Download Victorian Holding Cost Model - Commonwealth Grants Commission

Equalising the net operating balance
1. Following recent correspondence with Commission staff, we have been asked our view on
how holding cost revenue and interest revenue should be assessed under an assessment
of capital needs which is based on the equalisation of net operating balance rather than
net lending/borrowing.
2. Victoria had previously suggested that Holding Cost (HC) revenue and interest revenue
could be assessed EPC. However, we have gone back to first principles and undertaken a
more rigorous assessment of this question.
3. Victoria has always contended that States hold or acquire capital to deliver services and
therefore capital is simply another input to service delivery. The total amount of capital
held by a state is influenced by demand for services as well as choices between capital
and other inputs.
4. The following approach will produce an assessment that is neutral to State decisions on
the inputs and method of service delivery. It will avoid grant design issues by neutrally
assessing service delivery which involves capital, whether this capital stock is owned
(through either operating surplus or borrowings) or whether it is leased.
5. Victoria’s proposed approach takes into consideration both holding cost revenue, and
holding costs when assessing capital.
HOLDING COST REVENUE
6. Before we can answer the question of how to assess HC revenue, we need to establish
the conceptual case for the HC approach and thereby the nature of HC revenue. The HC
approach recognises that there is an opportunity cost of tying up funds in physical assets.
If not tied up in physical assets, these funds could have been:
used to earn interest revenue or reduce borrowing (ie provide a direct financial
benefit); or
more likely, this direct financial benefit could be combined with associated savings
from reduced depreciation costs, and applied to deliver services using a different
input mix (e.g. leasing assets instead of owning them). This is important because,
ultimately, capital is an input to service delivery: States do not hold assets as an end
in itself.
7. If the (gross) opportunity cost can be represented by the funding cost of holding physical
assets, what then is the corresponding ‘opportunity benefit’ or holding revenue? There
appears to have been a general assumption that holding costs and holding revenue cancel
each other out, but there is no clear conceptual basis for this assumption.
8. HC revenue represents the (financial) benefit received by States from holding physical
assets. Importantly, this is not the service delivery benefit. Explicitly, capital is held as an
input to service delivery - we don’t assess the service delivery benefit of other inputs (e.g.
wage or lease costs) and nor should we for capital.
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9. As noted in a consultants’ report for the 2004 Review , the financial benefit of holding
physical capital is due to the gain in nominal value of those assets due to inflation.
Inflation means that if an asset is disposed of, the nominal funds available will be greater
than if inflation had not occurred over the time the asset was held. Importantly, the CGC’s
assessment of all other expenses and revenue is calculated in nominal terms. The impact
of inflation is already implicitly included in other input expenses (e.g. wages and leases)
since they are a recurrent expense, so accounting for HC revenue serves to further put the
treatment of capital on to equal footing with the treatment of other input expenses.
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EMCORP Pty Ltd and DAKIMA Consulting Pty Ltd, 'Methodology for assessing capital related
expenditures', February 2002 (Report for 2004 CGC Methodology Review)
10. The argument for recognising holding cost revenue or the price movements of capital is to
ensure that the treatment of various inputs remains neutral. All inputs are affected by
price changes. These price changes will have negative or positive impacts on a state’s
finances. For most inputs these price changes are automatically recognised ‘above the
line’, For instance increases in wages flow through as a negative impact to the operating
result, whereas a decrease in freight costs would flow through as a positive impact.
11. In relation to capital, these prices changes are not automatically recognised. Holding cost
revenue can be seen as the recognition of the imputed benefit received from inflation in
physical asset prices. Positive price movements in the capital stock held will have a
positive impact on a state’s finances as the disposal value will increase (or, more likely,
not fall as much as they otherwise would post-asset usage depreciation). These price
movements are captured by revaluations but are recognised ‘below the line’.
12. We recognise that land holdings – which are not assessed – are historically subject to well
above-average price inflation. However, price inflation can affect all types of assets, not
just land holdings. For example, if construction costs increase significantly, the value of
existing buildings stocks would increase to reflect the higher replacement cost. Similarly, if
the price of new cars increase significantly the value of second hand cars would also
increase.
