Debt, rather than DCs, can lower the cost of building infrastructure
Beware of false fiscal prudence when funding infrastructure
Highlights
Ontario municipalities have alternatives to development charges, including financing projects through municipal debt.
While saving for projects using development charges may seem financially prudent, it can raise project costs, as construction inflation often exceeds interest rates.
Ontario municipalities can issue debt up to a debt limit. Most municipalities are nowhere near their debt limit, giving them ample space to increase their debts.
Overusing development charges can be a “false economy,” raising project costs and shifting debt from governments to households, who face much higher borrowing costs.
Municipalities across Ontario need to build infrastructure, and that money has to come from somewhere. Development charges are often touted as the ideal financing vehicle, as they help municipalities avoid debt.
While avoiding debt sounds fiscally responsible, it can often raise the costs of building new infrastructure. Here’s how.
How financing with development charges works
As our Development Charge primer showed, there’s no single development charge. Each service (e.g., transit, water, etc.) has a separate charge, with the money collected going into a separate reserve fund to be used for the service it was collected for.
If a municipality doesn’t have enough money when they are ready to proceed with an infrastructure project, it has two options.
First, it can choose to borrow money from a reserve fund from one service to pay for another, but then it has to pay the money back. For example, if a municipality is ready to move forward with building a new library but doesn’t have all the funds it needs, it can borrow what it needs from the roads reserve fund and pay that back.
Their second option is to borrow through banks and the bond market by issuing debt that is then bought up by investors, like how other orders of government borrow money.
At issue is that municipalities frequently choose to do neither. Instead, they typically wait until their library reserve fund has enough money to proceed, which can result in delivery delays if they don’t meet the revenue targets outlined in their development charge background study, which happens frequently.
As Ben Dachis from the Clean Prosperity Institute has shown, Ontario municipalities are increasingly financing less of their infrastructure using debt and more of it from development charges.
The financial downside to using development charges
Using development charges to finance projects may seem fiscally prudent. Cities can accumulate cash, earn interest on that money, and then, once enough money has accumulated, start building infrastructure so that debt is not incurred.
While the “wait and build” approach may seem like the financially responsible thing to do, it comes with two big financial costs. The first is that by waiting to build income-generating assets, such as a water treatment plant or parking garage, the municipality is foregoing years’ worth of revenue.
The second is that while interest expenses (and revenues) are real, they tend to be small relative to construction cost inflation, so delays increase costs for taxpayers. According to a Toronto staff report, the city was able to access financing for between 3.25% to 4.55% interest in 2022. In that year, building construction cost inflation for non-residential, the inflation statistic commonly used for infrastructure planning in Ontario, was 14.5% in the Toronto CMA. When inflation rates are higher than the rate of inflation, total project costs, in real terms, increase over time.
There is a better, and less expensive way, and that is by financing projects with municipal debt.
Ontario municipalities can, and do, run debts
There is a misconception that municipalities in Ontario, unlike other orders of government in Canada, cannot have debts. While it’s true that municipalities cannot run debts for operating expenses, they can and do take on debt for capital projects, such as the building of infrastructure.
For example, a city can take on debt to build a water treatment plant (capital expense), but it cannot run a deficit to pay the salaries for workers to operate it (operating expense). For operating expenses, Ontario municipalities need a revenue source, like fees from charging for water consumption or property taxes, to pay the workers’ salaries.
A primer on debt limits
While municipalities in Ontario can go into debt, they also have regulations that impose debt limits on them.
A debt limit is a fiscal policy that restricts a government's ability to borrow money beyond a certain threshold. All municipalities in Ontario, with two exceptions, have a provincially mandated debt limit of no more than 25% of own-source revenues.
Own-source revenue is all the fees and taxes a municipality collects, less any grants it gets from the provincial or federal government. After accounting for existing debts, municipalities are restricted to what is known as the ‘annual repayment limit’ (ARL).
