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Smoke and Mirrors: Fallacies in the NSW Government’s Views on Local Government Financial Capacity

Peter Abelson and Roselyne Joyeux
Applied Economics, 2015

As many readers of Public Money and Management will be aware, the NSW Government plans to amalgamate local councils across the state of NSW. Within metropolitan Sydney the Government proposes to reduce the 38 local councils with an average population size of just over 100,000 down to about 14 councils with an average population of 270,000 and growing. The new council structures were proposed by the Independent Local Government Review Panel (ILGRP, 2013). Under its “Fit for the Future” program, the NSW Office of Local Government (OLG, 2014) requires all local councils to demonstrate by 30 June 2015 that they are adopting the proposed council structures or some alternative structure that meets its three critical criteria of scale, strategic capacity and financial sustainability.

It is not clear that scale defined as population has any significance separately from strategic and financial capacity. And strategic capacity is defined in the “Fit for the Future” document in terms of 10 amorphous criteria such as “Knowledge, creativity and innovation”, “Advanced skills in strategic planning and policy development” and “Credibility for more effective advocacy”. These criteria cannot be quantified. Thus they would appear to allow the Government to reach any conclusion that it sees fit. But the focus of this paper is on the relationship, if any, between size of jurisdiction and financial sustainability.

In “Fit for the Future”, the NSW Government defines a financially sustainable council as “one that is able to generate sufficient funds to provide the level and scope of service agreed with its community”. However the Government has pre-empted rational analysis of the efficient financial scale of local councils with its arguments that councils are currently running financial deficits of $1 million a day and that this can be rectified only by councils adopting a scale of organisation in the order of 250,000 persons per council.

It should perhaps be noted that the Chair of the ILGRP, Graham Sansom, has argued strongly in this very journal that the ILGRP recommended amalgamated councils solely on strategic, and not on financial, grounds (Sansom, January 2015). This assertion may surprise readers of the ILGRP report which appears at many points to link the case for larger councils with concerns about financial sustainability (see, for example, pages 3, 7, 18, 26, 72-3 and 98). Whether or not the ILGRP did allege a causal relationship between population size and financial sustainability, the NSW Government has certainly done so in its “Fit for the Future” program.

We should also recognise the recent valuable contribution by Drew and Donnelly (July, 2014) in this journal. Drew and Donnelly make three main points. Commercially based financial ratios and their associated benchmarks should be used with extreme caution as a basis for structural reform; there is little evidence of any relationship between the financial sustainability ratio benchmarks and population size in Sydney; and it is very doubtful whether amalgamations would improve the financial ratios.

This paper complements the Drew and Donnelly analysis. In this paper we show that the NSW Government’s equation of population size with financial capacity is both baseless and incorrect at least in Sydney.

In particular, we make the following three main points.

1 The NSW Government has changed a key financial benchmark which was the basis for government rate setting since 1977 and has exploited this change to allege that many local councils lack financial capacity without taking responsibility for the rate pegging.

2 Lack of financial capacity is fundamentally a function of low income not of the size of a local council.

3 Differences in expenditure per capita are explained by differences in income and service levels not by the size of the local community or the unit cost of services.

These points show that the local council population and financial capacity are not equivalent. Financial capacity is fundamentally a function of income, not of “scale” however defined. This has fundamental implications for the structure of local government and amalgamation policies.

For many decades, both local councils and the OLG reported revenues inclusive of capital contributions and grants. Council surpluses were estimated primarily as the difference between total revenue (including capital contributions and grants) and total expenses. Typically an extra row in council accounts would show council operating results with capital contributions and grants excluded.

Table 1 shows how OLG reported total revenue and expenses in its annual reports up to 2010-11. These reports showed total revenue inclusive of capital grants and expenses and total expenses, and we added the total surpluses into the table. They also showed operating revenue and expense per capita, but not the total operating deficit or operating deficit per capita, which we have estimated and included.

