14 Apr 2016

The road to Commonwealth infrastructure funding: paved with value capture?

by Owen Hayford

Value capture has a place in the funding mix, but it won't supersede the need for user charges, asset recycling and other initiatives to generate the funds needed to pay for our infrastructure.

Transport infrastructure shapes the physical layout of cities and drives enormous economic growth and property value increases in its wake. More often than not in Australia, the individuals and business that receive these windfall gains from government funded infrastructure make no direct contribution to its cost. Government is showing renewed interest in capturing a share of these windfall gains so that private interests who gain from the new infrastructure help to pay for it.

Soon, state and local governments may have no choice in the matter. The Federal Minister for Major Projects Paul Fletcher has flagged that State Governments might have to employ this strategy, known as "value capture" or "value sharing", in order to qualify for federal infrastructure funding. Infrastructure Australia's most recent infrastructure plan also contains a recommendation to this effect.

Using value capture mechanisms to help pay for the infrastructure that delivers the value is not new ‒ it has been done before, both in Australia and overseas. However, our three levels of government, political realities, existing laws and tax regimes make value capture tricky to implement. It is often considered as a potential funding mechanism for new infrastructure projects but then relegated to the "too hard" basket when the political ramifications become apparent. The Commonwealth's new position is likely to make State and Territory Governments try harder to make it work. But is it the silver bullet that will solve the infrastructure funding dilemma?

Betterment levies and taxes

Many local governments levy rates on landowners based on the unimproved value of their land in the local government area. As the value of that land increases, including as a result of the development of transport infrastructure in the vicinity of the land, the rates levied by the local council also increase. If local councils could isolate the increase in rates attributable to a particular infrastructure project, it could apply such funds towards the cost of funding the project. However, isolating the increase in rates attributable to the project, as opposed to other factors, is not easy.

But if a supplementary levy is imposed, the additional revenue collected via the supplementary levy can be easily isolated and hypothecated. This approach has been used in Australia previously to contribute to the funding of the Sydney Harbour Bridge and the Melbourne Underground Rail Loop. However, in both cases government succumbed to political pressure from land owners and local businesses and removed the levies before the full intended contribution to the infrastructure costs had been collected. This results in the funding burden being spread back across the general tax base, including taxpayers who receive little if any direct benefit from the infrastructure.

A slightly different approach was adopted for the Gold Coast Light Rail project. In this case, the Gold Coast City Council levied a flat levy per property on all properties in the local government area, regardless of the increase in value to the relevant property. Those landowners that benefited significantly from being close to the new light rail stations contributed the same as landowners that saw smaller increases in the value of their property.

Levying betterment taxes by reference to the boundaries of local government areas is often sub-optimal from a fairness and equity perspective.

The NSW Government is proposing another variant of a betterment tax for the proposed Parramatta light rail corridor, with its proposed Special Infrastructure Contribution (SIC) of around $200 per square metre of gross floor area of new residential developments. The boundaries of the SIC area are yet to be defined. Under this arrangement, the levy will be paid by developers of new residential developments along the rail corridor. Developers will seek to pass the cost of the levy on to purchasers of the units, but the market will constrain their ability to do so, especially if similar apartments are available for sale just outside the SIC area. The levy can therefore be expected to influence the price that a developer will pay to acquire development sites within the SIC area, and could hinder the Government's urban renewal objectives if not set at an appropriate level.

Tax increment financing

The tax revenue collected by Local Councils and State Governments in the form of rates and other property taxes increases when new infrastructure raises the value of the value of properties. Can the future incremental property tax revenue that the new infrastructure will create be used to raise the finance needed to pay for the infrastructure?

This is what happens in the United States, where it is called Tax Increment Financing (TIF). It is also being trialled in the United Kingdom. One of its benefits, compared with betterment levies, is it avoids the need to impose a new tax on landowners and businesses and the associated politics.

However, the approach is not without its own problems. For example, there is the obvious risk that the incremental tax revenue generated by the infrastructure will be less than expected and, perhaps, insufficient to service the associated debt. If the lender requires the relevant State Government to take this risk, by guaranteeing the repayment of the debt, then the State Government would be better off simply borrowing the finance itself using its credit rating and avoiding the added complexity of TIF. In addition, the concept doesn't translate nicely to the Australian environment given our wide range of property related taxes, and the various level of government at which they are levied. We would also need to make legislative changes to allow Local Councils and/or State Governments to hypothecate future expected tax revenues to underwrite debt for specific infrastructure projects

Property value increases

Governments can also capture property value increases caused by the development of new infrastructure by purchasing land that will increase in value as a result of a proposed project prior to announcing the project. The government can then sell the land after its value has increased. The NSW Government has adopted this approach for its Northwest Metro project, by buying extra semi-rural land surrounding the proposed new stations for use during construction, with a view to later selling this land to developers. Similarly, if government already owns land that will increase in value as a result of the new infrastructure it can capture that value.

