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:

Other councils will be a little different. Rural councils, especially, get a higher percentage of revenue from subsidies (for roads) than urban councils. But these figures are roughly representative of a council budget. Some key points:

• 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:

1. This is absolutely orthodox accounting; if councils didn't depreciate their assets they would be breaking the law
2. 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.

LG Funding: A Big Picture

Any discussion on local government funding needs a big picture to help keep all the bits and pieces straight. As the picture below shows, councils  get their money from many sources. And those funds take different pathways through a council. This map applies mostly to territorial authorities not regional councils although the rules are the same for both.

Council budgets and accounts are structured into operating and capital components. The operating budget pays for supplies (maintenance contractors, energy, insurance etc), staff, payment of interest, and depreciation of assets. The capital budget pays for new and replacement assets as well as upgrades. These assets are both the public assets (roads, pipes, libraries etc) as well as internal assets (such as council buildings, IT, vehicles etc).

Notes:

1. Local Government uses standard accounting

All council accounting practices comply with NZ accounting standards. Some councils go even further and sign up to International Financial Reporting Standards. This means their accounts can be read in exactly the same way as Spark's or Fonterra's.

2. Local Government budgets backwards

Unlike central government, councils work out what they need to spend then work backwards to calculate how much they need to raise by way of rates and debt to fund the programme.

3. The Operating Surplus

The Local Government Act requires councils to balance their operating budgets and, as a rule, they do not budget for a profit or surplus. The surplus they do generate comes mostly from depreciation of assets. So this is the money they "put aside" to replace assets when they wear out. In practice they do not route the money through a reserve account and it goes straight to the capital expenditure accounts. If an activity does not need all that money for asset replacement in any one year then the capital surplus goes to the capital reserves. So I show a direct link from operating surplus to capital budget.

Local Government Funding: The Shand Report Ten Years Later

Funding local government is back in the news. Most recently it was Phil Twyford floating an infrastructure bond scheme. As well as backing the Twyford proposal, the New Zealand Initiative are pushing very hard for a revenue sharing agreement between central and local government linked to GST. And there has been lots of discussion on a bed tax to fund tourism infrastructure. Auckland Council wanted to toll the government's motorway network to pay for their own transport projects. Local Government NZ did a sector-wide funding review and produced its own 10-point plan. What is in common to all these proposals is that there is a need for more infrastructure that is not being met quickly enough for lack of funds to get it built.

What is so hard about ensuring that public goods provided locally are properly funded? It's mainly political. Central government would have to either raise taxes or cut its own budgets to divert more money to councils. Or they would have to grant more freedom to councils to raise funds through new tax mechanisms (like bed taxes, tolls, regional sales tax etc). Both courses of action would require central government to reverse decades of stripping both power and funds from local government. And that is very unlikely to happen any time soon.

Central government have inadvertently painted themselves into a policy corner through their on-going narrative about the untrustworthiness of the entire local government sector. Most notably Rodney Hide and Nick Smith have been publicly critical of councils for spending too much money. But in reality almost all legislative changes pertaining to local government since and including the Local Government Act 2002 have had a sub-text of the need to rein in the sector and the need for central government to exert more control over local government. Obviously it is near impossible to promote that line over decades then turn around and simply hand over more money and/or power to councils.

So, I doubt there is any appetite outside Local Government New Zealand for granting the sector more money raising powers. I am OK with that if only because it gives us a chance to look properly at the problem rather than rush into a knee-jerk solution that will probably cause as many unforeseen problems as it solves.

What is missing from the equation is a shared, comprehensive understanding of local government finances and accounting practices. So what we are getting is a whole bunch of point solution proposals that may or may not work, and may or may not have unforeseen side-effects. Unfortunately we don't have a lot of independent analyses of local government finances to help us evaluate these proposals.

The Shand Report 2007

One place to start is the 2007 Shand Report (officially "Funding Local Government"). It is a wide-ranging look at local government funding with a focus on rates. To a large degree the main concern of the inquiry was affordability of rates so there are gaps. I don't think they really got to grips with the drivers of funding requirements but, from memory, the Terms of Reference stopped them from inquiring too deeply on that issue. Nevertheless there are still plenty of relevant takeaways in the report even 10 years on:

Local Government works

Overall the inquiry found that "local government works well....[i]t provides at reasonable cost a substantial range of basic services...". I cannot emphasise enough that the basic system, for all its faults, works fine. A close examination of the problems that get a public airing would show that the apparent faults in the system are specific to certain locations (especially Auckland) or to specific circumstances (e.g. tourism locations). We may not need sector-wide reform at all.

