Will the government's Housing Infrastructure Fund finally make a dent in New Zealand's housing crisis? Probably not. It has elements of being a step in the right direction but, overall, it is way too tentative and doesn't solve the real problem anyway.
The underlying problem
If houses in Auckland were as affordable as they are in the Greater Tokyo Area (the world's largest metropolis and one of a handful of truly global cities) then the median house price would be in the region of $450k - $500k.
The main reason that they are actually double that price boils down to insufficient land being made available for development. What little is available has been bid up to astronomical levels reflecting the incredibly short supply. Unfortunately a speculation bubble has also formed on top of the normal price rise in response to the short supply.
Without going into all the ins and outs, any policy response to the high price of residential housing has to deal with two, inter-related problems: (i) there aren't enough dwellings to house the population of the country and (ii) speculators will keep bidding land and dwellings up out of the reach of normal people as long as they are convinced that authorities cannot or will not make it possible for enough dwellings to be built.
If building restrictions are just lines on maps then why don't councils simply allow more building? That was the theory behind Special Housing Areas. But fast-tracking permission to develop land for housing means nothing when there is no supporting infrastructure. You simply are not allowed to even start building a house in New Zealand unless you can demonstrate that basic services can be supplied.
The fact is that councils cannot find enough funding through normal channels to build enough basic infrastructure to get ahead of the demand curve for development. This is well known to the land bankers who can rely on council funding constraints when assessing the risks of land speculation.
The Housing Infrastructure Fund
Will the HIF break this log jam? Unlikely. Some of the reasons why:
Showing posts with label LG finances. Show all posts
Showing posts with label LG finances. Show all posts
Tuesday, 25 July 2017
Monday, 17 July 2017
Depreciation pt 1: the mechanics and revaluations
OK depreciation is a pretty dull topic. But it's not widely understood and it is a crucial component in the council funding model. We can't have a sensible discussion about the merits of Municipal Utility Districts or infrastructure bonds without a working knowledge of depreciation. This post aims to show that the mysterious world of depreciation and asset revaluation is really quite mechanical. A planned later post will discuss the "so what?" aspects of depreciation.
We are all familiar with the decline in value over time of the stuff we own. Our cars, computers, furniture etc are worth less this year than they were a year ago. In business, both private and public, this decline in asset value is formally tracked and accounted for in financial statements. So each year the value of fixed assets (cars, computers, plant) in the books is written down by some fixed percentage. Eventually, for accounting purposes, individual assets are deemed to be worthless and are no longer depreciated.
But there is a useful accounting practice that makes up for the loss of value. All private, public and not-for-profit businesses count that loss of value as an expense. As these organisations take in money they also have to pay operating expenses such as staff costs, power, insurance, raw materials and so on. Depreciation is counted as another expense except that there is no bill to pay so the money stays inside the business. That bit of cash can be put aside before any income or company taxes are calculated and paid.
For example if you buy a computer for a business for $900 that has a nominal life of three years then each year you depreciate the value of the computer by $300 and "put aside" $300 in cash. You can do whatever you like with the cash but if you did hold onto it, after three years your computer would be valued at $0 and you would have $900 in the bank. So you could go out and buy a replacement computer if you wanted to without having to put any more of your own money into the business.
Councils do the same thing with the value of their physical assets. But, because they are capital intensive industries the sums of money are comparatively eye-watering.
A simple example
Let's say a council builds a new bridge for $20m and the bridge's accounting life is 100 years. (Of course there are Roman bridges still standing after 2,000 years but for the purposes of managing money you have to draw a line somewhere).
The calculations are pretty straight forward at first. For accounting purposes the bridge will be worth $0 after 100 years so each year the council depreciates the bridge by $200,000. After one year the bridge is valued down to $19.8m and there are cash reserves of $200k. That process could continue each year for 100 years until the bridge was valued at $0 and there was $20m in cash in the bank.
That $200,000 cash still has to physically come from somewhere and it mostly comes from rates. In this example, building a new bridge automatically added $200,000 p.a. to the total rates take. If that seems a little strange I plan to clarify rating for depreciation in a later post.