Following the NSW Treasury Corporation (TCorp, 2013) report on The Financial Sustainability of the Local Government Sector, with its strong emphasis on the operating deficit, the OLG radically changed the format of its annual report, dropped total revenue inclusive of capital contributions and grants, and published only the operating revenue as in Table 2, including retrospective changes to the 2009/10 and 2010/11 figures.

Table 1 Summary of Financial Results for NSW Councils

   

Mean

High

Low

Median

2009/10

         

Total revenuea

$’000

61,592

457,841

5,947

37,991

Total expensesa

$’000

54,832

378,870

4,610

32,474

Total surplusa

$’000

6,760

78,971

1,337

5,517

Operating deficit per capitab

$

-13

-358

-3

-62

2010/11

         

Total revenuea

$’000

(c)

496,989

7,034

38,736

Total expensesa

$’000

(c)

390,797

6,656

37,794

Total surplus a

$’000

(c)

106,192

468

942

Operating deficit per capitab

$

-75

-179

-6

-143

a) Revenue including capital grants and contributions.

b) Excluding capital grants and contributions.

c) Figures given were wildly different and clearly inaccurate and so not reproduced here.

Source: Office of Local Government, Comparative Information of NSW Local Government Councils 2009/10 and 2010/11.

Table 2 NSW Key Financial Aggregates for Local Councils ($ million)

 

2009/10

2010/11

2011/12

Total revenuea

8,284

8,811

9,340

Total expenses

8,510

9,485

9,606

Operating surplus (deficit)a

-93

-532

-267

(a) Excluding capital grants and contributions

Source: Source: Division of Local Government, Comparative Information of NSW Local Government Councils 2011/12, October 2013.

These changes substantially change the outcomes. Comfortable council surpluses with the inclusion of capital contributions and grants become operating deficits without them.

It should be noted that we support this change in definition of a surplus. Ideally current services should be met from current revenues and capital grants spent on capital expenditure and included in the capital budget. This maximises the net public assets of the community.

However, having said that, a council that runs a net surplus inclusive of capital contributions and grants is increasing the net assets of the local community, even if it has an operating deficit exclusive of capital grants. These communities are becoming better off, not worse off as some of the rhetoric implies.

More important is the NSW Government’s responsibility for rate pegging and its consequences. The NSW Government has pegged council rates annually since 1977. The Independent Pricing and Regulatory Tribunal (IPART) took over in 2011/12.

As shown in Table A.1 in the Annex, between 1999-2000 and 2013-14, regulated rates rose by 56.5% compared with the rise in the CPI of 50.5%, the rise in the wage price index of 63.9% and the rise in nominal GDP (which includes real income as well as price increases) of 134.8%.

Despite large rises in population, community incomes and demands, the state government did not allow for any increase in local council services in over 10 years. Moreover, in effect the government was viewing operating deficits without concern. If these deficits had been a concern, the government could have allowed rate increases at least up to the increase in GDP. Certainly local councils could apply for rate variations. But evidently the OLG was content with the financial results that it was overseeing and regulating.

Further, following the TCorp report in April 2013, IPART in December 2013 regulated a miserly 2.3% rate rise for 2014-15. This was the lowest rate increase since 1998-99. Yet, a few months later IPART (September, 2014) wrote “We consider that operating performance ratio is a key measure of financial sustainability and is fundamental for councils to be “fit for the future”. If IPART was so concerned about councils’ operating deficits, why did it not provide for a higher rate increase?

In this regulatory environment it is wrong to infer that councils are unable to run balanced budgets. The NSW Government made the rules, the benchmarks and the rate pegs. It has now changed the benchmark but not the rate pegs. That is fine. But the state government should accept responsibility for this and not use the rule change to denigrate the financial capacity of local councils.

In a major review of the revenue raising capacities of local councils around Australia, the Productivity Commission (2008) concluded that “the fiscal capacity of a council is best measured as the aggregate after-tax income of the community ... The higher is the fiscal capacity of a local government, the higher is its potential to raise revenue”.

