15 December 2006
Business rates need to be brought urgently back under local government control, argues Paul Raynes. The current system is inefficient, keeps councils in bondage, involves huge, unnecessary financial flows and costs central government dearly
Here's a paradox: relocalisation of the business rate is politically impossible because businesses and councils agree about it. This is because they share a narrow view of what relocalisation means. They agree that the point is to allow councils to increase tax on business and, naturally, they take opposite views about whether that is a good idea.
It's just one of the thorny issues Sir Michael Lyons is grappling with as part of his inquiry, extended again last week. But what if both sides are wrong about the real point of rate relocalisation?
Freedom to increase the rate locally is only one part of the discussion. The opportunity is to get central government out of local government finance. For the hidden truth at the heart of the fiendishly complicated local government finance system is that there is actually no need at all for central government to pay grants to councils, if only it could recognise that business rates are local revenue. Getting to this outcome would have huge benefits for councils and, just as importantly, for the Treasury too.
Look at the status quo from local authorities' point of view. Capping means that the amount of council tax a council can raise is pretty much fixed by the government. So every council's budget is decided to within a fraction of a percent, not by its local tax, but by the allocation of central government grant that makes up the rest of its budget.
This gives central government total control. Government decisions to change grant distribution formulas can cause significant changes in councils' ability to spend. The targets and inspections councils face are driven by accountability to Whitehall for government money. Financial dependency is the decisive element in the infantilisation of local government.
For central government, control comes at a price, though. Most citizens now blame it, not local government, for the level of the council tax. Also, budgetary brinkmanship by councils has cost the Treasury unplanned financial bailouts in three of the past four Pre-Budget Reports. The centre is overpaying for power.
And look at the rotten incentives the system creates. First, the fine balance of the formula system means that any change creates winners and losers. Not only is it hard for councils to plan well, they have an excuse for unplanned financial changes, and that creates positive incentives not to plan well. Secondly, the role of government creates a client culture, and often a bidding culture: there is an incentive for councils to ask for more money, not to use what they have well. Thirdly, councils have an incentive to squabble over their share of the tax base, not to foster growth in the tax base (which, in the case of the business rate, is synonymous with promoting economic growth). Fourthly, the incentive to 'game' the system diverts management time and effort that would be better spent on local service delivery. Few councils are happy with the financial status quo but it is clear that the government is losing out from the current arrangements too.
It isn't astonishing, or even unusual, for governments to design a system that promotes inefficiency and overcentralisation under cover of doing something useful, of course. What is amazing about local government finance is that all this is blatantly unnecessary. There are 148 upper-tier local authorities in England (for simplicity's sake, this article treats counties which raise council tax but not business rates and districts which raise both and pass a share of their business rates on to the county councils via the national pool as single financial units).
About a third of the 148 raise more revenue locally through business rates and council tax than they spend. Their local tax bases are enough to fund their budget requirements in most cases by a comfortable margin and in some by a huge margin. Three councils raise more than twice the money they need from local taxation. Yet every single local authority gets at least 3% of its budget in the form of Exchequer grant, paid for by national taxation.
So why do tax-rich councils get government grant they don't need? The real reason for this absurdity turns on business rates.
Business rates are, legally and administratively, a national tax. Councils raise the money, hand it over to the centre, and then get it back via a formula that the government uses to distribute it. This supposedly shares it out fairly between councils that have both very different spending needs and very different tax bases.
If that is what today's local government finance system is doing, however, it is doing it in a very odd way. It does not just share out some councils' local tax surplus among those with a deficit. The net contributors to the system surrender £7.5bn a year to the national business rate pool and receive £3.3bn straight back. Almost as much money goes into creating noise in the system as goes into genuine redistribution.
And an odd corollary of this is what happens to the £3bn or so of Exchequer grant revenue support grant that tops the system up. 'Poor' councils get pretty much the same slice of central government grant as 'rich' contributors to the redistribution system (the 'rich' get about 6% of their budgets in RSG on average compared to about 7% on average for the 'poor').
So the formula-and-pool arrangement creates enormous, unnecessary gross financial flows, while its principal effect is to distribute an even layer of Exchequer grant. Hugely varying amounts of redistributed business rates act as a balancing item needed to make up councils' capped budgets.
In other words, the redistribution is not a Robin Hood system, taxing wealthy authorities to give to the poor. It is a Leveller, making sure no-one is self-sufficient and everyone needs a slice of government largesse. If ever there were an example of an artificial dependency culture, local government finance is it.
All this adds up to a clear case for re-establishing the business rate as a genuinely local tax. The third of councils that can fund themselves should be allowed to. Their real surplus some £3bn in 2006/07 should continue to be redistributed to councils that need it to make their sums add up. But there is no logic and no benefit to their remaining hostage, from year to year, to the vagaries of the grant formula.
There is, in fact, no need for any council to be financially dependent on central government. The unhypothecated Exchequer top-up RSG is now a tiny part of the overall arithmetic. The government could rebalance the system by scrapping it and adding an equivalent amount to the special single-purpose grants to police authorities and the Greater London Authority, who are also part of the formula funding arrangements. Councils would then be wholly independent of unhypothecated support from central government.
Under a system like this, redistribution between 'rich' and 'poor' councils would still be needed. But it need not be the subject of decisions by central government. An independent body or local government itself, acting collectively could referee a new system of less complicated financial solidarity among councils.
This is an exciting vision for anyone who cares about transparency, simplicity and accountability in the public finances. It would end a generation of conflict and divide-and-rule in the relationship between central and local government. It would give local authorities new virtuous incentives to promote economic growth without raising the spectre of higher tax bills for business. And it wouldn't we need a drum roll here to help the business lobby take note make a whit of difference to anyone's rate bill.
But it is a testing challenge to the maturity of the players. Is central government mature enough to relinquish control? Are councils mature enough to own their own problems? The opportunity to make this decisive shift exists only because the current balance of central and local funding favours it: a potential tipping point has arrived. Does anyone dare seize the moment?
Paul Raynes is a programme director at the Local Government Association
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