Australia's Future Tax System

Final Report: Detailed Analysis

Chapter G: Institutions, governance and administration

G3. Local government

G3–1 Local government's roles and revenue sources

The roles of local governments vary across Australia

There are around 560 local governments in Australia, the majority of which are statutory bodies constituted under State and Territory legislation.6 Although they are not formally referred to in the Constitution, local governments have come to play an important role in the delivery of government services in Australia.

The revenue-raising mechanisms of local governments across Australia are similar, but there is much variation in the roles individual local governments play. Often this variation is driven by characteristics of each type of local government. For example, to meet their community needs, some rural and remote local governments operate aerodromes so that fly-in medical assistance can be accessed (Productivity Commission 2008).

Local governments typically provide a range of goods and services, some of which are public in nature, such as a local park that provides benefits to the wider community and is consumed at a low per-unit cost. Other goods and services local governments provide are more private in nature. For example, some local governments provide child care services. For some goods and services, the delineation between public and private is not always clear and can depend on circumstance (see Section E1 User charging). For instance, a car park provided by a local government in a major city is likely to be private in nature as more people will want to park their car there than the number of places available. But in less populated areas, the good is likely to have more public good characteristics as car parks are more likely to remain available for the public at large (hence one person using the car park does not stop another using it). The diversity of goods and services local governments provide suggest they should raise revenue from a mixture of taxes and user charges (consistent with the principles in Section E1).

Local governments raise most revenue from their own sources

Local governments (in aggregate) raise the majority of their revenue from their own sources. Chart G3-1 shows that in 2005–06 local governments raised 83 per cent of revenue from their own sources with 17 per cent of revenue received as grants from other levels of government. For individual local governments these percentages can vary significantly, reflecting differences in revenue-raising capacity.

Chart G3-1: Sources of local government revenue, 2005–06

Chart G3-1: Sources of local government revenue, 2005–06

Source: Adapted from Productivity Commission (2008).

Rates

Local governments have access to just one tax base: local government rates (often referred to as municipal rates). In 2007–08, local governments (and the ACT Government) raised around $10.2 billion from rates.

Local government rates are a tax charged on the value of property, with most types of land included in the tax base. The tax rate, however, can vary according to the type of land. For example, land for residential use may be charged a different tax rate from land for commercial use. Local governments generally have autonomy in setting the tax rate although there may be restrictions on how rates can be varied. In New South Wales, for example, the Minister for Local Government determines the maximum percentage by which general income from rates and charges may vary from the previous year.

The average tax rate varies significantly across jurisdictions. Jurisdictions with lower average land values tend to charge higher tax rates for a given property value. This may reflect that if one area has lower land values than its neighbour, it must charge a higher tax rate to raise the same level of revenue so it can provide the same level of services.

The tax rate applied by a local government can also vary from year to year, as local governments generally set the rate to achieve a revenue target. A significant rise in land values from one year to the next can lead to a lower average tax rate if the local government's revenue target does not change significantly.

Local governments use a variety of valuation methods (although differences between some of them can be minor). Unimproved value, site value, capital improved value (that is, the total value of the property) or rental value are all possible valuation methods. Some States allow local governments a choice in the valuation method, while others do not (Productivity Commission 2008). The merits of different valuation methods are discussed in Box G3-1.

Box G3-1: Land valuation methods for local government rates

Local government rates can be levied on the improved or 'property' value or on the unimproved land value. There are at least two competing theories about which of these are more efficient — the 'benefits tax' view and the 'capital tax' view (see Zodrow 2007). The benefits tax view argues that improved or property value taxes are efficient, as they simply recover spending on local public goods that benefit the property owner. However, people are less likely to improve their property if that leads to an increase in taxes, and improved-value taxes therefore provide a disincentive to invest. Nor is it easy to see why the ratepayer who improves a property gains more benefit from the council's spending on public goods than a ratepayer who does not.

In contrast, the capital tax view argues that improved or property value taxes distort the use of capital within a jurisdiction. That is, taxing the capital used to develop land is likely to be less efficient than taxing more immobile bases, such as the land itself. Zodrow (2001) found that the empirical literature in the United States provided limited support for this view.

The fact that capital can move between councils more easily than it can move between countries suggests that council rates should be levied on unimproved or site value. Using unimproved or site value would still reflect the beneficiary principle, as local government spending that improves a local area is most likely to be reflected in land values.