Inflation and revaluation
Inflation (even super-low inflation) will savage that $20m over 100 years. The council could invest the money and chances are they could preserve its spending power. But, for a number of reasons, councils don't do that (they pretty much spend the money straight away). Instead, they revalue their assets periodically and, as a result, adjust the amount of depreciation they charge to keep in line with cost inflation.
Councils base their depreciation calculations on what it would cost to replace their assets today not what they originally spent. In the example of the bridge, after three years of owning it the council would get it revalued and recalculate the depreciation charge. The Civil Construction Price Index is currently running at about 3% p.a. (i.e. double the rate of consumer price inflation). At 3% annual price inflation the same $20m bridge would cost about $21.855m to build three years later.
Since the bridge is already three years old it only has 97 years of accounting life left, therefore the book value is set at $21.2m (97/100* replacement cost). The bridge is still going to be depreciated to a value of $0 over its remaining life so the new annual depreciation charge is 1/97 * book value or $218,545 p.a..
By revaluing the bridge every three years the council can keep lifting the depreciation charge to stay in line with current construction costs. Effectively it inflation-proofs its depreciation.
To Takeaway
Sure this stuff is as dry as dust but that is the whole point. The actual process of calculating and funding depreciation is orthodox accounting practised by private and non-private organisations all over the world. From time to time I see people convincing themselves that depreciation and revaluation is some kind of double-dipping or shady money practice. Nothing could be further from the truth.
Revaluation is a normal practice too. Listed property companies would not survive an audit if they didn't revalue their buildings every few years.
The only interesting part is what happens to the money that does collect via depreciation. And that topic is for another day.
We are all familiar with the decline in value over time of the stuff we own. Our cars, computers, furniture etc are worth less this year than they were a year ago. In business, both private and public, this decline in asset value is formally tracked and accounted for in financial statements. So each year the value of fixed assets (cars, computers, plant) in the books is written down by some fixed percentage. Eventually, for accounting purposes, individual assets are deemed to be worthless and are no longer depreciated.
But there is a useful accounting practice that makes up for the loss of value. All private, public and not-for-profit businesses count that loss of value as an expense. As these organisations take in money they also have to pay operating expenses such as staff costs, power, insurance, raw materials and so on. Depreciation is counted as another expense except that there is no bill to pay so the money stays inside the business. That bit of cash can be put aside before any income or company taxes are calculated and paid.
For example if you buy a computer for a business for $900 that has a nominal life of three years then each year you depreciate the value of the computer by $300 and "put aside" $300 in cash. You can do whatever you like with the cash but if you did hold onto it, after three years your computer would be valued at $0 and you would have $900 in the bank. So you could go out and buy a replacement computer if you wanted to without having to put any more of your own money into the business.
Councils do the same thing with the value of their physical assets. But, because they are capital intensive industries the sums of money are comparatively eye-watering.
A simple example
Let's say a council builds a new bridge for $20m and the bridge's accounting life is 100 years. (Of course there are Roman bridges still standing after 2,000 years but for the purposes of managing money you have to draw a line somewhere).
The calculations are pretty straight forward at first. For accounting purposes the bridge will be worth $0 after 100 years so each year the council depreciates the bridge by $200,000. After one year the bridge is valued down to $19.8m and there are cash reserves of $200k. That process could continue each year for 100 years until the bridge was valued at $0 and there was $20m in cash in the bank.
That $200,000 cash still has to physically come from somewhere and it mostly comes from rates. In this example, building a new bridge automatically added $200,000 p.a. to the total rates take. If that seems a little strange I plan to clarify rating for depreciation in a later post.
Inflation and revaluation
Inflation (even super-low inflation) will savage that $20m over 100 years. The council could invest the money and chances are they could preserve its spending power. But, for a number of reasons, councils don't do that (they pretty much spend the money straight away). Instead, they revalue their assets periodically and, as a result, adjust the amount of depreciation they charge to keep in line with cost inflation.