This fundamental finding is strongly confirmed from analysis of the local councils that NSW TCorp (2013) deemed likely to be financially weak. In the Annex we provide a map of weak, moderate and strong councils based on TCorp views of their financial outlook and a table of income and other statistics for local councils in the Sydney Metropolitan area.

As shown in Table A.2, drawing on 2011 Census data, the average taxable income of the seven council areas in metropolitan Sydney deemed by TCorp to have a financially weak outlook was $42,366. The average taxable income of the other 30 council areas deemed to have a moderate or strong financial outlook was $61,237. No area with an average taxable income of over $48,000 has a weak financial outlook. It is clear that income is the key source of financial weakness.

It may also be observed that while TCorp (2013) deemed less than 20% of the Sydney metropolitan council areas to have a weak financial outlook, two-thirds of all other councils in NSW were found to have a weak financial outlook (see Annex Figure A.1). Nineteen councils in the north coast and western regions of NSW are among the 24 least financially sustainable regions in NSW.

TCorp also recognises that most of the urban councils that are financially weak or very weak are “in regional areas outside Sydney”. Financial weakness is due to low population density as well as low incomes and is principally (though not solely) a non-metropolitan problem.

Certainly larger councils have the potential to achieve more economies of scale than smaller councils. However, small councils can generally achieve similar economies of scale by shared services with other councils or by outsourcing services to large private providers.

Moreover, there is little doubt that organisational and behavioural inefficiency rises with the size of the bureaucracy. Truly it may be said that all bureaucracies waste money and the larger the bureaucracy the more is wasted.

What is the evidence for cost efficiency and population size? The ILGRP report (2013) did not produce any evidence.

Dollery et al. (2012) provide detailed evidence in Australia and internationally that forced amalgamations have not produced cost savings. They conclude that anyone who still believes that compulsory council amalgamation leads to lower costs or scale economies is not acquainted with the vast empirical literature on amalgamation.

In another major review, Dollery et al. (2013) cite 15 international studies from the United States, Canada and Europe all of which throw doubt on claimed economies of consolidated local councils. They also examine 8 Australian inquiries into the financial sustainability of local councils over the past decade and found (p.215) that “with one exception, these inquiries are sceptical of the ability of forced amalgamation to improve local authority financial viability”.

On the other hand, the NSW Independent Pricing and Regulatory Tribunal (IPART, 2014) endorsed the ILGRP view that larger councils are more efficient than small ones. According to IPART, the data showed that “around 30% of the variation in opex per head amongst the councils of Greater Sydney is inversely associated with their population and that opex per head is lower the larger the population of the LGA”.

However, this finding failed to account for the substantial inverse correlation (of –0.49) between local council size and income levels per capita (see Figure 1). In Sydney, smaller councils generally have higher income per capita and hence the local residents expect, and are willing to pay for, more services. Larger councils in Sydney spend less per capita than small ones because of lower income, not greater efficiency. The lower expenditure would indicate efficiency only if the larger councils were producing equivalent services to small ones.

In this paper we test the hypothesis that differences in operating expenditure per head are due primarily to differences in income and this hypothesis is strongly validated. Figure 2 depicts this bivariate relationship. Once differences in income are allowed for, the relationship between expenditure per head and population size is not statistically significant.

Figure 1 Average Taxable Income and Population of Local Council

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Figure 2 Average Taxable Income and Expenditure per Capita

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To explain differences in local government expenditure, we collected the latest public data on expenditure per capita, population and average taxable income for the 37 local councils in metropolitan Sydney (excluding the City of Sydney and outlying councils) as shown in Annex Table A.2.

We then ran a regression with expenditure per capita explained as a function of population, average taxable income per capita and a dummy variable for major business centres (North Sydney, Willoughby and Parramatta). This equation is in log-log form. This means that the coefficients represent percentage changes in both the dependent and the explanatory variables. The results are shown in Table 3.

As shown, taxable income and business centre are highly significant at the 1% level of significance. A 10% increase in average taxable income raises expenditure per head significantly by actually quite modestly 3.2 per cent per capita. A business centre raises expenditure per head by nearly 19%.

Differences in taxable income and business centres account for about 50% of the variation in expenditure per head. As there is significant heteroscedasticity, robust standard errors are used. On the other hand, after allowing for differences in income per capita, population is not statistically significant at the 10% level of significance (the p-value is greater than 0.10).

Table 3 Explaining Differences in Expenditure per Capita

Variable

Coefficient

Std. Error

t-ratio

P-value

Significance

Constant

4.367

1.570

2.78

0.009

***

Log Pop’n

-0.093

0.556

-1.68

0.102

 

Log Tax income

0.323

0.105

3.07

0.004

***

Business centre

0.186

0.040

4.68

0.000

***

R squared

0.532

       

Financial sustainability or capacity is fundamentally a function of local community income, not of council size. The ILGRP produced no evidence to show that large councils are more financially efficient than small councils. Nor has the NSW Office of local Government explained why population scale and financial capacity are synonymous.

Most councils in the Sydney metropolitan area could run sustainable, balanced, operating budgets if they were not subject to rate pegging. It is irresponsible to decry operating deficits and then in 2014-15 to allow the lowest rate increase in 15 years. On the other hand, less well-off and lower density council areas, especially outside the Sydney Metropolitan area, would need financial assistance with, or without, amalgamation.

Finally it should be noted that this paper has been concerned with financial capacity as this is a core focus of the NSW Government “Fit for the Future” requirements. We recognise that there are other important issues, including the provision of local services and care for the local environment on the one hand and metropolitan and state wide planning of transport, housing and other infrastructure on the other hand.

It is strongly our view that small and medium sized local councils are the best vehicles for provision of local services and protection of the local environment. In the famous words of Montesquieu ( 1748), “In a small republic, the public good is more strongly felt, better known and closer to the citizen”.

Other vehicles such as Joint Regional Organisations may facilitate the provision of metropolitan and state infrastructure or, in the language of Fit for the Future, provide “strategic capacity”. Regrettably discussion of strategic capacity to date, including in the ILGRP report, has been characterised more by slogans and rhetoric than by careful, evidence-based, discussion of the real issues.

Dollery, B., Grant, B. and Kort, M., 2012, Councils in Cooperation, Shared Services and Australian Local Government, Federation Press, Sydney

Dollery, B., Grant, B. and Korrt, M., 2013, ‘An evaluation of amalgamation and financial viability in Australian local government’, Public Finance and Management, 13, 215-238.

Drew, J. And B. Dollery, 2014, “The impact of metropolitan amalgamations in Sydney on municipal financial sustainability”, Public Money and Management, July.

Independent Local Government Review Panel, 2013, Revitalising Local Government, Final Report (October).

IPART, September 2014, Review of Criteria for Fit for the Future.

Montesquieu, C., 1748, The Spirit of the Laws, ed. By A. Cohler, B. Miller and H. Stone, in 1989, Cambridge University Press, Cambridge.

Office of Local Government, September 2014, Fit for the Future, Local Government Reform in NSW.

Productivity Commission, 2008, Assessing Local Government Revenue Raising Capacity, Research Report, Canberra.

Sanson, G., 2015, “Debate: The case for local government amalgamations in Sydney: fact and fiction”, Public Money and Management, January.

TCorp, April 2013, Financial Sustainability of the New South Wales Local Government Sector.

Figure A.1Applied Economics

Source: Office of Local Government based on TCorp maps.

Table A.1 Analysis of Rate Pegging and Comparable Data

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Sources: Office of Local Government and Reserve Bank of Australia

Table A.2 2011/12 Data for 37 Local Councils in Metropolitan Sydney excluding City of Sydney

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Source: Office of Local Government: Comparative Information on NSW Local Government, 2012/13.

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