Understanding municipal debt
Debt is borrowed money that needs to be paid back (usually with interest) later. Municipal debt is not a revenue tool, but it can be an important capital financing tool. Long-term debt can be used to fund things like capital projects for example, rehabilitating a bridge or constructing a water treatment facility.
Regulations and restrictions
Ontario’s regulatory framework for municipal borrowing helps municipalities to use debt responsibly while regulating their overall ability to borrow. Rules include:
Long-term borrowing for capital projects
Municipalities can only incur long-term debt for capital projects. They must balance their budgets in accordance with legislation and generally can’t borrow money over the long term to fund current operating expenses. However, a municipality may temporarily borrow money to pay for operating expenses while they are waiting to receive taxes and other revenues for the year. This framework assists municipalities by maintaining their long-term financial health while maintaining public services.
Annual Repayment Limit (ARL)
The ARL may be summarized as the maximum amount that a municipality can pay in principal and interest payments in the year for new long-term debt (and in annual payments for other financial commitments) without first obtaining approval from the Ontario Municipal Board. The ARL calculation is prescribed by Ontario Regulation 403/02 (Debt and Financial Obligation Limits) under the Municipal Act, 2001.
The ARL can be described as a 2 step process:
- The Ministry of Municipal Affairs determines each municipality’s limit annually using a formula in the regulation based on the financial information supplied to the ministry by the municipality through a Financial Information Return (FIR). For most municipalities, the ARL is set at 25% of their annual “own-source” revenues (a ministry-determined amount which includes property taxes, user fees and investment income) less their annual long-term debt servicing costs and annual payments for other long-term financial obligations.
- The ARL is updated by a municipality for each proposed borrowing. In greater detail, when a municipality proposes to undertake long-term borrowing (or other long-term financial obligation), the treasurer is generally responsible for updating the limit issued by the ministry and for determining whether there is capacity for the proposed additional annual debt carrying costs within the municipality’s ARL to undertake the planned borrowing.
Debt policies and procedures
Municipalities may wish to establish internal policies and procedures on debt. Council, for example, may wish to consider policies and procedures for asset management planning, the purposes for which the debt is issued for example, to construct a road, and other factors that may assist municipalities to make informed decisions. Some municipalities like the Town of Moosonee have decided to establish their own policies to manage the ARL internally.
Reasons for taking on debt
Municipalities may take on long-term debt to finance infrastructure and other capital assets. In some cases, depending on the municipality’s size, service responsibility and local policies, it may make sense to borrow in the short-term to help maintain municipal services as debt is paid off.
Some reasons municipalities use debt to finance projects include:
Spreading out the cost of capital projects over their useful lives
Municipalities may not have enough resources to directly pay for a project in one year. Borrowing allows them to spread out the cost of the project over its useful life and allows infrastructure costs to be paid not just by today’s taxpayer, but by future users as well.
Limited internal and external financing sources
Municipalities may have limited access to internal financing sources like reserves or reserve funds and may not have existing assets available for sale. External financing sources include government grants (federal and provincial), fundraising or donations, which generally offer a limited source of additional funding.
Low interest rates or escalating project costs
If interest rates are lower than the rate of inflation for certain construction projects, it may make sense to borrow for a project sooner, rather than pay a higher cost for the project later.
What to consider before taking on debt
Need or urgency
Municipalities may wish to consider the urgency of the proposed project. For example, if public health and safety is a concern, there may not be time to set needed funds aside in reserves. Borrowing can be an effective tool when there is an urgent need for financing.
Interest rates are affected by several factors including the riskiness associated with the creditor. Since smaller municipalities have a smaller tax base, there is a chance that they may be less capable than a larger municipality of handling local economic shocks (such as a factory closure) which could impact the ability to pay off debt. As a result, small municipalities may have to pay higher interest rates.
Setting aside funds for debt repayment could impact a municipality’s ability to respond to unexpected events such as extreme weather. To get a better picture of their debt position, municipalities could consider conducting analysis using the following financial indicators:
- debt per capita
- debt charges per capita
- debt charges as a percentage of revenue
- debt charges as a percentage of municipal levy
- using data from the FIR, municipalities can gather information on their debt levels and can compare themselves to other municipalities
Long-Term Financial Plan
A long-term financial plan incorporates all the financial policies of a municipality into one document. This can help to feed into overall financial planning, including a local decision about how much debt a municipality may handle. It also speaks to a municipality’s financial resiliency, capital infrastructure planning and expected revenues over time.
Supports for municipalities
Municipalities may be eligible to qualify for long-term financing through Infrastructure Ontario.
Infrastructure Ontario provides affordable, long-term financing solutions, including short-term construction loans and long-term take-out financing to help renew public infrastructure and deliver value to customers and residents across Ontario.
Debt is one of several capital financing tools available to municipalities. When used responsibly, it can be a powerful tool to help finance long-term capital needs. Municipalities are encouraged to consider all the tools they have for a balanced approach to finance capital expenditures. Taking on too much debt could impact the level and quality of service provided by a municipality.