Publication: C.D. Howe Institute Commentary
Publication Date: 01-DEC-06
Delivery: Immediate Online Access
Author: Kitchen, Harry

Article Excerpt
In this issue ...

When municipal councillors fret over the crumbling roads, and antiquated water and sewer lines in our towns and cities, amid pressing demands for new and better infrastructure, their first job is unquestionable: get their financial houses in order.

The Study in Brief

How best to finance major municipal infrastructure projects? Roads, recreation centres, parklands and water and sewage services all contribute to Canadians' living standards--yet the financing methods for the construction and maintenance of these generally big-ticket spending items are commonly in a state of disrepair. Examples:

* The importance of separate capital and operating budgets for efficient, transparent and accountable capital investment is well known but rarely well handled. Many municipalities, including some large ones, do not have separate capital and operating budgets and, even where they do, there are problems with what is included or excluded.

* Lack of carefully constructed cost-benefit analyses for many large-scale projects means that costs and benefits are often incorrectly or incompletely documented or understood.

* Failure to coordinate capital projects between local departments and special purpose bodies such as utility commissions means that capital maintenance or construction is rarely coordinated with other projects--for example, when road and watermain maintenance and repair are not jointly planned.

* Finally, most capital spending is for short-term rehabilitation and renewal, even though longer-term projects might generate greater net benefits. This arises because municipal politicians tend to be interested in projects whose time horizons coincide with their terms of office.

Pursuing better practices and innovations in infrastructure financing would set towns and cities on better financial footing. The most important point is that municipal infrastructure should be financed, as far as possible, by the residents who benefit from it, because this provides the surest guide to how much should be invested in what.

The underlying principle of benefits received is straightforward: those who benefit from local infrastructure and the services it provides should pay for it. Other recommendations for policymakers and city managers: use multi-year capital budgets and dedicated fund accounts to plan longer-term projects. Municipalities should also take advantage of innovative approaches to infrastructure finance, such as a dedicated municipal fuel tax, parking lot taxes and private-public partnerships.

The Author of This Issue

Harry Kitchen is a professor in the Department of Economics at Trent University.

C.D. Howe Institute Commentary is a periodic analysis of, and commentary on, current public policy issues. James Fleming edited the manuscript; Diane King prepared it for publication. As with all Institute publications, the views expressed here are those of the author and do not necessarily reflect the opinions of the Institute's members or Board of Directors. Quotation with appropriate credit is permissible.

To order this publication please contact: Renouf Publishing Company Limited, 5369 Canotek Road, Ottawa, Ontario KIJ 9J3; or the C.D. Howe Institute, 67 Yonge St., Suite 300, Toronto, Ontario M5E 1J8. The full text of this publication is also available on the Institute's website at www.cdhowe.org.

$12.00; ISBN 0-88806-701-1 ISSN 0824-8001 (print); ISSN 1703-0765 (online)

Public concern over the state of municipal infrastructure in Canada and related safety and environmental issues raises questions about municipal funding. Crumbling, congested roads, antiquated water and sewage lines, inadequate public transit: all are issues that have moved from town council agendas to newspaper headlines, highlighting the importance of municipal capital investment and how it is financed. The challenge is nation-wide. As municipalities expand and age, more resources must flow to expanding, rehabilitating, or replacing local capital stock. Water, sewage and waste facilities, cultural and recreational complexes, transportation and transit need updating and expanding. Brownfield remediation must be addressed, and "blighted" areas of cities revitalized and redeveloped.

Most public infrastructure in Canada is the responsibility of municipal governments (Harchaoui, Tarkhani, and Warren, 2004; and 2001 Ontario budget). The importance of capital investment and the availability and quality of services provided by it are critical factors in improving quality of life, economic growth, productivity and international competitiveness (The Institute for Competitiveness and Prosperity 2005, 17). How this capital investment is financed, then, must not be treated lightly, for the choice of instrument and the way it is used may impact both the level of services provided by infrastructure and the size and range of the infrastructure itself.

Yet, municipal financing itself is in disrepair, in a manner of speaking, with best practices the exception rather than the rule in most jurisdictions across Canada. Among current shortcomings: politicians tend to support short-term projects with re-election in mind, rather than the welfare of future generations; accounting practices fail to include replacement costs for depreciating assets, thereby assuring a fiscal shock when replacement time arrives; there is seldom any relationship between who pays for new projects and who benefits from them. There is much room for improvement. Well-designed user fees and correctly structured local taxes will reveal the true demand for--and therefore, indicate the efficient supply of--local public infrastructure. Incorrect or inadequate user fees and local taxes promote under- or over-consumption of local services and too much or too little infrastructure (Gillen 2001; and Swimmer 2001).