Councils base their depreciation calculations on what it would cost to replace their assets today not what they originally spent. In the example of the bridge, after three years of owning it the council would get it revalued and recalculate the depreciation charge. The Civil Construction Price Index is currently running at about 3% p.a. (i.e. double the rate of consumer price inflation). At 3% annual price inflation the same $20m bridge would cost about $21.855m to build three years later.
Since the bridge is already three years old it only has 97 years of accounting life left, therefore the book value is set at $21.2m (97/100* replacement cost). The bridge is still going to be depreciated to a value of $0 over its remaining life so the new annual depreciation charge is 1/97 * book value or $218,545 p.a..
By revaluing the bridge every three years the council can keep lifting the depreciation charge to stay in line with current construction costs. Effectively it inflation-proofs its depreciation.
To Takeaway
Sure this stuff is as dry as dust but that is the whole point. The actual process of calculating and funding depreciation is orthodox accounting practised by private and non-private organisations all over the world. From time to time I see people convincing themselves that depreciation and revaluation is some kind of double-dipping or shady money practice. Nothing could be further from the truth.
Revaluation is a normal practice too. Listed property companies would not survive an audit if they didn't revalue their buildings every few years.
The only interesting part is what happens to the money that does collect via depreciation. And that topic is for another day.
Thursday, 22 June 2017
LG Funding: Capital Funding Overview
If rates are almost always used to fund daily operating expenses where does the money come from to build or buy the big assets like pipes, roads and buildings? The answer depends largely on what the reason for the project is.
Councils carry out capital projects for a number of reasons but all projects will fit into one or more of three categories: new, upgrade or replacement. When we talk about how councils fund capital works we need to use these terms precisely since different funding streams attach to the three categories.
Replacement projects
All major assets will wear out eventually. The lifetime of pipes, roads and buildings is measured in decades but there will still come a point where, even with regular maintenance, an asset has to be replaced rather than patched up.
There is an existing funding stream for replacement via depreciation charges. The vital thing to remember is that the amount of funds collected assumes that assets will be replaced on a like-for-like basis. A narrow bridge attracts depreciation at "narrow bridge" levels not "4 lane motorway bridge" levels.
Over decades circumstances change so it is rare to see a pure replacement project except for some components like a water pump that has a much shorter life. We expect better quality buildings than the ones we built 80 years ago; and we expect better quality roads, water systems etc. For example Dunedin's covered stadium is technically a replacement project since the city was replacing the old Carisbrook facility. But no-one would tear down Carisbrook and simply rebuild it as was, so the new stadium has a lot of upgrade components to it to bring the sporting venue to modern standards (and a bit beyond). However, as the on-going saga of how to fund that stadium shows, depreciation doesn't pay for the new goodies, only for replacing the worn-out components.
New Assets
New means genuinely new. Either a new asset extends or enlarges an existing network or it provides a completely new service. So putting in new pipes in a subdivision creates new assets as does building a new pump station to service that development. Building a water activity pool next to a swimming pool adds a new asset.
When a project adds capacity to an existing service to cater for growth (as in the former example above) then councils can ask the creators of new properties (usually developers) to make a capital contribution to pay for new assets. These capital contributions can be either or both of financial contributions under the Resource Management Act or development contributions under the Local Government Act.
When councils simply want to do something new (as in the latter example) there is no dedicated funding stream and councils have to find new money themselves.
Upgrade projects
A pure upgrade project simply lifts the quality of an asset without changing its function or its capacity. A simple example would be replacing older windows in building with double-glazed units. The building has the same capacity and does the same job, it just does it better.
Upgrade projects should not be confused with life-extending capital works. Many assets will survive long past their design life if, from time time, some major money is spent on them to maintain their integrity. In this case it is normal to use accumulated depreciation to fund this type of work.
A reasonably common example of an upgrade project is re-aligning a road or intersection for safety reasons. A corner may be rebuilt or a road straightened but at the end of the project the road is still doing the same job for the same number of users albeit with a lower probability of a serious accident occurring there.
