Most Municipalities Don’t Understand that Coke Doesn’t Make More Profit by Charging $1000 a Can
Price elasticity is real, but absent from municipal math
Highlights
Municipalities routinely collect and spend significantly less than they estimate when it comes to Development Charges.
One reason is that municipalities fail to account for price elasticity. When the taxes on new development go up, the amount of new development goes down. Yet when setting development charges, they treat the amount of development as a constant, unrelated to price.
Municipalities may be setting development charges so high that they are forgoing revenues, leading to infrastructure delays and expenditure shortfalls.
A curious thing
Back in January, the Mayor of Vaughan, Stephen Del Duca, appeared on TVO’s The Agenda to talk about recent changes to development charges policy changes, with the Mayor stating:
“…if you start to cut anticipated revenues, that you might have a bit of a challenge I will say on the back end. The problem is, the last couple of years in our city [Vaughan] and I suspect it's true in most GTA municipalities, there hasn't been a ton of new housing starting. So, one of the reasons why I was comfortable making these changes and I told myself and colleagues on council I would much rather that we get half of something than 100 percent of nothing.
Later in the episode, the host, Steve Paikin, asked the Mayor:
“I take your point you'd rather have 50 percent of something rather 100 percent of nothing getting built. But if this does not work as well as you hoped, you'll be forgoing revenue for the treasury presumably. Has staff come back to you with an estimate on how much this could cost you in the end and therefore you will have the money for those fire halls or municipal pools, et cetera?”
To which the Mayor responded:
“Hard to know in the moment, it's based on activity and how much construction has started, how many permits will be applied for and ultimately approved. But the other thing I didn't mention is when we did our last development charge study in Vaughan in 2022 we notionally in that plan, in that bylaw we put together what we anticipated the revenue would be for development charges annually. When we did that work we anticipated about 230, $240 million a year give or take. What we actually achieved we actually brought in, its been dramatically less than that.”
This exchange is the first time we can recall any Mayor in Ontario publicly acknowledging revenue shortfalls related to too-high development charges.
Although this reality is often not spoken aloud, many development charge background studies that lead to increases in development charges end up overestimating future revenues because they assume there is no relationship between taxes on new housing and the amount of new housing that is built. Unfortunately, municipalities do not conduct regular reviews to understand and acknowledge revenue and homebuilding shortfalls. If annual reviews were conducted, more Mayors and councillors would better understand the relationship between development charge rates and housing starts.
How the system works
Below is a figure taken from Vaughan’s 2022 Development Charge Background Study outlining all the steps required to determine development charge (DC) rates. The figure is produced by Hemson Consulting, one of the major consulting firms that helps municipalities with DCs; this chart is commonly found in their studies.
The important thing to note here is that the development forecast is the first input into the model and is inserted as a constant. The DC study starts with an estimate of how many homes will be built over 10 years and then calculates development charge rates based on that. Because the development forecast is a constant in the formula, no feedback effects are built into the model, so the level of development charge rates plays no role in forecasting how many homes will be built over the next decade.
Figure 1. Key steps in calculating development charge rates
Source: 2022 Development Charge Background Study
Economists have a concept known as price elasticity, which describes how the quantity demanded, or quantity supplied, of some good or service, is affected by changes in prices. The way that development charges are calculated in Ontario, it is assumed that housing development is completely price inelastic, that cities will get the same amount of homes built if rates are set at $1 or $1,000 or $1,000,000 a home.
We know, however, that is unlikely to be true. When a city raises development charges, those charges impact the final price of the home. Buyers and renters, in response to those higher prices, will look for less expensive options, including surrounding communities where development charges are lower. Others may have to forego buying or renting a new home entirely; high housing prices in Southern Ontario have led to a historically high proportion of 20-34-year-olds living with their parents. Higher development charges lead to higher prices, and households finding other alternatives leads to fewer homes being built in that municipality.
New housing construction is not exempt from the old maxim, “If you want less of something, tax it more.” Raising taxes beyond a certain threshold will cause total revenues to fall; the revenue-maximizing rate is not an infinitely high price.
The assumption that increases in development charges have no impact on the number of homes that are built has real consequences. Councils will raise development charges, expecting a proportional increase in revenues. However, those increased revenues often fail to materialize due to offsetting reductions in housing construction, potentially leading to municipalities losing out on billions they could otherwise have gained to fund the infrastructure they need to support their populations.
By the numbers
Revenue shortfalls are not a theoretical concern. From 2013 to 2019, municipalities in the Greater Toronto Area only collected 63% of the revenue they anticipated from development charges:
Figure 2. Projected and Actual Development Charge Revenue
Source: New Homeowner Money in the Government’s Bank
In short, raising development charge rates does not guarantee higher revenue, and Ontario is littered with examples of cities finding that increases did not yield the cash windfalls they expected. Similarly, lowering development charge rates does not necessarily result in lower revenues.
Coca-Cola would not become more profitable if it suddenly decided to charge $1,000 for a can of Coke. Price elasticity is real but is too often ignored by policymakers. Kudos to Mayor Del Duca for acknowledging the link between development charge rates and housing development.
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