Addressing this problem requires answering many questions. What is municipal infrastructure? What are the characteristics of good capital budgets and why are they important? What instruments are used for financing capital expenditures and how appropriate are they? What is the role of public-private partnerships? How should governments trace the revenue and expenditure flows associated with capital projects? And critically, what prices or local taxes will promote an efficient level and allocation of infrastructure investment? This Commentary addresses these questions and offers suggestions for future financing that should promote an efficient and more desirable level of infrastructure to better support Canadian living standards.

These suggestions include improvements in current financing methods: the use of multi-year capital budgets; dedicated fund accounts; and ensuring that those who benefit from a project bear its costs. I also recommend fresh alternatives that would further increase allocative efficiency, such as volumetric pricing for water, sewage and garbage services, and dedicated fuel or parking lot taxes, as discussed recently by the mayor of Toronto, David Miller. Municipalities should also give greater consideration to innovative approaches that have been tried with success in other jurisdictions, such as revenue bonds, tax increment financing and public private partnerships (P3s).

What is Municipal Infrastructure?

Municipal infrastructure includes buildings, structures, facilities, equipment, rolling stock, furnishings, development and purchase of land, as well as the associated items to bring the foregoing into operation, and major rehabilitation work. Infrastructure expenditures differ from operating expenditures in three important ways. First, the financing of major infrastructure projects is lumpy in nature; that is, large expenditures in one year generally preclude similar expenditures in subsequent years. Second, benefits from large infrastructure projects often extend over many years. Third, infrastructure is often funded from special assessments, development charges, reserves, borrowing, grants, and own-source revenues, while operating expenditures are funded only from grants and own-source revenues.

Why Are Capital Budgets Important and What Should They Do?

A capital budget should be a multi-year financial plan for the construction or acquisition of capital projects and should indicate how they are to be financed. The importance of separate capital and operating budgets for efficient, transparent and accountable capital investment is well known (Bird 2005) but, often, not well handled in practice. Many municipalities, including some large ones, do not have separate budgets and even where they do, there are often problems with what is included and what is excluded. For example, future operating and maintenance costs are often ignored, especially when grants from senior governments are available. Similarly, municipalities often take debt costs into consideration, but they rarely consider foregone alternatives or depreciation and replacement costs in determining annual operating costs. Other problems include:

* Lack of carefully constructed cost-benefit analyses for many large-scale projects means that projected costs and benefits are often incorrectly or incompletely recorded.

* Failure to coordinate capital projects between local departments and special purpose bodies such as utility commissions often means that capital maintenance or construction is not coordinated with other projects--tearing up recently built or rehabilitated streets to work on water and sewer mains, for example. Municipal governments often talk about integrated approaches to capital programs and growth management, but the numbers of people involved and their focus on selected aspects of the overall plan frequently impedes this objective.

* Finally, most capital spending is for short-term rehabilitation and renewal, even though longer-term projects might generate greater net benefits. This arises because municipal politicians tend to be interested in projects that provide visible signs of political initiatives and coincide with their term of office. As well, municipal decisionmakers also hesitate to commit to long-term projects without guarantees of future funding.

Municipal Infrastructure--How should It Be Financed?

Municipal infrastructure should be financed, as far as possible, on the basis of benefits received (Kitchen 2006), because this provides the greatest likelihood of securing a more allocatively efficient and optimal level of local capital investment. The underlying principle of benefits received (Duff 2003) is straightforward: those who benefit from local infrastructure and the services it provides should pay for it. The ability to set correct prices, taxes or fees depends on the asset. For assets such as water and sewers (where specific beneficiaries can be identified, income redistribution is not a goal, spillovers are few, and all operating and capital costs are measurable), charging for each litre of water should be relatively easy. For assets such as local streets and roads (where it is difficult to identify specific beneficiaries and where local spillovers may exist), setting local tax rates to capture local benefits is harder but not impossible. The benefits-based model is particularly important because it satisfies five important criteria:

* Economic (allocative) efficiency, which is achieved when the charge or tax per unit of output (service received) equals the cost of the last unit consumed, because this is the point where society secures the greatest net gain from the consumption of this service.

* Accountability, which requires that the design of a tax or charge be clear to taxpayers and that the link between the beneficiaries of a government service and payment for that service be tight.

* Transparency, which means that citizens/taxpayers have access to information and decisionmaking forums so they are familiar with the way in which local tax rates and user fees are set.

* Fairness, which is achieved when those who consume public services pay for them. Income redistribution is better achieved through income transfers or targeting (Boadway and Kitchen 1999, chaps. 8 and 9) than by tampering with charges or taxes.

* Ease of administration, which...



NOTE: All illustrations and photos have been removed from this article.



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