Most upgrade projects have no dedicated funding available. The safety upgrade I mentioned above might attract funding from NZTA under certain circumstances and from time to time there may be some nation-wide subsidy schemes operated by government that councils can take advantage of. But, in general, they have to find the money themselves for these sorts of projects.
Real Life Jumble
In practice capital projects rarely fall into those simple categories and many are funded from multiple sources. So councils have to exercise considerable judgement in deciding how much to fund a specific project from capital reserves (depreciation), how much from development contributions, and how much from debt or other sources. We have to hope they exercise good judgement because their mistakes may take decades to become obvious.
How well does the system work?
We can keep council assets going in their current state indefinitely under current arrangements. The Shand Inquiry was confident that councils would have no significant problems replacing assets over time. Their assessment was backed up by the Auditor-General who also saw no looming problem.
In theory we can also grow our cities using existing funding mechanisms but the system definitely works best when growing out rather than up. It is also a clunky and inflexible system that tends to lock councils into ten or eleven years of commitment that assumes a fixed and predictable rate of growth. As Auckland found out over the last decade assuming steady rates of growth is unwise.
If councils want to avoid levying capital via rates (and they should avoid that practice as it is manifestly unfair) then upgrading existing assets is always going to be difficult. The major source of funds for upgrades is debt. Once a council has reached its practical limit for carrying debt then it is in a difficult place if some new must-do project comes along.
The system works adequately as long as the following conditions apply:
Councils carry out capital projects for a number of reasons but all projects will fit into one or more of three categories: new, upgrade or replacement. When we talk about how councils fund capital works we need to use these terms precisely since different funding streams attach to the three categories.
Replacement projects
All major assets will wear out eventually. The lifetime of pipes, roads and buildings is measured in decades but there will still come a point where, even with regular maintenance, an asset has to be replaced rather than patched up.
There is an existing funding stream for replacement via depreciation charges. The vital thing to remember is that the amount of funds collected assumes that assets will be replaced on a like-for-like basis. A narrow bridge attracts depreciation at "narrow bridge" levels not "4 lane motorway bridge" levels.
Over decades circumstances change so it is rare to see a pure replacement project except for some components like a water pump that has a much shorter life. We expect better quality buildings than the ones we built 80 years ago; and we expect better quality roads, water systems etc. For example Dunedin's covered stadium is technically a replacement project since the city was replacing the old Carisbrook facility. But no-one would tear down Carisbrook and simply rebuild it as was, so the new stadium has a lot of upgrade components to it to bring the sporting venue to modern standards (and a bit beyond). However, as the on-going saga of how to fund that stadium shows, depreciation doesn't pay for the new goodies, only for replacing the worn-out components.
New Assets
New means genuinely new. Either a new asset extends or enlarges an existing network or it provides a completely new service. So putting in new pipes in a subdivision creates new assets as does building a new pump station to service that development. Building a water activity pool next to a swimming pool adds a new asset.
When a project adds capacity to an existing service to cater for growth (as in the former example above) then councils can ask the creators of new properties (usually developers) to make a capital contribution to pay for new assets. These capital contributions can be either or both of financial contributions under the Resource Management Act or development contributions under the Local Government Act.
When councils simply want to do something new (as in the latter example) there is no dedicated funding stream and councils have to find new money themselves.
Upgrade projects
A pure upgrade project simply lifts the quality of an asset without changing its function or its capacity. A simple example would be replacing older windows in building with double-glazed units. The building has the same capacity and does the same job, it just does it better.
Upgrade projects should not be confused with life-extending capital works. Many assets will survive long past their design life if, from time time, some major money is spent on them to maintain their integrity. In this case it is normal to use accumulated depreciation to fund this type of work.
A reasonably common example of an upgrade project is re-aligning a road or intersection for safety reasons. A corner may be rebuilt or a road straightened but at the end of the project the road is still doing the same job for the same number of users albeit with a lower probability of a serious accident occurring there.