However, taxes on improved value are only inefficient to the extent that they impact on marginal investment decisions — as is the case with stamp duties on property — and therefore act as a disincentive to invest. In regard to local government rates, the consensus is that the distortions and efficiency costs of using improved value are small (Productivity Commission 2008). If the tax liability depended on the improved value of all houses in the area, rather than an individual assessment of a specific house, then the inefficiency is likely to be substantially reduced. However, some ratepayers may regard this as inequitable.

Exemptions (such as land owned by other levels of government) and concessions (such as for pensioners and other income support recipients) from local government rates are prescribed in State legislation. State governments usually rebate local governments for revenue losses due to pensioner concessions (although in New South Wales local governments only receive a partial rebate) (Productivity Commission 2008).

Because local government rates are generally a tax on land, which is a highly immobile tax base, they are a relatively efficient tax (see Section C2 on land taxes). Further, given that land is immobile, local government rates are an appropriate tax base for local governments to use to fund the provision of local public goods (see Section G2 State tax reform).

Finding

The immobility of land makes local government rates based on land value an appropriate tax base for local governments to use to fund local public goods and services.

User charges

Local governments charge fees for many goods and services — such as sporting grounds, and water and sewerage services — that are private in nature. As Chart G3-1 shows, around 29 per cent of total local government revenue comes from user charges. Provided these charges accurately reflect the cost of provision (see Section E1 User charging), they are an appropriate revenue source for local governments.

Local governments also receive revenue from developer charges, often known as infrastructure charges. Infrastructure charges can operate as either user charges or taxes, depending on the level at which they are set. They are user charges when they reflect the cost of providing the additional infrastructure needed for the development, but operate as taxes when they exceed such costs. The supply of infrastructure and the associated charging are important factors in the supply of land suitable for housing and they can have significant consequences for affordable housing. Infrastructure charges are discussed further in Section E4 Housing affordability.

Finding

User charging, when implemented correctly, is an appropriate funding mechanism for local governments to deliver private goods and services.

Local governments receive tied and untied grants

In 2007–08, local governments received more than $2.3 billion in grants from the Australian government. This consisted of $1.78 billion in untied financial assistance paid through the States and $554 million paid directly to local governments and 'tied' to specific purposes. State governments also provide grants to local governments for specific purposes or services, as well as to reimburse rate concessions.7

Australian government untied financial assistance is provided under the Local Government (Financial Assistance) Act 1995 and consists of general purpose assistance and an identified road component. The road component is identified but untied and can be spent according to local government priorities.

Each year the Australian Treasurer determines an escalation factor to be applied to the untied financial assistance grants. It is set by reference to population growth and the consumer price index.

The untied financial assistance is paid to the States on the condition that it is fully passed on to local government. The general purpose assistance is distributed to States on a per capita basis, while the road component is based on fixed historical shares. The distribution within States is in accordance with recommendations made by State grants commissions. These recommendations are required to conform to a set of national principles (See Box G3-2).

Box G3-2: Principles for distributing untied revenue assistance to local governments

State grants commissions are required to distribute untied revenue assistance provided under the Local Government (Financial Assistance) Act 1995 in accordance with the following principles:

  • Horizontal equalisation: each local government should be able to function, through reasonable self-effort, at a standard not lower than the average of other local governments in that State.
  • Effort neutrality: actual revenue or expenditure policies should not impact on the grant received by local councils.
  • Minimum grant: no local government can receive less than 30 per cent of its per capita share of the untied revenue assistance provided to its State under the Local Government (Financial Assistance) Act 1995.
  • Other grant support: any grants received by local governments in respect of assessed expenditure needs should be accounted for in the assessment.
  • Aboriginal and Torres Strait Islander people: assistance should be provided to councils in a manner that recognises the needs of Aboriginal and Torres Strait Islander people within the local government area.
  • Identified road component: this funding should be allocated on the basis of road expenditure needs.

There seems little reason that local governments with large fiscal capacities should receive a guaranteed minimum grant (which allows them to tax their residents less than they otherwise would) at the expense of local governments with relatively small fiscal capacities (which result in them taxing their residents more than they otherwise would). The current requirement that each council receives 30 per cent of its per capita share of untied financial assistance grants may prevent State grants commissions from redistributing to councils that require greater assistance.


6 There are no local governments in the ACT. The ACT Government performs many of the functions that local governments perform in other jurisdictions.

7 It is difficult to determine the total amount of State grants to local government as some State governments also provide contract payments to local governments to carry out some State functions. The Productivity Commission (2008) estimated that in 2004–05 State government grants to local government were $1.831 billion. As a comparator, the Productivity Commission estimated Australian government grants to local government were $1.813 billion in 2004–05.