Vista Analyse Will Investigate the Integration of Capital Costs into the Revenue System for the Norwegian Local Government Sector

In a new assignment for the Ministry of Local Government and Rural Affairs, Vista Analyse will investigate whether capital costs should be included in the revenue system for the local government sector and, if so, how.

“We are pleased to embark on a new and exciting assignment at the intersection of the municipal revenue system and capital measurement. We look forward to working closely with the Ministry of Local Government and Rural Affairs,” says project manager and responsible partner in Vista Analyse, Rasmus Bøgh Holmen.

Vista has hired Knut Moum on the team on a project basis. Moum has previously been a special adviser and director general in the Ministry of Finance's economics department, as well as head of research at Statistics Norway. In addition, the project will be supervised by a reference group with extensive expertise in municipal economics, the municipal revenue system and capital estimation.

– At the intersection of the municipal revenue system and capital theory

The revenue system for the local government sector includes schemes for smoothing out involuntary differences in expenditure between municipalities and county municipalities, such that they are enabled to provide equal services. Today, capital costs, including interest expenses and depreciation of capital, are not included in the revenue system, with the exception of county municipalities' road investments. Nevertheless, the system aims to cover both operating and investment expenses, which otherwise have to be covered by free income.

Previous public reports have reached opposite conclusions as to whether or not capital costs should be included in the levelling of expenditure in the revenue system. The disagreement is not due to divergent fundamental assessments, but different assessments of the magnitude of measurement errors associated with capital costs.

“From a theoretical point of view, there is little basis for differential treatment of net operating expenditure and capital expenditure in the revenue system. This suggests that the cost categories should ideally be treated equally. In practice, however, incomplete data potentially combined with any strong correlation between capital costs and net operating expenditure may constitute an argument against including capital costs in the levelling of expenditures,” explains Holmen.

The project will also investigate whether municipalities and county authorities should face different systems. Since the county municipalities are more capital-intensive than the municipalities, ignoring capital costs will presumably have a greater impact at the county level than at the municipal level.

– Room to further exploit the field of capital measurement

The project can build on some good study work based on insight into the revenue system for the municipal sector and municipal finances. A few previous study projects and research articles also aim to measure capital costs in the local government sector in practice.

“Nevertheless, in our opinion, there is scope for further utilizing the field of measurement of fixed capital and interest expenses in the study of capital costs and the municipal revenue system. There is extensive literature on the measurement of real capital and interest costs, with obvious relevance to this issue,” Holmen comments.

He mentions the choice of capital estimation methodology, price management, depreciation rate and opportunity cost targets as examples of key topics that should be investigated further. Furthermore, he highlights the importance of heterogeneity in the mass of capital over forms of capital and sectors.

– A theoretical and an empirical subproject

The project is part of two subprojects. The first subproject investigates possible causes of systematic variation in capital costs and the implications of different ways of taking capital costs into account in the levelling of expenditures in the income system. Furthermore, the opportunities and challenges associated with including investment expenses, depreciations and interest expenses in the income system are studied. The team will also carry out a critical review of previous reports and studies on the topic.

The second subproject explores the practical consequences of ignoring the cost of capital for expenditure levelling in the revenue system. This includes examining different ways of estimating and integrating capital costs into the income system, empirically. Furthermore, the significance of measurement errors when estimating capital costs is analyzed. Based on its own and previous theoretical and empirical investigations, the team will make recommendations on the inclusion of capital costs in the revenue system and any facility.

“Capital measurement constitutes a professional heart child for many of us, so we are looking forward to working on this project. It is also gratifying to have yet another important project that consolidates Vista Analyse's strong position within municipal finances”, Holmen concludes.