Most upgrade projects have no dedicated funding available. The safety upgrade I mentioned above might attract funding from NZTA under certain circumstances and from time to time there may be some nation-wide subsidy schemes operated by government that councils can take advantage of. But, in general, they have to find the money themselves for these sorts of projects.
Real Life Jumble
In practice capital projects rarely fall into those simple categories and many are funded from multiple sources. So councils have to exercise considerable judgement in deciding how much to fund a specific project from capital reserves (depreciation), how much from development contributions, and how much from debt or other sources. We have to hope they exercise good judgement because their mistakes may take decades to become obvious.
How well does the system work?
We can keep council assets going in their current state indefinitely under current arrangements. The Shand Inquiry was confident that councils would have no significant problems replacing assets over time. Their assessment was backed up by the Auditor-General who also saw no looming problem.
In theory we can also grow our cities using existing funding mechanisms but the system definitely works best when growing out rather than up. It is also a clunky and inflexible system that tends to lock councils into ten or eleven years of commitment that assumes a fixed and predictable rate of growth. As Auckland found out over the last decade assuming steady rates of growth is unwise.
If councils want to avoid levying capital via rates (and they should avoid that practice as it is manifestly unfair) then upgrading existing assets is always going to be difficult. The major source of funds for upgrades is debt. Once a council has reached its practical limit for carrying debt then it is in a difficult place if some new must-do project comes along.
The system works adequately as long as the following conditions apply:
- population growth is low-medium
- population growth is predictable
- the urban form and infrastructure allows for outwards expansion in preference to intensifying existing built areas
- there aren't too many external drivers of change at once
You will note that none of these conditions apply to Auckland.
Some specific problem areas
Intensification
Upgrading infrastructure to support higher density populations causes all sorts of financial problems. Working in a built environment is more costly than in open fields. But, worse, upgrading often means throwing away serviceable assets in favour of new assets with greater capacity. For councils there will almost certainly be a funding gap that can only be plugged through debt even though they will be able to use both depreciation and development contributions. Again, once a council has reached its debt ceiling it can't intensify any further until some of the debt is paid off.
Stormwater
Councils have a huge off balance sheet liability staring them in the face right now: climate change. Stormwater and drainage systems have been designed for lower intensity rainfall events. They can't handle every event but most common ones they can. But we are already experiencing more frequent events at higher intensity levels and that will be the new normal. Dunedin is the most high-profile drainage failure but we have also had problems in Auckland, Edgcumbe, Hutt Valley and we can expect flooding problems to be more widespread around the country in the future.
Councils have some accumulated depreciation to use to upgrade their systems but that's it. Who knows where the rest is going to come from.
Others
There are other problems heading our way: drinking water (in the aftermath of the Havelock North gastro outbreak), disaster resilience, tourism infrastructure are a few that leap to mind.
There will be funding problems for all of the capital projects that the public may expect or the government may mandate to deal with problems in these areas.
Tuesday, 13 June 2017
Funding tourism infrastructure
Paula Bennett has just announced funding for tourism-related projects in our smaller councils. A typical example is the Hurunui District's proposal to build toilets and a dump station for motorhomes at Culverden for $250k. The government is funding the construction with Hurunui District owning and operating the facility afterwards.
This contribution is certainly not nothing but it isn't totally generous either. There's an old saying that buying a car is the cheapest thing you ever do and that is certainly true of infrastructure like this. Taking advantage of the cash contribution of the government could well end up costing Hurunui ratepayers twice as much over the lifetime of the asset. In present value terms it's about half the lifetime cost of the asset. Not nothing but why isn't the government funding 100% of the lifetime cost?
Once Hurunui District have built their toilets they will immediately incur a whole bunch of operating costs which will have to be funded by ratepayers. Depreciation alone will rack up, say, $5k every year assuming a 50 year lifetime. Cleaning, carting away sewage, general maintenance, insurance, power, supervision etc will add at least another $5k p.a. Over 50 years that's about $500k. The present value of that cash flow is about $200k.