The Inquiry could not identify any glaring issue in local government funding so their recommendations are a basket of smaller reforms that were intended to stabilise rates funding and ensure its sustainability. Their recommendations included council spending restraints, changes to the rating system itself to make it fairer, more use of debt funding, permitting tolling, lifting the share of fuel tax payable to councils, possibly lifting roading subsidies on major urban arterial projects, and government funding support for the three waters.

Increased use of debt funding

Noting how much fully funding depreciation added to rates the Inquiry proposed that councils not fund depreciation and rely more on debt funding for capital renewals rather than accumulated reserves. This is a huge proposal that turns a lot of orthodoxy on its head and I'm not even sure it would be legal under the Local Government Act. But it is closely related to infrastructure bonds so it is very much still a live proposal.

More central government funding

The Inquiry were not coy about recommending that central government divert some of its revenues to local government. In passing it noted that government had withdrawn funding support for water infrastructure and needed to reinstate all or part of it.

More spending restraint

This is not about cutting down on the sausage rolls. The Inquiry's comments concern capital spending programmes. They assumed that councils have total discretion on their programme and should stretch their programmes out more. Because they didn't look too deeply into why councils spend what they spend they may have missed the fact that central government has mandated much of the capital programme over the last 20 years.


How did the Inquiry work out?

Obviously it didn't because successive governments have done almost everything except implement these recommendations. There has been a contestable Infrastructure Fund that has been a failure so far in its objectives and that's about all. From time to time we hear of a council adjusting its capital programme to smoothe out rates rises. Mind you rates affordability doesn't get the air time it once did either. John Palino made a concerted and plausible effort to capture the "down with rates" vote in the last Auckland Council elections but he didn't get very far.

But, as I have noted in passing, many of the Inquiry's recommendations are still live and may yet be implemented. But we can only wonder how Auckland would be today if Rodney Hide (the prime instigator of the Shand Inquiry) had implemented these recommendations when he became Minister of Local Government in 2008. Instead, after ten years of missed opportunity, we are still looking to see whether Hide's only legacy, the forced amalgamation of the Auckland region's councils into one, will ever deliver any significant benefits.

First (and probably only) casualty in Hawkes Bay

We heard today that Hawkes Bay Regional Council Chief Executive, Andrew Newman, has "resigned". For Havelock North and other Hawkes Bay residents who are looking for accountability over the Havelock North gastro outbreak, Newman's departure may be the nearest they get to satisfaction.

Make no mistake: regardless of how it is dressed up Newman has been persuaded to leave. He was always on shaky ground since last year's local body elections. He has been a driver of the Ruataniwha water storage and irrigation scheme for some time. But last year's election tipped the balance on the Council away from the scheme. So instead of having the backing of the elected members Newman was now on the wrong side. He either had to leave or diplomatically pull his head in. He did neither.

HBRC Chair, Rex Graham, is claiming the departure stems from differences over the Ruataniwha scheme but I think there is more to it than that. The nail in the coffin was Newman's extraordinary and unilateral decision to prosecute Hasting District Council over a peripheral matter related to the gastro outbreak. Newman committed the cardinal sin for a local government staffer of taking a sensitive decision with huge public risk attached to it without getting the go ahead from the elected members.

I have no idea why Newman exercised such poor judgement but the prosecution and the investigation that preceded the prosecution showed evidence of a witch hunt. The HBRC investigation into the cause of the gastro outbreak (not their job and they have no expertise in the area but they did it anyway) was completely one-sided. It very much looks like HBRC wanted to blame HDC from the very start and only collected what evidence they needed to support a prosecution. Why would they do that? The Inquiry only needed the various parties to turn up with copies of their records; no-one needed to conduct investigations.

I can only assume that HBRC really wanted to deflect attention from their own failings. It is possible that HBRC did not do enough to protect the groundwater source that HDC relied on or had their attention so diverted by the Ruataniwha scheme proposal that they neglected important scientific work in other parts of the region.

