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A capital budgeting methodology for a small town.

A problem faced by many local governments is to provide a stable level of services to a growing population without continually accelerating tax increases. The normal practice to accommodate growth is to wait until capital expenditures are required and then either raise taxes or float a bond issue to pay for them. This "incremental" spending approach generally results in abrupt increases in taxes, causing voter resentment and making it difficult for local governments to function effectively.

Good planning for growth can balance revenues and expenditures over long periods and reduce costs to taxpayers, as well. This article describes the financial planning methodology developed for the town of St. Albans, Vermont, a methodology allowing the elected town officials to replace old equipment, maintain services desired by voters and still present a budget calling for only moderate increase in taxes. The voters accepted the plan, it has been implemented, and the process has been gaining increasing support for its businesslike approach to government finance.

The Setting

The town of St. Albans, Vermont, like many small communities, is trying to provide government services and to support controlled and orderly growth while minimizing tax increases. It is a small town of about 4,000 permanent and 1,200 seasonal residents, located 30 miles north of Burlington on Lake Champlain. The town's proximity to Burlington has subjected it to rapid growth in recent years: During the 1980s it had a population growth of about 15 percent, twice that of the state. While desiring to accommodate controlled and managed growth, the residents did not want to lose their quality of life, which is based on a mixture of farming, light industry, recreational business and residence.

St. Albans is governed by a select board of five members. As one of several measures designed to promote controlled and orderly growth and development, the select board adopted a town plan with zoning bylaws and subdivision regulations TABULAR DATA OMITTED in September 1987. They also formed a capital budget planning committee (CBPC).

Among its first actions, the CBPC took an inventory of capital assets and prepared a schedule of asset purchases for the period 1989-1994 that was designed to meet the goals of the town plan and maintain the existing level of services. The capital spending plan incorporated replacements and improvements needed to comply with changes in building codes for accessibility and safety, as well as for expected population growth. Exhibit 1 lists the timing and cost of projected capital expenditures over the five-year planning period, separated into school-related and nonschool items.

Voter resistance to tax increases was perceived by the CBPC and the select board as a critical problem, and they considered it imperative that any proposed financing plan minimize the tax rate in order to be acceptable. To assist in developing a financing plan that could meet this challenge, they retained a consulting firm that specializes in economic analysis and financial management. The consultants advised that if the town 1) followed a consistent plan for financing asset purchases and 2) made annual investments into a sinking fund for asset replacement, the total cost to taxpayers could be minimized and the tax burden stabilized.

The Methodology

A methodology was devised which would evaluate alternative financing plans and their impact on the tax rate and the tax bills of property owners. The analysis looks at debt service costs associated with alternative financing arrangements, as well as the cost of providing for a sinking fund for asset replacement. The sinking fund is designed to provide for maintenance of the current investment in assets without future borrowing or increased taxation.

Four alternative scenarios were used to illustrate the potential impact of alternative methods for financing capital expenditures on the tax burden of the average homeowner. They were selected to illustrate the widest possible range of financing alternatives: from paying for capital items from current revenues to totally long-term financing.

Scenario 1, essentially a pay-as-you-go plan, was based on the following assumptions: 1) borrowing would only occur for school construction, and all other capital expenditures would be paid for from current tax revenues; 2) the grand list (the list of assessed value of all the property in the town) and operating expenses would grow 5 percent annually, which was the growth rate in the grand list from 1987 through 1989; 3) property would not be revalued; and 4) interest rates would be 8.47 percent for three- and five-year borrowing, 7.97 percent for 10-year borrowing and 7.47 percent for 15- and 20-year debt. These interest rate projections were based on the yield curve at the time and were employed in all four scenarios.

Scenario 2 was the same as scenario 1, except that capital assets were assumed to be individually financed for their estimated lives rather than being purchased with current revenues.

Scenario 3 adopted the assumptions of scenario 2, but differed in assuming that, during the first two years of the five-year planning period, capital expenditures would be financed by bond anticipation notes and that 20-year bonds would be issued in year three to cover the cost of all planned capital purchases. It also assumed annual payments into a bond retirement fund which would be used to retire the bonds over the 20-year financing period.

Scenario 4 was the same as scenario 3, except for a property revaluation in 1990 which was assumed to result in a 25 percent increase in the value of the grand list. This was considered a conservative estimate by the select board.

Each scenario incorporated a sinking fund for asset replacement. Because the sinking fund was independent of the method by which assets were to be financed, the sinking-fund expenditures were constant for all financing methods. The payments into the sinking fund were determined so that each asset could be replaced at the end of its useful life, assuming stable prices. An investment return of 9.47 percent (a 2 percentage-point premium over the borrowing rate) was projected to be earned on sinking fund assets. Exhibit 2 shows the projected payments into the sinking fund over the five-year period.

The sinking fund for asset replacement was designed to achieve two important objectives. The first goal was to avoid future bond issues for asset replacement. Providing for replacements through the sinking fund would be more economical than bond-financed replacements and would result in a more constant level of expenditures and taxes. As future growth tapers off, the need for new borrowing should fall, and with a built-in line item to replace capital, the tax rate should flatten out. The second objective was to provide a measure of the current service level for purposes of assessing growth impact fees. This would allow a more equitable property owners and future property owners.

Results of the Analysis

To illustrate the methodology, the results of scenarios 1 and 3, the high- and low-tax scenarios, are discussed below.