The figures will vary lots between projects but these representative figures indicate the government is contributing just over half the real cost. In practice I would assume that the contribution is less than half because the operational costs of looking after high use facilities is higher than the average for normal assets. There's more damage, more cleaning, more signage, more inspecting.
For a small district like Hurunui all these little costs add up and, while it would be nice to pass on those costs just to those local businesses that benefit from tourism it isn't practical to do so. All the ratepayers will have to share in these costs because there is no way to charge the tourists themselves.
In general I am not a fan of revenue-sharing but this is one situation where it is merited. Dr Eric Crampton recently:
There is certainly a moral case for the government to hand over more of their tax take to councils to support tourism. It doesn't have to be huge. Bigger centres can handle the current number of tourists without noticeable distortions in their budgets. Auckland and Christchurch especially profit from their ownership stakes in busy international airports. But the smaller councils could do with more help. And that help should be annual operating support not just occasional capital contributions.
There is nothing new in the concept of targeting capital and operating funding to councils. The NZ Transport Agency has been doing it for years for roading. The government just needs to copy the method and apply it to tourism.
Ironically the Minister for Tourism, herself, has articulated the best case for revenue sharing. She recently rejected allowing councils to charge bed taxes on the basis that tourists already pay enough in GST. Fair enough. Now all she has to do is see that our international tourists benefit fully from the taxes they pay by handing over some of it to councils to build and operate better tourist facilities.
This contribution is certainly not nothing but it isn't totally generous either. There's an old saying that buying a car is the cheapest thing you ever do and that is certainly true of infrastructure like this. Taking advantage of the cash contribution of the government could well end up costing Hurunui ratepayers twice as much over the lifetime of the asset. In present value terms it's about half the lifetime cost of the asset. Not nothing but why isn't the government funding 100% of the lifetime cost?
Once Hurunui District have built their toilets they will immediately incur a whole bunch of operating costs which will have to be funded by ratepayers. Depreciation alone will rack up, say, $5k every year assuming a 50 year lifetime. Cleaning, carting away sewage, general maintenance, insurance, power, supervision etc will add at least another $5k p.a. Over 50 years that's about $500k. The present value of that cash flow is about $200k.
The figures will vary lots between projects but these representative figures indicate the government is contributing just over half the real cost. In practice I would assume that the contribution is less than half because the operational costs of looking after high use facilities is higher than the average for normal assets. There's more damage, more cleaning, more signage, more inspecting.
For a small district like Hurunui all these little costs add up and, while it would be nice to pass on those costs just to those local businesses that benefit from tourism it isn't practical to do so. All the ratepayers will have to share in these costs because there is no way to charge the tourists themselves.
In general I am not a fan of revenue-sharing but this is one situation where it is merited. Dr Eric Crampton recently:
International tourists currently contribute over a billion dollars in GST. If more of the tourists’ contribution to the government’s coffers turned into better facilities in the places tourists go, pressure on those places would ease, making a better experience for locals and tourists alike.Where does the $1bn go? Good question. The two main contributions the government makes towards tourism is (i) funding Tourism New Zealand ($110m odd) and (ii) funding the Department of Conservation ($465m) The DoC funding benefits tourists and locals alike and covers activities that appeal to tourists and many that have no relevance to tourists. When you strip out the components of the funding that do not directly service international tourism you would be very generous to assume tourists benefit from any more than $300m of the taxes they pay. So maybe $400m all up is used by the government to support international tourism. Which leaves $600m profit per annum for the government to spend on other things. Needless to say private sector operations do not enjoy a 150% contribution toward profit from their expenditure. And small councils get nothing at all from their expenditure.
There is certainly a moral case for the government to hand over more of their tax take to councils to support tourism. It doesn't have to be huge. Bigger centres can handle the current number of tourists without noticeable distortions in their budgets. Auckland and Christchurch especially profit from their ownership stakes in busy international airports. But the smaller councils could do with more help. And that help should be annual operating support not just occasional capital contributions.
There is nothing new in the concept of targeting capital and operating funding to councils. The NZ Transport Agency has been doing it for years for roading. The government just needs to copy the method and apply it to tourism.