We have more important evidence to be given on the Mangateretere Pond as a source of contaminated water. And then we may know little more about who knew what and when and whether you assign blame to any organisation or person. I suspect we will not have any clear accountability; that we have a systemic error. That being the case take Mr Newman's "resignation" as the price he has paid for HBRC's contribution to the gastro outbreak.

Sorry Havelock North, Probably No Heads on a Pike

RNZ reported on 2 February that the independent Science Caucus assisting the Havelock North Drinking Water Inquiry has determined it's most likely that the source of the campylobacter in the outbreak came from a pond close the the Brookvale No 1 bore. And it seems clear that there is a hydraulic link from the surface pond to the bore.

In terms of deciding what happened there are still two possibilities to be examined: contaminated water ran across the surface into the Mangateretere Pond during a high rainfall event then either entered the bore (i) via the aquifer or (ii) via a hole in the well casing.

In the first scenario the contaminated water was basically sucked down from the pond via a natural pathway through the impervious layer then into the well with the normal clean water.

In the second scenario there is no pathway through the impervious layer but contaminated groundwater flowed around the well and entered the water supply via a hole in the well casing.

A lot of smoke has been wafted around by Hawkes Bay Regional Council, Hastings District Council as well as a lot of private submitters to the Inquiry concerning the cause of the gastro outbreak and, by extension, who is to blame. This report clears the air considerably but, unfortunately, will probably not result in any clear accountability.

Reports suggest that both HBRC and HDC knew about this hydraulic connection as early as 2008. We wait to find out who knew what and when but until then it is likely that the division of responsibilities between HBRC, HDC and the Hawkes Bay District Health Board mean that we simply won't be able to finger one organisation let alone an individual.

The Swimming Baths?

When I was a kid people talked about going to "the baths" about as often as going to the "swimming pool". It always seemed kind of weird but pretty much everything adult was a mystery to me then. I am happy to say I finally solved that little mystery recently when I delved into The Great Filth by Stephen Halliday. 

While the Inquiry into Havelock North's Drinking Water was in recess I thought I would put the whole outbreak and the inquiry into some context. I knew that in the 19th century huge advances were made in public health but I had no idea of the detail. This book is a very readable primer on the various strands of improvement of disease prevention that took place then. The "War Against Disease" had two major strands: the purely medical involved vaccination, childbirth practices and antisepsis in hospitals; the public health stream involved cleaning up water supplies, removing rubbish and improving housing. It's the latter stream that is most relevant to the Inquiry.

You cannot underestimate what a game changer public health improvements were at that time.

During the 60 odd years of Queen Victoria's reign, life expectancy in Britain increased by a staggering 50%. Declines in infant mortality and deaths in hospital, and the eradication of smallpox were important factors as was a lift in nutrition. But, just as important were the great public sanitation improvements carried out by councils: improving the supply of drinking water, improving the removal of sewage and stormwater, providing bathing facilities, and demolishing unsanitary buildings.

Local government achieved something in the late 19th Century that was more important than all the inventions of the time: they made cities livable. Not in the ill-defined way that that word is used today but literally. Until the heroic age of sanitation cities were dangerous places where disease was rife. In fact all places where humans were jammed together in large numbers were dangerous. The enlisted men in the army and navy were much more likely to die from disease than enemy action. Likewise prisoners in London's notorious Newgate Prison had more to fear from "prison fever" than the hangman.

But, as councils built proper water supply systems, and pipes to remove sewage and stormwater, and removed rubbish from the streets the incidence of communicable disease declined significantly. This allowed cities to grow and to benefit from the bringing together of people and their businesses.

There must have been a real sense of mission in some councils. Many of these activities were encouraged by the Medical Officer of Health - who was a council employee in those days. In addition to the engineering works the MoH also oversaw the demolition of insanitary buildings and encouraged changes in city design to get noxious industries separated from people. Amongst other things councils built public bathing facilities so that people could wash if they had no access to proper water supplies. Quietly, over the years, those facilities have transformed into recreational swimming pools although they were known as "the baths" into modern times.

That sense of purpose is long gone and we have been flailing around for the last 30 years trying to define just what local government is for. We are probably still no closer to a compelling answer to match the triumph of the Victorian Age.

As the Havelock North Drinking Water Inquiry continues I will be looking to see whether this loss of purpose was a factor in the outbreak. It certainly let down everything that the great pioneers of public health fought for 150 years ago.

Break over

I'm back from an extended break now that that the Havelock North Drinking Water Inquiry has resumed.