Scenario 1. The financing schedule for scenario 1 is shown in Exhibit 3. It is based on paying for all capital purchases from current tax revenues, with the exception of school construction--new schools will be financed with 20-year bonds. The combined expenditures for capital purchases, debt service, sinking fund payments and operations, along with their tax impact, are shown in Exhibit 4. The forecast of operating expenditures in Exhibit 4 was provided by the select board, with an assumed 5 percent growth rate.

The only bonded indebtedness for scenario 1 occurs as a result of the school construction in 1993, and the only debt service occurs in 1994 as a result of the school bonding in 1993. All other capital expenditures are paid from current tax revenues. The sum of all expenditures provides the estimated total expenditures for each year of the five-year planning TABULAR DATA OMITTED TABULAR DATA OMITTED period. Dividing the total expenditures by the estimated value of the grand list (assumed to grow at 5 percent per year) gives the projected tax rate per $100 of assessed valuation.

Under scenario 1, the tax rate increases or $2.258 in 1990 to $2.888 in 1993 and then falls to $2.568 in 1994. The tax bill for the average single-family home, which had a fair-market value of $67,890 in 1988, rises from $1,533 in 1990 to $1,961 in 1993 and falls to $1,743 in 1994. The 1993 tax bill for the average single-family home is projected to be almost 28 percent higher than the 1990 tax bill; for 1994, it is expected to be almost 14 percent higher than the 1990 cost. The total taxes paid on the average residence over the five-year period would be $8,725, an average of $1,745 per year. Conclusion: Scenario 1, based on a pay-as-you-go plan for all capital expenditures except schools, would subject taxpayers to a rising and unstable tax burden.

Scenario 3. The results of scenario 3 are shown in Exhibit 5. This financing plan assumes that all capital assets are financed with 20-year bonds at an interest rate of 7.47 percent. Debt service payments for each of the first five years of these bonds are shown for both school and nonschool construction, as are the annual sinking fund payments. The tax analysis shows that the maximum tax rate of $2.416 occurs in 1994 and results in a tax bill of $1,641 for the average single-family home, which is only 12.3 percent higher than the lowest bill of $1,461. Even though taxes increase each year under scenario 3, the increases are smaller and fluctuate less than under scenario 1. For the five-year period, total taxes under scenario 3 for the average residence would be $7,737 for an average of $1,547; this compares to $8,725 and $1,745 under scenario 1. Furthermore, scenario 3 yields a lower tax bill for each of the five years.



Predictable Expenditures

The select board recommended a budget incorporating scenario 3 to the voters, and it was accepted. St. Albans has completed the third year of its five-year planning cycle, and the results are encouraging. The tax rate only had to increase by $.02 per $100 of assessed valuation for the town portion of the capital plan, and a property revaluation has not been undertaken. With decreasing interest rates, the annual payments into the sinking fund have had to be increased; however, the cost of borrowing also has fallen, the net result being no change in total costs.

It appears that the long-term effect of investing in the sinking fund for asset replacement and borrowing for initial asset purchase is equivalent to having paid cash for the capital purchases. Furthermore, despite the depressed New England economy, the town is not struggling with budget problems. Some asset purchases have been postponed because growth has slowed. Overall, implementing financial planning has enabled St. Albans to do a much better job of managing expenditures and costs and of adapting to the recession.

As this paper was being prepared--in February 1993--the town of St. Albans was preparing its annual capital purchases proposal for the voters. It was also in the process of revising the five-year capital plan to conform to the new town plans. While the town continues to require technical assistance in its annual review and update of the plan, the quality of the planning process has improved dramatically. The CBPC is clearly in command of overall policy strategies and is able to establish specific capital service goals. This result is due to the town now having a systematic record of acquisitions, depreciation and service levels.

True to its purpose and despite the severity of the recession, the capital budget planning process has enabled St. Albans to stabilize the growth in its tax rate. It has also been able to stabilize its purchase schedule. Because sinking funds are available to replace deteriorating assets, the town is able to proceed with the replacement of capital on schedule. This provides two sources of savings. First, the town has fewer maintenance costs and less down-time for repairs, both of which tend to increase short-term operating costs. Second, the town avoids the problem of lumping deferred purchases together at the end of the recession. It is these accumulated sums of replacement capital commingled with the need to acquire capital to accommodate new growth that create politically unpalatable spikes in the tax burden.

At the end of ten years, it is expected that the majority of St. Albans' capital purchases will be routine replacements from sinking funds. Only net additions to the capital stock will require new borrowing. The town will be able to maintain a standard level of services, have a predictable level of expenditures and be able to focus capital planning efforts on long-range goals consistent with managed growth.

The objective of the capital financing alternative methodology was not to produce "the correct plan," but to provide St. Albans' CBPC and select board with a planning tool to help them evaluate their options and make the decisions which were best for them. As a result of having this analysis prepared for them and the details of the process discussed with them, the members of the CBPC became more aware of the planning analyses that could be done in a small town. They are more astute in financial matters and are better prepared to ask the appropriate questions.

RICHARD G. ELMENDORF, DBA, is assistant professor in the Department of Accounting, University of Wyoming. He previously was associated with the consulting team that developed the capital budgeting methodology for the Town of St. Albans. PHYLLIS W. ISLEY, PH.D. is a member of Economic and Financial Consulting Associates, Waterbury, Vermont, the firm that has worked with the Town of St. Albans on its capital planning.
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Title Annotation:Spotlighting Small Governments
Author:Elmendorf, Richard G.; Isley, Phyllis
Publication:Government Finance Review
Date:Apr 1, 1993
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