Economic trends: council funding system faces overhaul

Councils play an important role in delivering public services and supporting and regulating local economies. They are responsible for social care, public health, maintenance of local roads and support for public transport, refuse collection, libraries, and housing services. They manage the planning, licensing and trading standards systems.

However, despite these big spending powers, historically councils received most of their money from central government in the form of grants. Those grants were adjusted to compensate for differences in the amount different councils could raise from local taxpayers and in their spending needs. This was designed to ensure an equitable distribution of spending and service provision around the country. But it meant councils had little financial incentive to boost local tax bases and tackle spending needs – if they did, their grants would be cut.

This is still largely the case in Wales and Scotland. But recent years have seen big changes to this system in England. Grants have been cut as the government has tried to tackle the budget deficit. Those that remain are no longer automatically updated as local tax bases and spending needs change. Since 2013-14 councils have borne up to 50% of any real-terms change in local business rates revenues.

The aim of all this is to provide stronger financial incentives to councils to boost local tax bases, grow local economies and tackle underlying spending needs drivers. But local tax bases and spending needs can change for reasons completely outside councils’ control too. A global recession could hit, causing the closure and demolition of a major factory and throwing local residents out of work. That would hit local tax revenues and could push up demands on local services.

In the past more of that risk was borne by central government – now councils bear more of it. If some depressed areas see a series of commercial buildings mothballed and demolished, while other growing areas see a spate of new construction, bigger funding divergences could open up between different parts of the country.

So what seem like technical changes aimed at providing stronger financial incentives could also come with costs. They could significantly affect the kind of country England is, one where what services people can expect from their council could depend more on local economic performance.

The Institute for Fiscal Studies is undertaking a major programme of research on what we think is a true revolution in the way councils are funded. This is important because the government is planning to increase the share of real-terms changes in local business rates revenues borne by local councils to 75%and maybe even 100%.

One of our recent papers looked at the extent to which divergences in council funding could open up as local tax revenues and spending needs evolve in different ways over time. It found that quite sizeable divergences could open up for some councils after just a few years. But that the scale of these would depend very much on the technical details of the scheme. The importance of the technical details is something accountants and economists are both familiar with, but sometimes gets lost in the political debate.

We used data on council revenues and needs between 2006–07 and 2013–14 to model councils’ incomes if 100% rates retention had been in place over this period. The Figure shows how councils’ ‘relative funding ratios’ – the ratio between their revenues and assessed spending needs, both measured relative to the national average – would have evolved over time. The grey line shows the median council, and each pair of coloured bars around the median represents 20% of councils. One-in-ten councils would have had a relative funding ratio above the top bar, and another one-in-ten below the bottom bar.

In 2006–07, most councils’ ratios would have been close to 100%, as the system would have been set up with this aim. In subsequent years, as councils bore 100% of any real-terms changes in their business rates revenues, these ratios would have diverged. By 2013–14 one-in-ten councils would have seen ratios below 94%, implying revenues at least 6% below their relative needs.

The government has started piloting the 100% scheme in councils covering around half the English population, including Greater London, Greater Manchester, Merseyside, Berkshire, Gloucestershire, Lincolnshire and Surrey. It claims that these pilots were ‘cost neutral’ at the point of delivery. But we don’t think that is the case.

The pilots are actually costing the government and benefiting pilot councils to the tune of around £870m in 2018-19. This is money that would otherwise have flowed into Treasury coffers and could have been used for other purposes, including grants to councils that would have benefited all, not just pilot councils. So there is a real opportunity cost to this policy. 

This Figure shows our estimates of how much funding different council areas are set to gain or lose per person in 2018–19 as a result of the 100% retention pilots, compared to if £870 million had instead been allocated according to councils’ assessed spending needs. Most pilot councils are set to gain relative to such an allocation: Berkshire and London to the tune of £46 and £31 per person, respectively (6.5% and 3.1% of the core spending power of councils in these areas). However, those pilots with high needs and/or low business rates revenue growth would have been better off if the funds had been allocated according to needs: this includes Liverpool and Oldham. Of course, all non pilot councils implicitly lose out compared to a needs-based allocation: councils in Northamptonshire, for instance, could have received £14 more per person or £10 million in total (they have instead received nothing).

Given the way the pilots are designed, we are not sure much can be learned from them. The government still has lots of decisions where more analysis and advice is needed. One of these is how to deal with the issue of appeals by ratepayers against their rates bills. At the moment councils bear the financial risk associated with these appeals, despite the valuations being outside their control (the Valuation Office Agency handles them). Councils have to make provisions for how much they expect to lose from these appeals. This can mean taking a big hit up front when revaluations take place, potentially requiring councils to draw down reserves or cut back on spending.

It is a difficult task: councils have very little information to go on as they try to forecast losses, especially as the appeals system has recently changed. So as the government continues its reforms there is lots more work for economists, lawyers and accountants to get stuck into.

Originally published on Accountancy Daily and reproduced here with permission.