York Region is the first exception to the 25% rule, as provincial regulations require it to maintain at least an AA credit rating score, but also allow it to borrow an additional 80% of the average of the last three preceding years in development charge collections (known as the growth supplement) above the 25% provincial limit. The City of Toronto is the second exception, as it has no restrictions at all.
Self-imposed debt limits
Despite not having a provincially imposed debt limit, Toronto has three different self-imposed debt limits for capital works. Depending on the type of infrastructure, the city either limits its debt to 15% of property taxes or 20% of own-source revenues. The city also limits its long-term debts to no more than $2 billion.
Toronto is not unique in setting a bar lower than the provincial ADRL, as other municipalities also have more onerous self-restrictions. For example, Newmarket has a debt policy that sets its limit to 10% of own-source revenues, 15% less than what the province allows.
Municipalities have substantial room to increase debt
In every year between 2009 and 2022, collectively municipalities in Ontario utilized between 6.0% to 8.2% of own own-source revenues, well below the 25.0% own-source revenue debt limit.
Municipal avoidance of debt financing increases costs for residents
We can illustrate the benefits of debt financing with an example of a project. Consider a $100 million project, with the following parameters:
Municipalities pay 4% interest on debt.
Municipalities earn 3% interest on savings.
Construction cost inflation is 6% a year.
The project is “revenue neutral”, in that it generates just enough revenue to pay for upkeep, maintenance and depreciation.
Option 1: Build immediately, taking out a 4% construction loan, payable over ten years, with payments made annually.
A standard loan calculator shows that the municipality would need to make ten annual payments of $12.33 million to pay back a $100 million loan with a 4% interest rate over ten years.
Figure 1: Payment schedule for a $100M 10-year loan with a 4% annual interest rate
Source: Calculator.net
The alternative to this is to collect the money up front using development charges.
Option 2: Collect $12.33 million in development charge revenue every year for 10 years, earn 3% interest per year on savings, then build at the end of year 10.
The $12.33 million is equivalent to the annual payments on the construction loan. Thanks to the power of compounding, the 3% interest on savings will allow this to grow to $141.35 million over those ten years
Figure 2: Revenue schedule for an annual $12.33M investment, at 3% interest (in thousands)
Source: Get Smarter About Money
However, the power of compounding also applies to inflation. After ten years of 6% inflation, infrastructure that would have cost $100 million now costs over $179 million.
Figure 3: Inflation calculation for $100M inflated by 6% per year for ten years
Source: Calculator.net
The municipality now needs to pay $179 million to build this infrastructure, but it has only just over $141 million in accumulated savings, creating a shortfall of over $37 million.
This is a highly simplified example, but it illustrates the dynamics of the cost of waiting to build infrastructure when construction cost inflation exceeds interest rates. In both examples, municipal taxpayers pay $12.33 million each year for ten years to fund this infrastructure. However, in the case of using debt financing, they are fully able to finance these costs. In the case of using accumulated savings from development charges, the municipality is still over $37 million short at the end of ten years.
Of course, there is also a difference in which municipal taxpayers are paying for the infrastructure. In one case, a handful of new homebuyers and renters are having to foot the entire bill, in the other case, the money is coming from general revenue. However, it is important to recognize that while new developments do come with expenses, they also generate a stream of municipal property taxes (and taxpayers) that the city did not have before, which raises general revenues, which can be used to pay this debt.
Beware of false economy
Avoiding debt by using development charges sounds fiscally responsible, but it can increase costs and require a handful of new buyers and renters to pay for infrastructure used by the entire community. Unfortunately, no accountability or oversight process represents the interests of new homeowners or renters to ensure that municipalities are making the best decisions when it comes to financing infrastructure.
Using development charges to finance infrastructure does not eliminate debt; rather transfers it from the municipality to new homebuyers. This has the perverse effect of increasing financing costs, as interest rates on household mortgages are substantially higher than municipal borrowing costs. We can lower overall finance costs by financing projects using municipal debt, which is repaid through consumption fees and new property tax assessment value that comes from growth.
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