A Review Of The Wellington V8 Car Race Proposal
A REVIEW OF THE PROPOSAL FOR THE WELLINGTON V8 CAR RACE
School of Economics and Finance
Victoria University of Wellington
April 12 2005
(Note this is a revised version of a report published April 5th. The most significant changes in the report occur in Section 4.)
The Wellington City Council (the Council) has recently released a Statement of Proposal for a V8 Supercar Championship Series, to be run annually over a period of seven years. It has also commissioned a report from McDermott Miller Ltd to assess the economic impact of the event (dated 28 February). The Council’s Statement of Proposal argues that the cost to ratepayers from this event will average $2.5m per year over seven years, for a total of almost $18m. It also argues that the benefits to the city are $22.9m per year over the same period, for a total of $160m. On this basis, the proposal would appear to be desirable.
This paper examines the cost and benefit arguments raised in those two documents, and considers certain additional issues.
2. The Costs to Ratepayers
The Council’s Statement of Proposal argues that the cost to ratepayers from this event will average $2.5m per year over seven years, for a total of almost $18m. The figure of $2.5m per year represents the projected increase in rates. However, it excludes an amount of $800,000 per year that will be drawn from existing budgets  . Costs do not evaporate merely because they are drawn from an existing budget. Consequently, the true cost to ratepayers is $3.3m per year over seven years, for a total cost of about $23m.
To draw an analogy, suppose a Council project generated benefits of $3m and required Council expenditure of $20m, of which $19m was draw from an existing budget and the remaining $1m through an increase in rates. Clearly the project is undesirable, with benefits dwarfed by costs. However, following the Council’s practice of ignoring costs drawn from existing budgets, the project would be judged to have benefits three times that of its “costs”.
3. The Benefits: Definition Issues
The Council’s Statement of Proposal argues that the economic benefits of the project to Wellington City are $22.9m per year. This figure is drawn from the McDermott Miller report, and described as the increased spending on goods and services in the City arising from the race. However this figure is only one of four figures mentioned in the McDermott Miller report, on pages 9-10. The second figure mentioned is $8.6m, being new spending net of business costs incurred to generate this additional spending (in so far as they are paid to entities outside Wellington). The third figure mentioned is $14.6m, being the figure of $8.6m coupled with “indirect and induced” effects. The fourth figure mentioned is $15.7m, which appears in a table (Table 2.6) designed to support the third figure of $14.6m. The last two figures are incompatible, and therefore the third mentioned figure of $14.6m is presumably a typo.
Of these figures, McDermott Miller appears to favour $15.7m. The Statement of Proposal refers to the figures of $8.6m and $15.7m once, on page 8. However the benefit to ratepayers is claimed to be $22.9m per year repeatedly elsewhere in the document (on pages 4, 8, 9 and 14). The last of these occasions is the crucial summary table, which summarises the pros and cons of the race proposal. Thus, the repeated reference to benefits of $22.9m in the Statement of Proposal is not consistent with the emphasis in the McDermott Miller report.
Turning now to the question of which figure is appropriate, the precise nature of the $22.9m and $8.6m figures are clear enough. However, the nature of the “indirect and induced” effects that raise the $8.6m figure to $14.6m (or $15.7m) are never disclosed (although they are presumably flow-on effects of the same general type as those included in the figure of $8.6m). In view of this non-disclosure, and the failure to justify the increment, no credibility can be attached to the figures of $14.6m or $15.7m.
This leaves us with two figures, being $22.9m for new spending and $8.6m for new spending net of business costs incurred to generate this additional spending (in so far as they are paid to entities outside Wellington). Which of these two figures are appropriate? To answer this question, consider two specific examples.
Example 1: A visitor attracted by the race purchases an item of clothing from a Wellington retailer for $100, and the retailer purchases it from a Wellington manufacturer for $65. In turn the manufacturer incurs additional manufacturing costs of $40, paid to Wellingtonians.
Example 2: A visitor attracted by the race purchases an item of clothing from a Wellington retailer for $100, and the retailer purchases it from a manufacturer outside Wellington for $65. In turn the manufacturer incurs additional manufacturing costs of $40.
The McDermott Miller figure of $22.9m counts the sales revenue of $100 in both cases, for a total benefit of $200. By contrast, the McDermott Miller figure of $8.6m deducts the retailer’s costs of $65, but only in respect of Example 2. The result would be a total benefit figure of $200 less $65, equalling $135.
