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New Investigation Report: Conditional Recommendation on Capital Costs in the Municipal Revenue System

Oslo, 23.12.2024

In a new report, Vista Analyse examines whether – and, if so, how – capital costs should be included in expenditure equalization within the municipal revenue system. The new report summarizes previous findings, discusses the principal trade-offs, estimates capital costs in several alternative ways, and addresses the impact on expenditure equalization in the municipal income system.

The principal trade-offs related to the inclusion of capital costs have been discussed in previous studies, albeit with a more limited empirical foundation. The project was conducted by Vista Analyse on behalf of the Ministry of Local Government and Regional Development, with Knut Moum contributing on a project basis. Additionally, a reference group composed of experts in capital costs and municipal finance followed the project closely. The investigation report may be downloaded here.

A Richer Basis for Evaluation than Previously

In the report, Vista Analyse conducts alternative capital cost calculations based on a relatively comprehensive dataset, where KOSTRA and national accounts from Statistics Norway are the primary data sources. Municipalities' real capital stocks are measured in a reasonably robust manner using the "Direct Method" (DM) and the "Perpetual Inventory Model" (PIM), even though the estimates capture somewhat different aspects and their magnitudes carry a degree of uncertainty.

Regarding interest costs, both a floating rate, equivalent to the sum of the calculated interest rate for municipal cost-recovery services and a risk premium, and a fixed rate, corresponding to the public sector's real rate of return requirement on gross investments converted to a nominal rate, are explored. Different approaches to measuring capital costs yield strongly correlated metrics, though the levels of these metrics vary significantly. Capital cost indicators are highly correlated with key cost elements in the operating accounts and also capture external factors that gross operating expenses do not. Regression analyses of alternative cost measures and existing expenditure equalization criteria yield relatively few significant results across sectors.

"It has been a pleasure working at the intersection of capital analysis and municipal finance. We also see several interesting opportunities for further developing our municipal finance dataset, including capital variables, created in this project", comments partner Rasmus Bøgh Holmen, who led the project on behalf of Vista Analyse.

Significant potential for Including Capital Costs in the Municipal Revenue System

Vista Analyse's overarching recommendation in the report is to explore appropriate ways to include capital costs in the revenue system, with the expectation that this would not lead to radical changes in expenditure equalization. If a suitable method for including capital costs in expenditure equalization is identified, equal weighting of the DM and PIM estimates, calculated at the functional service level with disaggregated parameters for capital depreciation, is recommended. Alternatively, only the latter estimate could be used.

Furthermore, it is suggested that interest costs in the municipal revenue system be measured as a long-term rate with a risk premium, based on the underlying capital stock. If appropriate criteria for equalizing capital costs in primary municipalities are successfully identified, the recommendation is that capital costs should not be treated differently for primary municipalities and county municipalities, as considerations of estimate reliability and capital intensity pull in opposite directions.

"We would like to thank Knut Moum, the Ministry, and the members of the reference group for a productive collaboration with many interesting professional discussions and valuable input. We look forward to following the revision of the municipal revenue system and continuing to work on issues related to capital and municipal finance", Holmen concludes.

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