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:

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.

Tuesday, 4 April 2017

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).


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.