Which is the right figure? Clearly, it is appropriate to deduct the retailer’s cost of $65 in Example 2. The benefit to a Wellington retailer is not the sales revenue but the sales revenue net of their additional costs, being a net benefit of $35. In respect of Example 1, in which the visitor purchases an item manufactured in Wellington, the benefit to Wellington entities is the retailer’s profit of $35 and the manufacturer’s profit of $25, for a total of $60  . So, across both examples, the total benefit is $95.
So, we now have three possibilities. The sales revenue of $200, the figure of $135 and the figure of $95. The first figure of $200 is part of McDermott Miller’s figure of $22.9m, the second figure of $135 is part of McDermott Miller’s figure of $8.6m, and the third figure of $95 does not correspond to any of McDermott Miller’s figures. In the examples, the right figure is $95, being the additional profit flowing to Wellington entities. This shows that even McDermott Miller’s figure of $8.6m is too high, because it fails to deduct all of the costs incurred by Wellington manufacturers of items sold to visitors attracted by the race.
Here is an analogy. Suppose a company spends $25m to build a factory to produce a new product. The sales revenues are $10m per year for seven years, $5m per year is paid to outside firms in respect of various inputs used in production, and $2m per year is paid (at market rates) to a person who is also a shareholder in the company. In deciding whether the $25m initial expenditure on the factory is justified, which annual figure should be used? The correct annual figure is not the sales revenue of $10m per year or even the sales revenue net of the $5m paid to outside entities. The correct figure is $10m, less payments of $5m and $2m. The result is a benefit of $3m per year, over seven years, for a total of $21m. Even without allowing for the delay in receiving this $3m per year relative to the immediate expenditure of $25, the benefits of $21m are insufficient to justify the initial expenditure of $25m.
How would the Council’s Statement of Proposal have assessed this investment? They would have merely counted the sales revenue of $10m per year, for a total of $70m over seven years. Since this exceeds the initial expenditure of $25m, they would have declared the project to be desirable! What about McDermott Miller? The lowest of their figures ($8.6m) would correspond to sales revenue of $10m net of payments to outside firms of $5m per year, for a residual of $5m per year, equalling $35m over seven years. However both the $35m figure and the $70m figure are too high (the correct figure being $21m). Both the $70m and $35m figures bias the assessment towards accepting a project that should be rejected.
In summary, the appropriate definition of economic benefits is increased profits to Wellington City businesses rather than increased revenues or increased revenues net of payments to entities outside Wellington City. Accordingly, the economic benefits must be something less than $8.6m per year rather than the $22.9m claimed in the Council’s Statement of Proposal.
4. The Benefits: Capacity Constraints
McDermott Miller projects that the race will attract 20,500 visitors from outside the Wellington region (Table 2.1 of their report). They further project that 63% of these visitors will use commercial accommodation in Wellington City (page 11 of their report). This implies that commercial accommodation for approximately 12,900 visitors will be required in Wellington City. McDermott Miller also project that the available commercial accommodation in Wellington City in April 2006 will be around 12,900 guest nights. They add finally that “When usage for other purposes is taken into account, it is likely capacity limits will be reached”.
Their conclusion is something of an understatement, for two reasons. First, some wastage of capacity is inevitable because some rooms with space for more than one guest will be occupied by only one person. Secondly, and more significantly, the normal occupancy rate in April for Wellington City commercial accommodation is about 70%  . If that occupancy rate also applies to weekends, then McDermott Miller’s estimate of the additional usage of commercial accommodation in Wellington City will be overstated by 70%. Even allowing for the possibility that the occupancy rate is lower over weekends, and that some of the visitors reflected in the normal occupancy rate might be displaced to another date (when spare capacity is available), it is clear that not all of the potential additional visitors can be accommodated in Wellington City commercial accommodation.
The result of this must be a resort to either accommodation outside Wellington City or through potential visitors simply electing not to come to even the Wellington region. In either case, the alleged benefit to Wellington City in the form of an extra 12,900 guest nights in commercial accommodation simply cannot arise, and therefore McDermott Miller’s estimates of the benefits of this type are significantly overestimated. In addition, should the visitors not come at all, the overstatement of benefits in the McDermott Miller report also extends to shopping, restaurants and bars.