However, while many road and transport authorities are established with the power to acquire land for the purposes of building, operating or maintaining public infrastructure, they generally don't have power to acquire land for the purposes of later selling it at a profit to help fund the infrastructure. Accordingly, the legislation that establishes our existing authorities would need to be amended to give them these powers, or a new authority would need to be established with the requisite powers.

Another approach is for government to include associated development opportunities as part of the infrastructure project for which tenders are called. This approach was adopted for the Chatswood Transport Interchange in Sydney, where the PPP contract included the right to develop a shopping centre and residential towers above the new railway station and transport interchange. Care needs to be taken when structuring such arrangements to ensure that the contract incentivises the private sector to develop the public infrastructure appropriately, and that it is not distracted from the main game by the associated development opportunities.

Value can also be created by government decision to rezone land so that it can be used for higher value land uses. By planning and timing such decisions with other value capture mechanisms, government could capture a greater share of the value it creates by these decisions.

Perhaps the best example of these sorts of approaches is the Mass Transit Rail (MTR) project in Hong Kong. MTR is responsible for building and maintaining the mass transit railway system. In return, it is able to acquire land for stations at values based on a no-rail scenario and improve the land with the rail infrastructure, stations and residential and commercial developments. The model has been deployed with such success that it able to fully cover the cost of the mass transit system without any government subsidy. The density and associated land values of Hong Kong means that it is unlikely the model could be deployed with the same degree of success in Australian cities and regions. However, there are dense, urban locations where our transport infrastructure is presently inadequate where a MTR-style model could deliver additional funding.

Voluntary contributions

If a person or organisation will benefit from the provision of public infrastructure, it may be prepared to voluntarily contribute to the funding of the public infrastructure to make it happen sooner, or to obtain greater input into decisions on how it is developed. Developer contributions are one example of this. But there is room for government to further encourage such deals. For example, if a private organisation identifies a specific road upgrade that is needed to accommodate or grow its business operations, there should be an opportunity for it to invest in directly in the public road upgrade.

Similarly, if a developer seeks re-zoning of its land to allow a more lucrative development, there is an opportunity for local government to grant changes to land zoning and permissible land development uses in exchange for increased developer contributions which can be used to fund new infrastructure. There are risks and uncertainties associated with this approach including that the value of land often changes in anticipation of a zoning change, rather than solely occurring consequently following a re-zoning. In addition, a lack of transparency around charges associated with development can act as a deterrent to new investment.

The future of value capture

Value capture seems to have become the new buzz word in infrastructure circles. It seems that some see it as a silver bullet that will solve our infrastructure funding dilemma. Clearly, it has a place in the funding mix, but it won't supersede the need for governments to continue to pursue user charges, asset recycling and other initiatives to generate the funds needed to pay for our infrastructure. The Federal Government has a significant opportunity to drive State and Local Government to implement these reforms by making its financial contributions conditional on the appropriate application of value capture mechanisms and other reforms.

Public transport infrastructure is an obvious candidate for greater application of value capture mechanisms, but others will emerge, such as schools.

Governments must also take care to ensure that its desire to raise funds through value capture doesn't distort decision-making. Infrastructure solutions should be developed so as to best address the service need. There is a risk that the desire to maximise the value capture opportunities will result in more fundable, but otherwise sub-optimal, solutions.

Federal, State and Local Governments will need to carefully choose, co-ordinate and implement their value capture strategies in order to avoid unfair or perverse outcomes. Indeed, new levels of co-operation between Federal, State and Local Governments will be required to optimise the implementation of value capture in Australia. So it won't be easy!

Finally, government might wish to consider the potential flip slide of broader application of value capture in connection with transport infrastructure. If government is capturing a share of the uplift in value that some property owners receive as a consequence of publicly funded transport infrastructure, it will come under greater pressure to adequately compensate the owners of land that diminishes in value as a result of such projects.

Thanks to Tom Gardner, Mahsa Javam, Nick Thomas, Carrie Rogers, Isobelle Watts and Alison Packham for their contributions to this article.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.