Finding the balance, by Charles Armstrong

24 Nov 05
As Sir Peter Burt's committee reviews the options for a fairer local government funding system in Scotland, Aberdeenshire Council is arguing for local income tax. Charles Armstrong explains why

25 November 2005

As Sir Peter Burt's committee reviews the options for a fairer local government funding system in Scotland, Aberdeenshire Council is arguing for local income tax. Charles Armstrong explains why

The Convention of Scottish Local Authorities might have spoken for most of Scottish local government when it told Sir Peter Burt's Local Government Finance Review Committee that a modified council tax was its preferred option. But there is a small and determined group in Scotland, mainly Liberal Democrat led councils, that are promoting local income tax as a better alternative. The arguments for this are well rehearsed, but now Aberdeenshire Council has taken those arguments a stage further.

In its evidence to Burt, Aberdeenshire proposed a way of introducing local income tax not only to produce a fairer system of local taxation, but also to solve the 'balance of funding' problem.

In Scotland, as is broadly the case in the rest of the UK, the proportion of grant to local taxation is about 80:20. This brings with it the attendant evils of gearing, hypothecation and accountability.

Gearing affected Aberdeenshire heavily in the late 1990s. Because grant met around 80% of expenditure, a 1% shortfall in the rate of increase in grant translated into an extra 4% on council tax. Little wonder then, that the public's opinion of the council tax system is moving closer to its opinion of the old community charge.

With the Scottish Executive meeting so much of the bill for local services, there is an irresistible temptation to meddle more and more in how 'their' money is spent. This creeping increase in hypothecation has served only to reduce and constrain the ability of locally elected councillors to govern their local area.

Inevitably, this imbalance blurs accountability, with the general public holding councils wholly accountable for the delivery of services, while the contribution the public makes locally is only one-fifth of the cost.

The 'Aberdeenshire solution' involves the Scottish Parliament using its powers to cut the national rate of income tax in Scotland by 3p in the pound. This would be combined with a higher level of revenue from local income tax to move the ratio down initially to 70:30, with the prospect of moving eventually to a 50:50 split. Essentially, this would be done by transferring a significant share of the funding of local government from the national taxpayer, via national income tax, to the local taxpayer, via local income tax. The critical factor would be that, while the proportion of tax raised from each source would change, the impact at taxpayer level would be, in overall terms, neutral.

Supporters of LIT envisage that the tax would be collected along with income tax. The taxpayer's perception would be of tax at the combined rate, which would vary from council to council. The taxpayer would not be too concerned at the exact composition of that rate between the national and local elements. That affords an opportunity to address the balance of funding problem once and for all.

If Aberdeenshire Council, where the gearing ratio is now 77:23, is used as an example, its net spending of £402m in 2004/05 was funded as is shown in Table A. The total funding controlled by the Scottish Executive comes from national taxation – 56% – supplemented by business rates, essentially a national property-based tax (21%). Thus the total support from national taxation was 77%.

If we envisage LIT replacing council tax on a like-for-like basis, LIT would be set at a level sufficient to generate 23% of Aberdeenshire Council's income, the same as council tax in the above example. Obviously, the incidence of LIT on individual taxpayers would vary depending on personal incomes, but that, after all, is the whole point of LIT.

If the rate were set high enough to more than double the income generated, and the level of government grant support were cut by an equivalent amount, the Aberdeenshire picture would change to that in Table B.

At taxpayer level within Aberdeenshire and across the whole of Scotland, the effect should be neutral, in that the sum of personal, non-business taxation under council tax would be as shown in Table C and under LIT as in Table D.

It therefore appears that LIT could be used to address the balance of funding problem and return a significant level of fiscal autonomy to local level, with the revenue support grant being reduced by an amount equivalent to the reduction in national taxation.

There could be some concern that an erosion of the UK national taxation base might reduce the scope to use taxation as a tool for macro-economic management. However, the reduction, for Scotland only, in the UK national tax rate implied by this would be in the order of 10p, arguably not enough to have an adverse effect on the power of taxation as a national fiscal tool.

There are, of course, several problems to be overcome to get to a 50:50 split. The Scottish Parliament's tax-varying powers would allow only the release of some £750m, while the model above would require a reduction of more than three times that amount. Even at 3p, a move to 70:30 would be achievable. However, the Scottish Parliament's tax-varying powers apply only to the basic rate of income tax. Extend this to higher rates and to the starting rate of 10p and this should go some way towards increasing the £750m. There might, therefore, be some difficulty in moving directly to a 50:50 balance, but even a move towards 70:30 would be worthwhile.

There is also the question of council tax benefit, where the Department for Work and Pensions subsidy comes direct to Scotland from the Treasury. This is a significant sum that would need to be replaced by an equivalent increase in the Scottish block grant.

If LIT were to replace council tax, there would be no need for an equivalent to the council tax benefits arrangement as the former is directly related to ability to pay. Currently, a benefits subsidy of about £200m transfers from the UK economy to Scotland. This massive potential loss of income would have to be compensated for in some way, but to do so by an adjustment of revenue support grant to Scottish councils would risk upsetting the balance of funding again.

Is there an opportunity for Scotland to pilot an LIT scheme that would significantly address the balance of funding problem? In its evidence to Burt, Aberdeenshire suggested that this idea could be profitably examined in some more detail to assess if it could be the basis for a much wider shake-up in local government funding, at least in Scotland.

Aberdeenshire Council does not claim to have found the solution. There are many serious hurdles to be overcome. But a potential solution that restores a balance of funding and finds a practical way to overcome the inherent problem of the current local tax regime deserves serious consideration.

Charles Armstrong is director of finance at Aberdeenshire Council