This capacity problem also extends to the use of restaurants. In fact, given that the race will occur over the weekend, when restaurants are at their busiest, the capacity problem is likely to be particularly severe. Again, McDermott Miller does not subtract anything from their forecast benefits to account for this problem.
In summary, McDermott Miller’s failure to allow for capacity constraints implies that their estimate of the benefits to Wellington City businesses will be significantly overstated. In the case of additional use of commercial accommodation, the overstatement will be up to 70%.
5. Further Considerations
Further considerations are as follows. First, the Council’s Statement of Proposal pays no attention to the question of whether the event would occur anyway. If it would, the Council subsidy is unnecessary. Does every event that brings new spending to Wellington receive a Council subsidy?
Secondly, even if the event would not proceed without a subsidy, the process of assessing each such event in isolation is inappropriate. To illustrate this point, suppose that there are two Councils in New Zealand (call them Auckland and Wellington) and each subsidises a car race. Without the subsidy, the races will not proceed. If the Auckland race proceeds, a number of Wellingtonians will visit Auckland and their spending will benefit Auckland by $10m. If the Wellington race proceeds, a number of Aucklanders will visit Wellington and their spending will benefit Wellington by $10m. On this basis, each Council is persuaded to pay a $6m subsidy to the race promoter. However, if neither race proceeds, most of this spending of $20m will still occur, except that it will occur in the home city of the spender rather than in the city visited. Suppose 80% of it occurs anyway. In this case, the benefits to each city from both races proceeding rather than not proceeding is only $2m each, which is less than the subsidy of $6m paid by each Council. Accordingly, the subsidies should not be paid by either Council.
This example suggests that the two Councils should compare the aggregate benefits to them from both races proceeding ($4m) with the aggregate subsidies paid (of $12m). In this case, the two races should not be subsidised and this should be a joint decision of the two Councils. If Auckland breaks ranks and subsidises a race, it might appear to gain $10m compared to not breaking ranks. However the result of Auckland doing so is likely to be that Wellington also reverts to subsidising its event, in which case each city only gains $2m in benefits, for an outlay of $6m each.
Promoters prey on this “competition” between cities to host events, and focus upon the benefits to an individual city from an individual event. However, the alternative for a Council is not simply to refuse to subsidise a particular race, and thereby lose it. The alternative is for New Zealand Councils in aggregate to assess the overall benefits from these events. These overall benefits will be much smaller than adding up over the individual events in isolation, because most of the benefits from a single event are mere transfers of spending from one part of New Zealand to another, and these transfers wash out in the aggregate. If the overall benefits to all cities are less than the aggregate subsidies paid by the Councils, the Councils should collectively decline to subsidise such events.
In conclusion, four points are significant. First, the cost of the V8 street race to Wellington ratepayers is $3.3m per year, not the $2.5m repeatedly claimed in the Council’s Proposal. Second, the economic benefits to Wellington will be substantially less than $8.6m per year rather than the $22.9m repeatedly claimed in the Council‘s Proposal, both because of inappropriate definitions of benefits and through failure to allow for capacity constraints. On this basis, the case is simply not proven. Third, the Council has given no consideration to the question of whether the race would proceed without a subsidy. If it would proceed in the absence of a subsidy, there is no sense in offering the subsidy. Finally, even if these types of events will not proceed without subsidies, most of the alleged benefits are likely to be simply transfers of spending from one part of New Zealand to another. This suggests that New Zealand Councils should collectively consider only the remaining benefits, and collectively agree not to subsidise such events if the aggregate subsidies paid exceed these remaining benefits.
1 The additional figure of $800,000 is mentioned once in the Statement of Proposal, on page 3. However, the cost to ratepayers is claimed to be only $2.5m per year (or thereabouts) on three subsequent occasions in the Statement, on pages 4, 9 and 14. The last of these occasions is the crucial summary table, which summarises the pros and cons of the race proposal.
2 The Wellington manufacturer’s costs of $40 will contain a number of things, including wages and salaries paid to Wellingtonians. The McDermott Miller figure of $8.6m treats all such payments to Wellingtonians as race benefits. Clearly, people value leisure and therefore additional income earned by sacrificing leisure must be regarded as compensation for sacrificing leisure rather than a “benefit” from the race.