Is a municipal water department water required to charge a rate which covers it's actual costs?

Our town commission has always set water rates that resulted in a large deficit for the water department. The deficit has been paid out of the general fund. The expressed rationale is that water bills can not be deducted for income tax purposes, but property taxes can. Is there anything improper about a municipality intentionally operating to generate a loss? Does the expressed purpose of converting the non-deductable expense into a deductable tax raise ant red flags?