Características generales.

In general, a council with healthy finances would run a modest operating surplus. An operating surplus indicates that the costs incurred in the year in question are being met by today’s ratepayers, and not being transferred to future ratepayers. A persistent operating deficit indicates that rate revenue is insufficient to finance current operations, which demands liabilities to be incurred, or assets to be liquidated, in order to finance ordinary operations.

Financial performance of a council should allow a margin of comfort to cope with financial risks and shocks, which typically requires: 70

i) an operating surplus rather than operating deficit

ii) no significant infrastructure renewal backlog, and its annual capital expenditure on the renewal or replacement of existing assets should on average over time be about the same level as the council’s depreciation expenses, and

iii) annual net borrowing should not be putting any pressure on the council’s targeted net financial liabilities ratio.

4.1.1 Expenditure

Expenditure by local government in real terms has increased over time. Between 1999 and 2005, expenditure had a compound annual growth of 6.5%. This increase in expenditure reflects the expanding roles of local governments discussed in section 2.5, as well as strong cost growth rising at a faster rate than CPI. This substantial increase in local government operating expenditure in recent years may have reduced the extent of funds available for renewing infrastructure in some jurisdictions which may have been a factor in the development of the renewals backlogs estimated by Access Economics (see Table 4.2). However, this position will differ between states and between councils, with the MAV reporting that since 1999 there has been a significant improvement in the extent of infrastructure backlog in Victoria.

Operating costs

Depreciation is a major cost of many local governments. Depreciation costs average 26% across the sample of councils. This amount is significantly higher for rural remote

councils, where depreciation accounts for more than 37% of operating costs for most of the councils within this category.

The accuracy of the reported depreciation costs is an area of significant concern. On the one hand some councils with high depreciation rates may be too quickly reducing the values of investments, often made through lack of understanding regarding prudent asset renewals programs, which drives significant reductions in the overall value and can impact the operating result and the perceived financial sustainability of the councils.

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Independent Inquiry into the Financial Sustainability of NSW Local Government 2006, Are Councils Sustainable? Final Report: Findings and Recommendations May 2006, p.276.

Other councils may have depreciation levels that are too low due to exaggerated asset lives or asset values which require updating.

It is worth noting that application of the various depreciation methods is not always consistent between all councils and some confusion exists about the most appropriate depreciation methods and how to accurately apply them. Training in specific technical skills may therefore be a useful means for better understanding depreciation and further renewals costs for councils.

For example, for account purposes local roads tend to be depreciated over a life of 50 years. In reality the road surface has a life of 20-40 years (subject to heavy vehicle usage, gradient, climate, soil stability, etc), and the formation has a far longer useful life of typically 100 years. The mix of replacement cost between these two broad

components is typically 60% formation and 40% road surface. This has a significant impact on the accounting written down value of the asset and the actual physical

consumption of the asset. For instance the replacement cost of a basic two lane, sealed local road is estimated to be $400,000/km, or $4 million for a 10km stretch of road. Under the accounting method the book value of the total asset base of the road would be written down by 2% or $80,000 per annum.

Alternatively, when using a weighted asset life of the formation and surface of around 72 years, the straight line depreciation would be 1.38% or $55,200 per annum. Even this depreciation estimate is relatively high as it incorporates the replacement costs of the formation, which in reality would typically not be necessary. A better approach may be to only write down the value of the surface of the road, which if the useful life is estimated at 30 years, the depreciation rate would be 3.33% of $160,000/km or $5,300 per annum. Evidently, applying accurate depreciation rates of assets can be complicated. In this example, the best depreciation rate is likely to be between the 72 year depreciation of the total road replacement cost, and the 30 year depreciation of the surface.

This example illustrates how councils can under and overstate depreciation whilst also not accurately estimating efficient future renewals costs. Once council data for asset management plans, depreciation, and renewals estimates are more robust, uniform, and accurate, it will be possible to better appraise the extent of funding gaps, optimal

renewals spend, and any backlogs which may be present.

4.1.2 Revenue

The divergent nature of local governing bodies means that there is a wide disparity in their ability to raise revenue, which is largely determined by population size, rating base and the ability/willingness to levy user charges.

Figure 4.1 below shows the large difference in local government’s revenue by source. Whilst all councils except for those in Tasmania use taxation as their largest revenue source, the reliance on grants and subsidies and sales of goods and services vary significantly.

Figure 4.1 Local government revenues by source, by jurisdiction 2004-05 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% NSW Vic Qld WA SA Tas NT % of r e v e nue s o u rc e s

Taxation Revenue Sales of goods and services Interest Current grants and subsidies Capital grants Other revenue

Source: DOTARS 2005, Report on the Operation of the Local Government (Financial Assistance) Act 1995, p.25

General trends can be drawn from the data on the sample of councils. Urban councils tend to have a strong revenue base with rate revenue generally exceeding 40% and have the added benefit of an increased scope to extract user charges. Regional councils have a mixed ability to raise revenue, depending on the socio-economic mix of the community, whereas for rural councils revenue generating ability is very limited.

4.1.3

Rates and municipal charges

Urban councils have more scope to extract diverse user charges than their rural and regional counterparts. This is due to the larger variety of services provided by urban councils, compounded by the smaller economic base of rural and regional local

governments, which reduces their ability to significantly lift charges and rates to increase revenue for funding purposes.

Across the nation, councils average a rates coverage (defined as total rates received as a percentage of total costs) of 48%, however this ranges from 25.4% in the rural remote category to 66.5% in the urban regional category. The average rates coverage of 48% indicates that on average less than half of a council’s costs are recovered by rates. Rural remote and rural agricultural council categories also have the lowest percentage of councils with rates coverage less than 40%, with 87 and 54% of councils respectively not meeting this benchmark.

4.1.4 Grants

As discussed previously in sections 2.2.3, and 3.2 the Australian Government provides FAGs, while state/territory governments provide a mixed range of grants and subsidies to local government.

The rate of economic growth and consequent rises in national taxation revenue means that grants have decreased as a percentage of both GDP and tax revenue. While at the both the national and state level, rising tax revenue collected nationally (and in the case of the states, redistributed back to them through the GST) has allowed those spheres of government to meet increasing demands for services (and/or to run substantial budget surpluses), this has not been the case at the local government level. Given the infrastructure backlog and genuine financial need of many local governments, an increase in funding pro rata with GDP and tax revenue seems justified.

Figure 4.1 below shows the reliance of local governments within each state and territory on total intergovernmental transfers or grants. It can be seen that grants make up

between 12 and 20% of local government revenue for each state. Through an analysis of individual state data within the sample data however, it is apparent that the reliance on grants as a source of revenue varies hugely between different ACLG categories. Total revenue of urban capital cities and urban development councils have the lowest reliance on grant revenue at around 5% and 9% respectively, while rural remote (56%) and rural agricultural (33%) have the highest grants dependence. This largely reflects individual councils’ ability to generate revenue through its own sources of tax and user charges and hence generate own-source revenue to provide services to the community.

Figure 4.1: Intergovernmental transfers as a proportion of total revenue by jurisdiction, 2003-04 0 10 20 NSW Vic Qld WA SA Tas NT Jurisdiction in te rg o v ern m e n ta l t ra n sf ers as a % o f to tal r e ven u e

Source: DOTARS 2006, 2004-05 Report on the Operation of the Local Government (Financial Assistance) Act 1995, p.28

4.1.5 Operating surplus/deficit

Operating surplus/deficit is the key analytical indicator regarding local government’s annual operating activities. It is defined as operating revenue (including all

intergovernmental transfers) less all operating expenses, including depreciation

expenses, net interest expenses and taxes/transfers and dividends paid. It is an indicator of the ability of current rate payments to sufficiently cover all operating costs for local government. In interpreting this indicator, some caution is required as operating

surpluses (or mild deficits) can be driven by understated depreciation costs, which in turn usually arise due to conservatively low valuations of council assets or infrequent updates to such valuations.

An operating deficit was recorded by 28% of councils in the study sample of 100 councils, with the average operating result for all urban capital and rural significant growth

categories in deficit. This suggests that 28% of councils have a portion of costs incurred in the year not being met, as it should, by ratepayers. Whilst modest operating deficits do not pose a major concern to financial sustainability, operating deficits greater than 10% of total revenue indicate that a council is spending beyond its means and facing financial unsustainability.

Of the 100 council sample, the average council operated with an average surplus of 9.3%. The council categories with the worst operating result were urban development and rural significant growth, with 8.3 and 0% of councils respectively. These figures suggest that approximately 16.0% of all councils will therefore face sustainability issues as a result of operating deficit.

Operating deficits mean that current ratepayers need to fund the deficit by borrowing, or deferring renewal or replacement of existing assets and so shifting this burden onto future ratepayers.

It is worth noting, that due to data limitations, these ratios were developed with capital grants included in the operating revenue and so can be expected to have underestimated the proportion of councils running operating deficits. When Access Economics conducted its analysis of NSW local governments without the inclusion of capital grants, a total of 76% of councils were operating at a deficit, with 50% with a deficit larger than 10%. This is a concerning statistic, indicating that the majority of councils are currently unable to perform their operational activities with available funds.

If operating deficits continue for multiple periods for capital city councils, the compounded deficit creates debt levels which local governments are unable to repay, rendering them financially unsustainable. Whilst time-series data is required to determine whether the operating deficit is a trend for local governments who have a net operating deficit, the data available suggests up to one quarter of local governments are at potential risk of becoming financially unsustainable due to operating deficits. These councils are from all categories of councils except for the rural remote category. This is mainly due to a much smaller expenses base faced by these councils, however does not signal financial sustainability, as the operating surplus/deficit does not indicate whether infrastructure renewals/replacements is adequate, and whether adequate facilities are being provided to rural remote communities.