Taxation - Local difficulty has no easy solutions

Any day now, we should get a green paper on the future of local government finance. It may propose a radical change or just tinker round the edges. But we will not understand what it is trying to do unless we understand the pickle we are in now.

We have two taxes collected by local authorities: council tax and business rates. The revenue from council tax is kept by the local authority. Business rates, on the other hand, are not a local tax at all: they are a national tax which happens to be collected by local authorities. The rate is set centrally. All the money goes into a central pot, and it is then shared out according to population.

The other main source of local authority income is the revenue support grant, paid by the national government out of national taxes.

The grant is meant to take account of the fact that some local authorities have a much larger tax base than others. Rich districts have more high-value housing, so they can raise a lot of council tax easily. Other districts have special needs. High levels of poverty or a population spread out over a large area can make it expensive for a local authority to provide an acceptable level of services.

The missing link

The grant is calculated by a complicated process. Each local authority’s needs and ability to raise council tax is studied. The grant is then fixed so that every local authority could offer a standard level of services by setting the same level of council tax.

The problem is that there is no clear link between what a local authority raises in local taxes and what it spends. Changes in its tax base, for example, by attracting new businesses and therefore new residents into the district, may not lead to increased revenue for the local authority because the revenue support grant will be adjusted to take account of the increased ability to collect council tax. The extra rates will just go into the national pot, having practically no impact on the local authority’s spending power.

There is also a gearing problem. Changes in spending lead to greatly magnified changes in council tax, because council tax is the only source of a local authority’s income that is under its control: council tax has to bear the full brunt of any extra spending above the standard level of services. For the average English local authority, a 10% increase in total spending requires a 40% increase in council tax. For some local authorities, a 10% increase in spending requires a 100% increase in council tax.

Thus in every way, the link between what a local authority collects in taxes and what it spends is broken. Local authorities, like any tax-raising body, should be accountable to taxpayers. But it is hard to be accountable when there is no clear link between taxes and spending.

Another fine mess

Why have we got into this mess? It is not because British governments are especially stupid. Rather, it is because they have tried to pursue two conflicting goals.

One is to give local authorities real power to do things for their own districts, which means allowing them to raise taxes from their own communities.

The other is to be fair to different districts, which means transferring money from some districts to others. The more power over taxing and spending you give to local authorities, the less fairness you have between rich and poor districts, and vice versa. If the green paper cracks this one, it will be a remarkable achievement.

From a business perspective, there are other things it would be good to see. Top of the list is preservation of the certainty that the current rating system gives. Apart from five-yearly revaluations, a business can be certain that its rates bill will only rise in line with inflation each year.

Along with that goes control over local authorities which might like to increase business rates sharply. The best control would be a link with the council tax, so that increases in rates required increases in the council tax. Excessive rises could lead to the council being evicted at the next election.

Finally, it would be good to see some reduction in rates for smaller premises, which can generally make less profit per pound of rateable value than larger ones. