Perverse incentives may help erode housing affordability

In addition to the many COVID-related uncertainties, many Canadian cities also face a housing affordability crisis. And the reason is straightforward—the supply of new housing units is not keeping up with demand. Part of the problem stems from barriers put in place by local governments. Project approvals can take years, cost tens of thousands of dollars (per housing unit) in fees, and can be riddled with uncertainty regarding what can actually be built and where.

So why don’t local governments make it easier to get more homes built? This is where the complexities of municipal finance come into play.

Canadian municipalities—often referred to as “creatures” of the provinces—have limited powers to raise revenues, yet they have broad financial obligations— from building and maintaining roads to taking out the trash. In some respects, they are the level of government that Canadians interact with the most. But unlike the federal and provincial governments, municipal governments don’t have a role carved out in the division of powers laid out in the constitution. Indeed, provincial governments can create, dissolve or merge municipalities; determine what services cities should provide; and, importantly, decide what revenue cities can collect.

Municipal own-source revenue (which excludes transfers from other levels of government) comes primarily from property taxes. However, residential property taxes are also arguably one of the least popular tax categories, which helps explain why property tax rates are disproportionately higher for businesses than residents. With an effective cap on this electorally-sensitive revenue source, city governments also receive income from direct cash transfers from senior levels of government, and user fee revenue for services and facilities (such as parking). But transfer revenue can be sensitive to the whims of provincial and federal politics, while fees can also be unpopular (this is why, for example, most of Canada’s urban freeways remain un-tolled).

Here’s where municipal finance becomes relevant to housing affordability.

A growing population, combined with rising incomes, and amplified by historically low mortgage interest rates has generated tremendous demand for housing in Canada’s cities. The amount of housing built to respond to this demand, and the rate at which it can enter the market, are both controlled—in part or in full—by municipalities. Municipal zoning codes dictate where and how much housing can be built, while development permit application processes play an important role in determining timelines for homebuilders. Basically, city halls across Canada are responsible for enabling (or not) trillions of dollars’ worth of real estate nationwide—a formidable policy lever which a growing number of municipalities are not afraid to use.

Faced with effective caps on generating revenue from property taxation and user fees, local governments in high-demand urban regions have turned to a new(ish) less-politically risky revenue source. In exchange for the ability to build homes, builders face a series of fees and regulatory hurdles, which can vary by province and city, but all ultimately seek to exact compensation in exchange for the permission to build homes.

In British Columbia, for example, homebuilders face more formal cash-for-infrastructure fees such as Development Cost Charges (as they have for decades), but also more opaque or unpredictable hurdles, notably Community Amenity Contributions, which are effectively presented as a condition for rezoning (which is necessary to build more homes).

Similarly, Ontario municipalities use Section 37 of the Planning Act to negotiate conditions for additional density. And with cities like Edmonton recently implementing similar fees, it would appear that a growing number of Canadian municipalities are opting to use this handy revenue tool: withholding building permission and density to extract an increasing number of local services and amenities.

Electorally, this approach makes sense. Property taxes remain low while services are increasingly paid for by new development (and those living in it). Moreover, existing residents might be less likely to oppose new homes near them if they see tangible benefits—such as parks and community centres—come as a result. Of course, there are clear losers in this equation—folks who want to move in but can’t afford to—but because they don’t yet live in Canada’s most housing-starved communities, they have no voice in local elections. This is the very definition of a “wicked problem” in public policy parlance.

Which brings us back to municipal finance. As mentioned earlier, the housing affordability problem is at least partially a symptom of the funding arrangements foisted upon local governments. They pay the bills for municipal services, but have little control over their revenue. As detrimental as municipal barriers to housing can be (by denying a growing number of workers and their families access to Canada’s largest, most productive cities), it is logical for local governments to be using the biggest tools at their disposal (zoning and development permitting) to extract revenue from newcomers.

One potential solution to the dilemma of having to (or wanting to) fund more services than they can afford with the political and legal constraints on raising own-source revenue is to re-think the financial relationship between the three levels of government. Two broad approaches could be employed. The first is simply giving municipalities more control over which tools they use to raise revenue. The second, and related approach, is to reduce or eliminate transfers to municipalities and in the process pairing back the size of senior levels of government. This increase in responsibilities could also increase municipal accountability, which is often muddied by tri-level funding arrangements allowing municipal leaders to pass the buck to federal and provincial leaders, and vice versa.

Incentives matter just as much for politicians as they do for everyone else. Bad incentives can lead to perverse outcomes. And this appears to be a factor in both the lack of political will to green light more housing, and the tendency to extract as much revenue as possible from every unit that is built. If property value is the primary source you allow municipalities to draw revenue from, it is to be expected that they act accordingly. That can have far-reaching consequences.

The housing affordability problem is in part a symptom of Canada’s federal structure. In particular, the way local governments raise revenue, and the incentives they face vis-à-vis voters have created a perfect storm whereby housing shortages benefit city hall. By fundamentally shifting how municipalities earn revenue, they can begin to play their essential role in creating cities where everyone can afford to live, work and play.