Infrastructure funding tools part 2: A dispassionate comparison

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Our economist, David Norman, reviews infrastructure funding for local government in part two of his article series.
Our economist, David Norman, reviews infrastructure funding for local government in part two of his article series.

In my first article I highlighted the need to choose the right infrastructure in the right place, paid for by the right people, at the right price, announced at the right time, using the right funding tool.

In this second part of the series, I look at the funding tools available, the proposed criteria for selecting the right funding tool, and how the various tools already available to local councils stack up.

Not every funding tool was born equal. Not only should a funding tool satisfy the economic principles listed in my first article, but it should also fulfill as many other considerations as possible, including being able to leverage debt, create certainty of timing, allow the building of a kitty in advance of construction, and incentivise efficient use of land.

Existing tools, such as targeted rates and targeted levies, should be used more widely to achieve better economic outcomes, to leverage borrowing and incentivise the right development in the right place. Newly proposed tools, such as value capture taxes, could be added to the toolkit. However, these are fraught with challenges that functionally equivalent tools like targeted rates do not have.

What’s in the toolbox?

There are four main tools already available to local government for funding infrastructure, and an additional tool is proposed.

General rates are the largest single source of income for local government. These are charged on residential and business properties and include both a fixed (general uniform) rate and a component based on property value. The variable component is usually based on the property’s capital value (land plus improvement value) rather than on land values. This is a problem we tackle briefly under our discussion of how a funding tool can incentivise development. In cases where specific infrastructure charges for growth do not pay the full cost of that infrastructure, general rates (all ratepayers) pick up the tab, a fundamental misalignment with the economic principles set out in Part 1, particularly that those who benefit should pay.

Development contributions (DCs) are most commonly used by local governments to ensure new development contributes toward new infrastructure to facilitate that growth. DCs are generally charged at subdivision resource consent, at building consent for an additional dwelling on a site or, in rare instances, at service connection.

Targeted rates are collected by local councils for a specific purpose and in a specific geography, for example to fund the construction of the Wellington Regional Stadium in 1999. Some councils charge a rate targeted to a specific purpose, but it is effectively a general rate charged as a flat charge per rateable property or as a function of rateable value.

Targeted levies technically operate similarly to targeted rates. The big difference is that they allow access to third party funding (the Crown in the current form of the law) via the new Infrastructure Funding and Financing Act of 2020. Subject to legislative change, it may be possible, at some point in future, to use targeted levies to provide access to non-government third parties.

Value capture tax tools (not yet legal) seek to capture, for government, some of the private value gains that accrue to property owners in particular locations, as a function of government investment there. They are based on the economic principle of “beneficiary pays,” or those who benefit from investment in a specific location should be the ones who primarily pay for it.

Naturally, governments can benefit from value uplift of land they already own when they put in infrastructure or rezone it, and that can be used to cover the cost of the infrastructure, although that is not a funding tool per se. There are a few other tools such as Infrastructure Growth Charges or Financial Contributions that are, in simplistic terms, functionally equivalent to DCs, so they will not be introduced separately here.

Over the last several years I have identified at least nine considerations in choosing the right funding tool. This is a separate question from deciding how much someone benefits from the infrastructure (either through their use of it or the rise in their property value). There are undoubtedly more than nine, but we would do well to start by considering these.

Can we borrow against a funding tool?

This is one of the great weaknesses of DCs. This tool requires councils to guess (or if you’re an economist, “forecast”) what the development community is going to do. This means the revenue stream from DCs is uncertain and is not counted as a stable revenue stream against which to borrow by credit ratings agencies. General and targeted rates, on the other hand, are practically guaranteed revenues, underpinned by the property against which they are issued.

Does this funding tool create certainty of timing?

Closely tied to the previous point, any tool where we must try and guess when the money will materialise creates huge uncertainty. It also means you cannot have the confidence to get on and start building a piece of infrastructure because if the development market hits a downturn, your revenue stream to pay for the infrastructure is gone in a heartbeat.

Does this tool incentivise development?

If we want to make sure that a piece of new infrastructure does not sit under utilised if development materialises more slowly than anticipated, we need a funding tool that encourages more rapid development. Tools like DCs, which are triggered when a developer begins development, disincentivise development. Meanwhile tools like targeted rates, which are charged regardless of whether development slows or accelerates, nudges development along because the landowner is contributing at any given time. Developers are, albeit to a limited extent, incentivised to develop and move on.

