RD682 - Report of the Debt Capacity Advisory Committee – December 17, 2020

Executive Summary:

Following the Commonwealth’s increased use of debt in the 1980’s, Governor Wilder issued Executive Order 38 (1991) which established the Debt Capacity Advisory Committee (Committee or DCAC). Subsequent to the Executive Order, the DCAC was codified in Section 2.2-2712 of the Code of Virginia. The Committee was initially comprised of the Secretary of Finance, the State Treasurer, the Auditor of Public Accounts, the Director of Planning and Budget, the Director of the Joint Legislative Audit and Review Commission, and two citizen members appointed by the Governor. Legislation enacted in 2010 added three additional members to the Committee: the staff directors of the Senate Finance and House Appropriations Committees, and the State Comptroller. The Secretary of Finance serves as Chairman.

The Committee is vested with the power and duty to annually review the size and condition of the Commonwealth’s tax-supported debt and to submit to the Governor and the General Assembly, by January 1st of each year, an estimate of the maximum amount of new taxsupported debt that prudently may be authorized for the next biennium. The Committee’s recommendations must consider the projected debt service requirements over the current fiscal year and the following nine fiscal years. The Committee must also review annually the amount and condition of obligations for which the Commonwealth has a contingent or limited liability, and for which the Commonwealth is permitted to replenish reserve funds if deficiencies occur (i.e., Moral Obligation debt).

Control of debt burden is one of several key factors evaluated by rating agencies in their assessment of a state’s credit quality. Other factors include: economy, financial management, governance, budgetary and operating performance, and debt and pension liabilities. The Commonwealth’s triple-A bond rating, which it has held since 1938, facilitates access to the capital markets at the lowest borrowing cost. However, the ability to take on additional debt while maintaining the triple-A ratings is not unlimited. Higher debt service payments (a fixed expense) mean less flexibility to respond to economic cycles and address other budgetary needs. Because capacity is viewed with many other variables, there is no precise point at which increased debt levels will result in a lower bond rating.

In 1991, after consideration of various alternatives to assess capacity, the Committee decided on a measure based on tax-supported debt service as a percent of revenues. This measure provides a direct comparison of the state’s obligations to the resources available to pay them. Measuring the portion of the State’s resources committed to debt-related fixed costs provides a measure of the State’s budgetary flexibility and its ability to respond to economic downturns.

The target level selected by the Committee in 1991 was five percent - that is, debt service on taxsupported debt obligations should not exceed 5% of blended revenues. This measure is intended to ensure that annual debt service payments do not consume so much of the state’s annual operating budget as to hinder the Commonwealth’s ability to provide core government services. This basic measure has been endorsed by the DCAC in each subsequent year.

In the wake of the 2008 financial melt-down and the resulting economic downturn, coupled with the increased debt burden of several years of significant bonded debt authorizations, the December 18, 2009 DCAC Report to the Governor and the General Assembly conveyed there was no additional debt capacity. As a result of the findings in the 2009 DCAC Report, the Committee determined that a study should be completed to reevaluate the model and consider ways to smooth dramatic changes in capacity in times of extraordinary revenue fluctuations.

Following the 2010 study, the Committee considered various measures (e.g., debt per capita), as well as changes to the treatment of transportation debt in the model. Ultimately, the changes adopted by the Committee were the (i) inclusion in the model of the 0.25% sales tax enacted in 2004 and certain recurring transfers to the general fund from non-general funds, (ii) the reduction of debt service carried in the model for amounts expected to be paid from non-general fund sources, (iii) a change to the interest rate proxy used to estimate the debt service on future borrowings, and (iv) using a ten-year average capacity to arrive at the Committee’s recommendation rather than basing it solely on the next two year period. This latter recommendation was an effort to smooth the effect of dramatic revenue fluctuations, and to facilitate long-term capital planning. The target measure of annual debt service payments to annual blended revenues remained unchanged at 5%.

It is important to note that maintaining debt service at less than 5% of revenues is merely a benchmark of affordability. Debt service requires annual appropriation, and to the extent debt is authorized and issued, debt service will limit the amounts available for other budgetary needs.