Ironically the Minister for Tourism, herself, has articulated the best case for revenue sharing. She recently rejected allowing councils to charge bed taxes on the basis that tourists already pay enough in GST. Fair enough. Now all she has to do is see that our international tourists benefit fully from the taxes they pay by handing over some of it to councils to build and operate better tourist facilities.
Thursday, 27 April 2017
LG Funding: Rates
When it comes to funding local government, rates are usually top of mind. A lot of nonsense gets talked and written about rates as very, very few people genuinely understand what rates are and what they pay for. Even the Shand Report confidently talked about rates paying for local infrastructure which is technically untrue. So this post contains some more detail about the place of rates in the funding equation, what rates are spent on, and what affects the amount of rates charged.
It pays to have some real numbers available when discussing council funding. To that purpose I have raided Hamilton City's Ten Year Plan 2015-25 and pulled out what they proposed to spend in the current financial year. I think of Hamilton City as an "everyperson" city: it is big enough for its council to be engaged in every standard activity but it has none of the special case characteristics of other cities like Auckland and Christchurch. And these are their numbers:
- Rates provide 74% of operating revenue for the significant activities
- The core functions of water, sewer, stormwater, transport and rubbish take 56% of rates
- Parks and recreation take another 15% with all the other activities of the council taking up the remaining 29%
- Generally, rates only fund operating costs
- Hamilton City has a couple of unusual inclusions. They have deliberately budgeted for a modest operating surplus (profit) on top of normal operating expenses and they are levying capital via rates to fund new transport and parks projects. Combined, the surplus and capital levies still only represent a very small percentage of overall rates.
- The operating surplus I show in the diagram is far from modest but almost all of it comes from depreciation charged on existing assets. The operating "profit" is very small by comparison.
Do we need a change?
Rates pay for the daily costs of owning and operating all the infrastructure and other services of councils. And they are as good as any other way of getting local people to pay for local services.As I said previously, the Inquiry into Local Government Funding did not find any glaring problems with the existing set-up. In the end they suggested a series of modest reforms rather than a radical overhaul.
Of course there are ways of funding local government other than by rates. One common suggestion is for more revenue-sharing - that is, central government handing over some oif its revenue to councils based on some pre-set formula. Options include population-based funding (capitation) or a share of sales taxes (GST) generated locally. Local Government NZ would take the broadening of the funding base even further through granting councils the powers to impose their own taxes such as road-tolling or bed taxes. I would not support any major shift away from the current rating system. Rating has its problems but, thanks to some quirks in how it operates, it does deliver a good result to its communities.
Councils tax in the opposite way to central government. They forecast how much it will cost to deliver the required local public goods and services and then strike a compulsory rate across all the properties in their territory to recover their costs. Central government, on the other hand, take a percentage of income and consumer spending and then work out what to spend it on. In the normal run of things, government revenues rise and fall with the economy which tends to focus the minds of the Cabinet as they formulate fiscal and other policy. Conversely, the problem with rating is that there is no direct link between a council's budget and local economic well-being. Auckland Council does not suffer financially when households and businesses have to cope with massive rises in housing costs even though, arguably, it was the Council's own policies and plans that caused that rise in costs.
The ratepayer experience is also different from the taxpayer experience. Central government takes a very large part of its revenue invisibly through PAYE, ACC, GST, fuel tax and other embedded taxes. Ratepayers (except for renters) make an explicit payment and tend to notice it when they do. And because we notice the amounts on our rates demand we also tend to question whether the amount is too high. Unfortunately we have no way of assessing the true value of rates. We cannot comparison shop and we tend to take most of the rates-funded services completely for granted anyway. Our only practical option is to compare this year's rates to last years's and be very suspicious if they go up "too much" (whatever that means!). In this climate councils tend to take the "fiscal envelope" approach.
The fiscal envelope comes from the strong desire for councillors to want to restrict rate rises for homeowners (=voters) so that rises are predictable and, preferably, at or not too far above CPI. They will play with timing on expenditure to smooth out rises. But more importantly they will reluctantly put aside any grand plans that can only be funded via rates if they are not absolutely necessary.