13. Under the Australian Bureau of Statistics’ GFS system, capital stocks are (at least
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conceptually) measured in current prices i.e. post-inflation revaluation impacts. , Holding
cost revenue can therefore be calculated by applying an appropriate inflation growth
measure (such as the annual growth in the ABS chain price index for general government
sector gross fixed capital formation) to the ABS current price capital stock estimate as
follows:
HRt = Kt - (Kt / (1 + pt))
Where :
HRt = holding cost revenue for current year
Kt = capital stock in current prices at end of current year
pt = growth in relevant price index over current year
ASSESSMENT OF HOLDING COST REVENUE
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14. The 2004 Review consultants’ report also effectively pointed to a appropriate method for
assessing holding cost revenue:
the report noted that the inflation-derived opportunity benefit obtained from holding
capital stock is, by definition, proportional to the stock of assets;
the opportunity holding cost is also proportional to the capital stock
therefore the CGC’s assessment can be applied to net holding costs, which the
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consultants’ report (in simplified terms ) defined as :
NHCt = kt * rt
Where:
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kt = value of capital stock (pre inflation)
rt = real interest interest rate
ABS 5514.0, Australian System of Government Finance Statistics, Concepts, Sources and Methods,
2005, p. 22.
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ibid
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The 2004 report by EMCORP Pty Ltd and DAKIMA Consulting Pty Ltd distinguished between
capital stock financed by borrowing (borrowing cost) and capital stock financed by surpluses (interest
foregone). However, we have simplified this applying an interest cost to the total capital stock,
irrespective of the source of financing.
In other words, there is no need for a separate assessment of holding cost
revenue. Under this approach, the assessment is undertaken by applying
relevant recurrent disabilities to net holding costs.
15. As noted in paragraph 13 above, the ABS measure of capital stock is expressed in current
prices – that is, it has already (at least conceptually) incorporated the impact of inflation.
Under these circumstances, net holding cost can readily be calculated as:
NHCt = HCt - HR t
Where:
HCt = K t * i t
i = nominal interest rate (eg nominal bond rate)
HR t = holding cost revenue as per paragraph 13.
16. Note that since the holding cost measure incorporates the cost of borrowing to fund capital
stock, there is no need for a separate interest payments assessment. The only element
missing from the model is interest revenue.
INTEREST REVENUE
17. Interest revenue is difficult to assess due to policy difference across States; the
Commission therefore proposes to equalise the source of interest revenue, net financial
assets, so that States have the same per capita share of net financial assets from which
interest revenue is generated. The question therefore becomes, ‘do we need to equalise
NFA?’. Some States have argued that equalising NFA is essential due to the dilution
effect of population growth, that is, States with more rapid population growth will
experience declining NFA per capita relative to States with slower population growth, and
thus declining ability to raise interest revenue per capita.
18. Victoria accepts that there will be a dilution effect, ceteris paribus. However, ceteris
paribus does not apply and there are other impacts of population growth that are likely to
offset the per capita decline of NFA. As noted in previous submissions, this is evidenced
by data which show that there has been no dilution effect in practice.
19. We would note that the stock NFA (the source of net interest income or payments) is just
financial assets less financial liabilities. If dilution on financial assets did exist, Victoria
considers that financial liabilities per capita will be diluted at a similar rate as financial
assets per capita, leaving NFA per capita unchanged. Even if this is not the case, there
are potential positive impacts on per capita NFA from population growth.
20. The CGC has argued that State policies influence the standard, which is to say that the
standard policy across all States between 1999 and 2006 was to increase NFA per capita
from about $2 200 to about $5 000, or 127 per cent in 7 years. Victoria questions whether
this is completely policy driven, or whether it is a function of a prosperous economy that
enabled equity in GBEs to grow more rapidly than population growth.
21. In this context, it is important to note that equity in GBEs accounts for a large proportion of
total NFA held by States and Territories. GFS data shows that for 2006-07 total State
equity represented approximately 69 per cent of total State financial assets. In previous
years, GBE equity has comprised a slightly greater proportion, which is largely explainable
by trends in privatisation of state utilities. The drivers of GBE equity (including GBE
revenue and expenses) are appropriately not subject to (and therefore standardised by)
CGC equalisation and contribute to the observed growth in NFA per capita.
22. The inclusion of GBE equity in an assessment of NFA raises concerns since:
the scope of fiscal equalisation is the general government sector. There may be an
argument that equalising revenue which is generated from equity, effectively extends
the scope of the Commission’s assessments to partially include the PNFC sector. It
should also be noted that under the 2004 Review, dividend income from GBEs was
determined as so highly policy influenced that it was assessed EPC; and
As noted above, GBE equity is largely driven by factors not subject to equalisation,
therefore likely contravening the ceteris parebis dilution effect.
23. Given the significant policy influences, and the lack of evidence that any dilution effect
exists, Victoria contends that there is no need to equalise NFA and maintains that interest
revenue be assessed EPC.