There can be little doubt that New Zealand house prices, particularly in Auckland, have reached eye-watering heights. This week it was reported that capital valuations in Auckland have risen 33 percent over the past three years. Aucklanders already under pressure from lack of affordable housing must now worry that council rates, which are based on valuations, will also climb sky-high.

Such fears are unfounded, as Auckland Mayor Len Brown was quick to reassure ratepayers. His promise to restrict rate rises to just 2.5 percent may be ambitious but achievable. However, this points to a common misunderstanding about the way the rates system works. And it also shows what is wrong with relying on rates to fund local government.
 
The public often believes that rates are directly linked to property prices so that when houses prices rise the council increases its budget. That is only partly true: your share of the total ratings bill depends on your property’s value relative to other properties. But total rates revenue is determined by the council in advance and then broken down to ratepayers according to the values of their properties.

What sounds like a technicality has implications for a council’s behaviour. Because the total rates revenue is set independently of property prices or indeed the number of ratepayers, let alone figures relating to business activity, residential growth or income generated, councils do not have any financial incentives to pay attention to any of these matters. The budget will not be much affected regardless of whether the city is doing well.
 
The current local government finance system might in fact incentivise a council against development. Extra residential or business development typically costs councils money as they have to provide additional infrastructure and services to make it happen. Meanwhile, the benefits for councils are at best indirect and at worst non-existent.

Although there is no direct link between house prices and total rates revenue, higher house prices do make it easier for councils to justify overall rates increases. At least fast rising property prices make rates appear smaller in relation. In this way, there is no good reason for councils to care for housing affordability.

To correct for this situation, what would be needed is a local government finance system that rewards councils that go for growth and punish those that inhibit development. Our current rates system achieves the opposite – and that is what is wrong with rates.