Sorry for being a bit long-winded but I hope I have shown that the rating system provides a natural brake on the spending ambitions of councils, a brake we do not want to lose. Important institutions that support the development of good quality public expenditure in central government (competitive advice, skilled economic analysis, and informed public scrutiny) are simply absent from local government. And, you don't have to go far to find examples of councils indulging in hare-brained spending. Any increase in non-rates funding must avoid the moral hazard of simply dumping "no strings" cash into the hands of councillors itching to turn their place into the "world's #1 <insert current buzzword here> city". You only have to look at councils like Wellington City Council to see what happens when a council has too much money.
So, I don't want to see a significant change in funding mechanisms for operating expenditure in councils.
Why do rates rise faster than CPI?
If there is a brake on rates rises as I claim then how come rates still rise faster than CPI? There is no simple answer. Although councils are not known for aggressively seeking cost savings I have never been convinced either by the claim that councils are out of control. There are plenty of ways they could save money but the savings would not compensate for a couple of other major cost drivers: input costs and ownership costs of infrastructure.
Councils don't go to the supermarket. They buy energy to light streets, heat pools and run pumps; they insure their assets; and they pay contractors to build and maintain roads, water schemes, parks and buildings. Even before the Christchurch earthquakes insurance premiums for councils were rising faster than CPI as were energy costs. But the biggie is contained in 4 letters: S2GC. This is the code for the Civil Construction Price Index maintained by Statistics NZ. According to SNZ prices have been rising way faster than consumer prices for a long time. For example, in the 12 months ending December 2016 the Civil Construction Price Index rose by 3.12%. By comparison CPI only rose 1.3%. But these rising construction costs go way back to at least 2002.
Rising civil construction prices deliver a quintuple whammy to councils. Obviously the costs of capital projects are rising rapidly. But these rising costs also affect maintenance costs (same contractors, same charge rates), if debt-funding is used then there is more interest to pay, depreciation, and insurance. I will have a lot more to say about depreciation in the next post but if you consider that maintenance and depreciation are the the two biggest ticket items in the operating budgets for core network infrastructure then you see why rates are heading where they are.
The Operating Surplus
OK let's take a look at that massive operating surplus feeding into the capital budget. When I opened up Hamilton City's Ten Year Plan they did show both a deliberate "profit" and some capital levies via rates. But almost all of that operating surplus comes from depreciation. Depreciation is a big enough topic to require its own post. For now there are a couple of points to note:
- This is absolutely orthodox accounting; if councils didn't depreciate their assets they would be breaking the law
- Councils can do a handy thing because they are not subject to Income or Company Tax: they can transfer the surplus immediately into the capital accounts at the start of a financial year. It looks like they are rating for capital projects but really they are compressing into one year what private companies have to do over two.
So, in the end...
Rates (on the whole) are a pay-as-you-go scheme that effectively collects a daily charge for use of local public goods and services. Councils only take rates to fund legitimate operating expenses (more or less). In theory it doesn't matter whether you are a resident for 5 days or 50 years you pay your rates and use council services on an equal basis to everyone else.
The sustainability of rating doesn't appear to be an issue right now. Obviously we can't continue to have per-property rates rises in excess of income growth forever but we have no idea what the cutoff point is. Any limit you see published today is simply a number plucked out of thin air for the sake of having a number. How do you value supply of potable water to property against (say) takeaway food within a household budget?
Each resident of Hamilton (adults and children) pays about $85 per month through household rates for unlimited access to potable water, sewer, stormwater, roads and footpaths, parks and reserves; limited access to solid waste removal, libraries, art galleries; and subsidised access to swimming pool use. A monthly mobile plan for unlimited voice and text and limited use of the internet will set them back about $50. How do we compare the two plans?
Councils spend about 20% of revenue on staff salaries the rest goes to purchases and interest payments where the prices are supposed to be market-driven and competitive. Realistically, if we need rates to go down in real terms then the only option is to start cutting services.
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