in large part on how much aid the federal government provides to help capitalize the SIBs. It is also a function of how the states respond, including the way in which they structure their banks.

Using SIB funding increases efficiency in investment because it loosens federal constraints on a state's choice of projects. With fewer restrictions on its decisions, a state is free to choose projects with the highest overall economic returns and not just the highest returns within each category of federal aid (as traditional financing would require). The use of SIBs may also enhance efficiency in resource allocation through the mechanisms chosen for repaying SIB loans--for example, tolls and other user fees.

SIB financing has implications for who bears the costs of a project. Issuing debt shifts the burden of costs from current general taxpayers and payers of user taxes to future taxpayers, users, and other beneficiaries. Moreover, because debt issued by the SIBs is tax-exempt, using SIB financing transfers some of the costs from taxpayers at the state and local levels to those at the federal level.

Participation in the SIB program is voluntary, an attractive feature since not all states will find this kind of tool useful. Some states have projects ready that could benefit immediately from access to SIB financing. Other states are considering whether they have viable candidates. Still others are restricted by their own laws or constitutions in their ability to take advantage of this innovative financing mechanism.

At this point, the effect SIBs would have on the federal budget seems to be relatively small. The Congress provided $150 million in 1997 to capitalize the banks, but it appropriated no additional funds for 1998. The effect of the potential loss of revenues associated with the SIBs' tax-exempt debt must also be considered. The magnitude of the loss is hard to predict but appears minor in the near term.
 

Federal Credit Assistance

The Congress is considering several proposals for providing federal loans, loan guarantees, or other credit assistance to state and local governments for use in transportation projects. By making money available to lend or by promising to assist with repayment, those measures can enhance the quality of the credit that governments obtain to finance a project. They may also enable the sponsors of a project to borrow at lower interest rates.

How federal credit assistance affects efficiency, the distribution of resources, and the federal budget depends on the specific form that assistance takes. Moreover, analysis of such effects depends on whether federal credit assistance is viewed as a separate program in addition to the federal-aid highway program or as a substitute for all or part of it. In general, however, by leveraging federal aid, credit enhancements may be able to generate funding for more projects, compared with traditional outright grants of the same amount. A drawback to be kept in mind, though, is that a credit program might require additional federal bureaucracy.
 

Private-Sector Participation

In recent years, private firms have built two toll roads in the United States and formed partnerships with state and local governments to consider additional investments in transportation projects. Private investors are motivated by the prospect of profits, although such expectations are not always met. Viewing private participation as a source of badly needed capital, officials in some states have welcomed that investment.

The degree of private participation in highway building varies from project to project. For some ventures, it means complete private development and operation of a roadway; for others, it consists of incentive contracts in which governments have primary ownership and responsibility but private firms bear some degree of risk--and are rewarded for efficiency. Private investors generally scrutinize highway projects closely to make sure revenues will cover costs and provide a reasonable return on their investment. Their care in that regard enhances the probability that projects built with private money will use resources efficiently. Efficiency can be further enhanced by tolls or other user fees that allocate use--for example, of a congested highway--to motorists who are willing to pay.

Using private investment to fund highway projects shifts some or all of the cost and risk from governments and taxpayers to private investors and users of those roads. That change in turn reduces demands on government funds and conforms to the principle of public finance that the beneficiary pays, factors that may create greater public acceptance of privately financed toll roads. However, states need to be aware that private ventures can create new problems for them. For instance, a project may not generate enough revenues to cover operations, maintenance, and debt repayment, and the developers may then ask the state to bail them out. The agreements that governments enter into with private firms should make clear the responsibilities of all parties in the event of such contingencies.

As investors and public officials consider an increasing number of private or public/private projects, the most successful ways of financing and operating them are likely to emerge. However, the potential of private investment to fund a wide variety of highway activities at this time remains limited. The most promising candidates in the near term appear to be toll lanes that augment congested highways.
 

Conclusion

Which innovative financing measures are the most successful? The evidence suggests that no one approach is the magic bullet that would solve all highway financing problems. Rather, different measures work better in different situations. And of course, as economists say, there is no free lunch. The money for highway projects must come from somewhere. To some analysts, obtaining it from debt backed by tolls or from other fees imposed on motorists who use specific roadways is fairer and more efficient than using conventional tax financing. But tolls are not always structured efficiently, and users of toll roads also pay the same taxes on fuel that users of toll-free roads pay. Questions remain, moreover, about what will happen if a project does not generate enough revenues to repay its debt.

Until the 1990s, federal policies generally limited the ability of states to employ nontraditional financing. Relaxing restrictions on the use of federal aid has cleared the way for state and local governments to pursue new ways of financing transportation projects. Their experience suggests that the federal government could further the development of innovative financing tools by according states even greater flexibility in their use of federal aid. With freedom to experiment, state and local governments could test various approaches and adopt the measures that work best in their particular circumstances.

---