One other major incentivising element to funding tools is available through the economically-sound application of general or targeted rates. While general rates are usually a bad way to fund new infrastructure, if we must use them, then they should be based on land values rather than capital values. The advantages of a land value-based ratings system are covered in depth in a paper I wrote as Chief Economist at Auckland Council.

But in summary, capital value based taxes penalise people for developing their land efficiently. Land value-based taxes incentivise people to use land efficiently. Both are legal in New Zealand. Low uptake of land-based rating is for political rather than economic or financial reasons; people living on more valuable, but under-used land, would pay more rates under a land value-based system

Can this funding tool be hypothecated?

We are living in a time of major infrastructure deficit. Councils, being confronted with this reality, are being forced into far bigger rates rises to avoid infrastructure failure. At the same time, public engagement with, and trust in, local government remains low. A much better way to address this issue compared to a general rates rise, which can feel to ratepayers like money being poured into a black hole, is using a tool that can be ring-fenced for use on a specific piece of infrastructure. Targeted rates, targeted levies and DCs can all be used in this way, providing transparency as to what the funding goes toward.

Is this tool publicly acceptable?

In general, if a tool can be shown to primarily charge those who directly benefit from new infrastructure, it is likely to enjoy greater support. However, this is an area misunderstood, particularly by existing residents and ratepayers. For instance, consider the hypothetical case of Mrs Smith, resident in her home for 30 years and now in her 70s, who has a targeted rate imposed on her property to pay for a new bus lane or water supply improvements. She wonders how she will pay the extra $900 a year in rates for infrastructure she did not ask for.

Forgotten from this conversation are typically two facts. First, the $900 a year is a contribution toward infrastructure that raises the value of Mrs Smith’s land, possibly by hundreds of thousands of dollars because of the intensification it enables. When the new infrastructure is in place, a further three homes can be accommodated on the network on her section. While Mrs Smith has no intention of developing her backyard, she benefits from the land value growth predicated on the addition of new infrastructure.

Second, options such as rates postponements already exist that allow Mrs Smith to avoid paying extra rates she cannot pay on her fixed retirement income. This means until her home is sold, the deferred rates are held on account, the eventual house sale reaping the windfall gain that the new infrastructure has afforded. At that point she, or her children, get the benefit of that windfall gain, likely to be much higher than the value of the rates deferred.

Does this tool unlock third party spending?

Local governments already have all the funding tools they need, but five years ago I would have said there was a gap in the toolkit. This gap has been filled by central government’s targeted levy, developed by Crown Infrastructure Partners (CIP) in conjunction with local government. Targeted levies are functionally equivalent to targeted rates but allow councils with high debt levels to secure funding from central government that does not sit on the council’s balance sheet.

There is scope to widen the list of agencies that can apply this tool beyond CIP. This will increase the choice of financing partners available to local governments where the tool is already being applied.

Is this tool inter-generationally fair?

In net present value terms, there should be no difference between a one-off DC charged to a developer (and included in house prices) and a 30-year targeted rate or levy imposed on a property instead. They should both pay for the same infrastructure, at the same approximate cost. However, the latter rate/levy mechanism is arguably considerably more transparent and logical to the non-technical observer of a contribution toward infrastructure costs that is paid annually by the occupier in each year of the property. This creates a sense of fairness that favours targeted rates and levies over DCs.

Can this tool be used to build a kitty in advance of building?

A further consideration is whether a tool can be charged in advance of starting to build the infrastructure. This allows debt-heavy councils to build up a kitty to help pay for the infrastructure, say five years down the track. In the case of targeted rates, it has the bonus of allowing councils to borrow against those collected funds to leverage up available funds to build infrastructure sooner.

Do we need a legislative change to use this tool?

Except for value capture taxes, all these tools already exist. Any time new legislation is introduced, it is a lengthy process that creates risk of perverse outcomes. That is not a reason to avoid new tools or legislation but does encourage us to consider the usefulness of existing tools before we leap after new ones.

Summary

So how do the funding tools currently available stack up? We could write many pages on the intricate details of each, but the diagram above provides a useful summary. It clearly demonstrates the three best tools for funding infrastructure, and the also-rans.

Targeted rates and levies are the best funding tools we have available when we consider both the economic principles set out in part one of this series, and the nine considerations set out here. General rates, currently being used to fund up to three quarters of the cost of new infrastructure in some places, is probably the worst tool to use. Much-touted value capture taxes are certainly no silver bullet.

In fact, I would argue that a carefully thought out and implemented targeted rate or levy is functionally equivalent to a value capture tax, without the complication of trying to estimate exactly how much value a new piece of infrastructure adds to a property, and without new legislation.

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