Local government: The why, who and implications of accurately charging for infrastructure
At a glance
- In the first of our two-part thought leadership series on infrastructure funding for local government, we discuss some of the key questions councils should be asking with regard to infrastructure investment.
- Questions include whether we have rigorously demonstrated that an investment is needed, and that in deciding who pays, we follow best practice.
- Increasing infrastructure costs paid by development has impacts, but there is a lot of misunderstanding of what these impacts are and how they affect housing delivery in particular.
- It is human nature to want good things for free, so the main challenge to getting the right people paying for the right infrastructure is political rather than financial or economic.
Insatiable demand for infrastructure
As we emerge from COVID-19 and the economic angst caused by the lockdowns designed to curb its spread, many nations are pinning their hopes on infrastructure spending to drive their economic recovery. The G20 estimates around $94 trillion (300 times New Zealand’s GDP) will be spent on infrastructure over 20 years by just 56 countries.
At the same time, many countries like New Zealand are finally beginning to address decades of under-investment in infrastructure. But with closed borders, disrupted supply chains, competition for scarce skilled workers, and now rising interest rates, this infrastructure will not come cheap.
In New Zealand, local governments remain responsible for delivering a disproportionate share of local infrastructure that residents rely on, particularly given the 93:7 tax split between central and local government. Fresh water, wastewater and stormwater, at least for now, are all funded by local governments. Half of local roading and public transport costs are borne by ratepayers. Further, a massive share of social infrastructure, much of which reduces the burden on central government-provided services like healthcare and education, is paid for by ratepayers. This includes parks, libraries, swimming pools, community centres, sports fields, and museums. And that’s just scratching the surface.
In these times of eye-wateringly expensive infrastructure, councils are coming under increased financial pressure. Ratepayers’ service expectations continue to rise, as do the populations in most communities. But before we leap into building more, there are some crucial questions to answer.
Should we be building this in the first place?
Unpopular questions, but ones that must be asked by the cold-hearted economist include:
- Can we demonstrate, rather than simply hypothesise, the benefits (typically social, environmental or cultural) this new or upgraded infrastructure will provide our community?
- Can we demonstrate that these benefits will genuinely outweigh the (typically financial) costs?
- Why would the private sector not provide this service (something that should especially be thought about when councils offer gym services or golf courses, for instance)?
These are the types of question I have helped councils grapple with for years. Not every idea for new infrastructure is a good one. But we owe it to our ratepayers and ourselves to make wise investment decisions where we can articulate and demonstrate the benefits to local residents.
So we’re building. Who pays?
In the past, having decided to spend on infrastructure, most costs have been placed on the shoulders of general ratepayers or taxpayers, with some of the costs covered by development activity itself through development contributions or infrastructure growth charges. But is this the right way to do it?
Economics says, “Probably not.”
The right people
Economists argue that those who benefit from something most (in this case, infrastructure) should be the ones who pay the bulk of the cost. Occasionally we depart from this principle on equity grounds (e.g. maybe a new public transport route through a poorer neighbourhood, designed to provide better access to jobs, is not fully funded by that neighbourhood). However, this should be the exception, not the norm.
The right places
Infrastructure charges should incentivise development in places that achieve the broader goals for the jurisdiction. Development should also be incentivized where it best overcomes externalities such as the congestion that new development will impose on others, or the polluting effects of car-oriented development.
The right price
When we undercharge for infrastructure in a certain area, we incentivise development there. This exacerbates not only the under-collection of the true cost of those infrastructure costs but can also have other perverse outcomes such as encouraging development in flood-prone areas or where externalities including congestion and emissions are high.
The right funding mechanism
The funding tool chosen needs to be easy to administer and enforce. Questions considered here include how easy it is to calculate each party’s share of the infrastructure cost to contribute, and how certain we can be that we will receive payment. At one end of the spectrum, general and targeted rates on property are relatively easy to administer and enforce. At the other end, value capture (VC) tools, for example, are hard to administer. Attributing value gain to the infrastructure investment rather than other events, and implications of timing of the announcement of the tool are just two challenges to administering a VC tool.
The right timing of announcements
Price is a key signal to people as to where to develop, but so is telling them who will be paying for infrastructure. Infrastructure plans should not be announced before we know and have publicly confirmed how we are going to pay for it. This ensures that speculative market activity near new infrastructure (such as a rail station) does not push prices of land up there while the new owners, rather than those who get the windfall gain from the announcement, get stuck with paying for the infrastructure.
What does charging more accurately for infrastructure do?
As a general rule, the costs charged to the development activity that benefits from new infrastructure is currently inadequate. In one recent example, new greenfield development was paying round one quarter of the true cost of infrastructure to service it. Both Hamilton City and Auckland Council have recently revisited development contributions policy to try to close the gap between the price of infrastructure and what new development pays. But whenever talk arises about putting up the cost of infrastructure being charged to development itself, the same objections arise, many evidentially baseless. Still, there are other changes, positive and painful, that accurate charging will bring about.
House prices do not rise much; raw land prices fall
Number one on this list is that higher development costs will simply be passed on and house prices will rise. International evidence suggests that the vast bulk of these costs are not passed on. Instead, raw prices (currently inflated based on the assumption that the general ratepayer will continue to subsidise new development) will fall as the true cost of developing land is incorporated into its total price, but developers remain price-takers on the market price is for an existing home. Figure 1 demonstrates how this works.
There are undeniably short-term impacts from any move to ensure those who benefit from infrastructure (through higher land values) are the ones who contribute their proportionate share of the cost. Developers who have paid too much for raw land on the expectation that the general ratepayer will continue to fund growth infrastructure will be in the awkward position of facing higher infrastructure costs.
Development activity may slow down for a period as these developers re-assess the viability of their development and in some cases, are forced to sell their holdings for a price that more accurately reflects the value of raw land. The new owners will then be able to proceed with development based on the lower raw land price they will have paid.
From a mitigation perspective, a significant increase in the contribution to infrastructure can be smoothed with a phase-in timeframe or future introduction date a year or two away. Arguably, this may lead to a flurry of development activity in the short-term as developers seek to get ahead of the new costs. However, while this may weaken the short-term efforts to recoup the full cost of infrastructure, it has the benefit of accelerating development activity.
There will be less need for councils to ration capital programmes
Councils in tight financial positions find themselves often having to ration infrastructure spending. But charging accurately for new or upgraded infrastructure frees councils from this challenge. Further, it frees councils from the political ramifications of allowing growth in one area at large cost to ratepayers, but not in another area.
Politically challenging, but stay on course for better outcomes
Any process that involves raising infrastructure charges is politically challenging, especially in brownfield areas, and especially if a tool like a targeted rate on all properties benefitting from upgraded infrastructure is imposed. Most people in brownfield areas will be homeowners with no immediate intention of redeveloping their property. Yet they still benefit from the new infrastructure as it raises the value of their land because of the development it enables. Consequently, they should pay a share of the cost whether they intend to develop or not. When they sell, they will reap the windfall gain. Further, options such as rates remissions already exist, which allow those who enjoy these windfall property value gains but don’t have the income to cover the rates increase to avoid paying until the home is sold.
Having answered questions about whether the investment is needed, who should pay and what the implications on the market will be, attention turns to which funding tool is most appropriate. We cover that fundamental question in Part 2 of this series.