7.2 Capital Budgeting Process

There are multiple reasons for a capital budgeting process, which is distinct from the process for recurrent budgets. First, there are long-term (permanent) consequences of acquiring a capital asset. Capital projects often provide services over many years or decades, with taxpayers bearing the costs over the asset’s lifespan (inter-generational equity). The process separates capital expenditures from the recurrent budget and accounts for the time gap between initial outlays and future benefits. Second, technical risks (e.g., operating electric buses for the first time in a public transportation network) stemming from the one-time nature of many projects, and financial risks related to the future burden of debt financing need to be assessed prior to investment. Third, a long-term perspective on infrastructure stabilizes tax rates because expenditures are spread out over time, which reduces the immediate tax burden. The key steps in the capital budgeting process can be summarized as follows:

Identification of current capital asset inventory and future needs
Project evaluation and selection
Planning of financing and long-term financial analysis
Implementation of the capital budget and project management
Post-implementation activities such as operations, maintenance, and asset management

Note that due to the size of the federal government, there is no formal federal capital budgeting process since no single project would limit spending in other areas.

7.2.1 Inventory of Capital Assets and Future Needs

The current inventory of facilities involves evaluating factors such as the age, condition, usage, capacity, and replacement cost. This assessment may also include estimates for renovation, replacement, expansion, or retirement of facilities, with the possibility of incorporating some of those expenditures into the recurrent budget.

In terms of service characteristics, it is important to consider the current and future cost per unit of service provided by these facilities. The ideal situation would involve having an asset management plan that details the list of capital assets, associated maintenance costs, and other relevant information. Such a plan would serve as the foundation for decisions regarding the expansion of facilities and the planning of capital maintenance projects.

A vision regarding the future direction for the (local) economy, land-use, and development often precedes a plan to acquire capital assets. Such a vision (or plan) forecasts the need for future facilities (e.g., roads, sewage, libraries) given community growth and economic development. It estimates demand for services such as parks, transportation, offices, and residential needs. Here are some example for such plans:

You can also find some additional information at Government Finance Officers Association (GFOA): Master Plans and Capital Improvement Planning

Let us have a closer look at the Saint Paul for All 2040 Comprehensive Plan. Major trends informing the comprehensive plan policy are climate change, aging housing stock and infrastructure, constrained financial resources to pay for city services and facilities, and changing demographics. The plan identifies challenges and opportunities for the future including (1) equity, (2) growth and density, (3) economic development and opportunity sites, (4) climate change mitigation, adaptation, and resiliency, (5) designing a city for all ages and abilities, (6) fostering the next generation, and (7) new technologies and their impact on development patterns.

7.2.2 Project Evaluation and Selection

The cost of a project includes various components such as research and development, legal and other associated fees, as well as the construction cost itself. Beyond the initial outlay, life-cycle expenses must also be considered, including the costs of ongoing operation and maintenance, as well as major repairs throughout the project’s lifespan.

When evaluating a project, its overall effectiveness should be compared against the option of renovating existing facilities. This comparison should take into account both the project cost and the associated life-cycle expenses. Additionally, the appropriateness of the project should be assessed based on its alignment with the priorities outlined in the master plan.

A Capital Improvement Plan (CIP) is a multi-year strategic plan that provides detailed information, documentation, and justification for various capital projects, including the construction of new facilities as well as the renovation and replacement of existing ones. It outlines the financial and timing aspects of these projects, specifying cost and financing details, and ensuring the proper sequencing of work, such as installing sewer lines and utility cables before repaving roads.

The CIP is typically updated on an annual basis to reflect new priorities and emerging needs. It offers several advantages, such as providing a multi-year perspective for long-range policy development, aligning community goals with financial capacity, and fostering public consensus through a dynamic planning process. Additionally, the CIP serves as a critical financial management tool, assisting with credit ratings and acting as a comprehensive reporting document.

The CIP development process is guided by executive directions that establish project priorities. Cost estimates are provided by various agencies based on their needs, and the process may also include input from citizens to ensure that the plan reflects the community’s concerns and expectations.

7.2.3 Financing Plan and Long-Term Financial Analysis

After the selection of projects has been made, long-term financial projections and a financing plan is developed. This includes projecting tax revenue and baseline expenditures over time. There are two financing options for capital projects and acquisitions: Pay-as-you-go and pay-as-you-use.

“Pay-as-you-go” financing refers to funding capital projects using current revenue sources rather than incurring debt. For example, infrastructure investments may be financed through motor fuel taxes or other non-debt sources such as grants from state or federal governments, as well as accumulated reserves.

This approach offers several advantages. First, it eliminates the need for interest payments, reducing the overall cost of the project. It also preserves the option to borrow for other projects in the future, providing financial flexibility.

However, pay-as-you-go financing also has disadvantages. It may necessitate increases in taxes or fees to generate the necessary revenue, which can be unpopular or politically challenging. There may also be a misalignment between the timing of payments and the benefits of the capital asset, as current taxpayers bear the full cost of an asset that will provide benefits over many years. Additionally, reliance on this method can result in underinvestment in capital assets if sufficient revenue is not available to fund all necessary projects.

“Pay-as-you-use” financing involves funding capital projects through debt, such as bonds or other debt instruments issued by the government. The repayment of this debt is spread over the lifetime of the asset, ensuring that future users contribute to its cost. Leasing is another form of this approach, where the use of assets is paid for over time.

The main advantages of pay-as-you-use financing include the avoidance of immediate tax increases and a better alignment between the timing of payments and the benefits provided by the capital asset. This ensures that future generations, who will also benefit from the asset, share in its costs.

However, the approach comes with disadvantages. Debt service can place significant constraints on the operating budget, as funds are allocated toward repaying the debt rather than other needs. Additionally, relying on debt financing can lead to a high debt burden, potentially affecting the government’s credit rating and financial stability in the long term.

Possibility of combination between pay-as-you-go and pay-as-you-use financing

7.2.4 Financial Analysis over Capital Asset Lifetime

A comprehensive financial analysis over the lifetime of a capital asset considers several factors that impact the project’s revenue capacity, borrowing potential, and long-term financial viability.

The revenue capacity refers to the ability to generate own-source revenue and the proportion of that revenue available for capital investments. The approach taken—whether pay-as-you-go or pay-as-you-use—can significantly influence the amount of capital available. Pay-as-you-go relies on current revenue sources, while pay-as-you-use spreads the cost over time through debt financing.

The borrowing capacity of an entity is determined by the total debt relative to its size, interest rates, and debt service obligations. Credit ratings also play a crucial role, as they affect the terms and availability of future borrowing. Higher debt burdens can limit future borrowing options and increase financial risk.

Some capital assets generate revenue directly through user charges or fees. The financial analysis must project these revenues and determine what share, if any, will be dedicated to capital investment or debt service, helping offset costs over time.

External contributions, such as federal and state aid or partnerships with private entities (public-private partnerships), can supplement financing. These external sources reduce the direct burden on the entity and diversify the financing mix for capital projects.

A critical factor in financial analysis is the ongoing impact of the capital asset on the operating budget. Annual operating and maintenance costs, as well as debt service obligations, must be assessed. Debt service as a percentage of budget revenues will determine how much room remains for other operational needs.

Other revenue sources that may contribute to capital financing include one-time development impact fees, special assessments, or the sale of existing assets. These can provide immediate capital injections but are typically non-recurring, meaning they are limited in scope and availability.

This financial analysis framework helps ensure a balanced, long-term approach to capital investments, minimizing risks and aligning financial strategies with organizational goals.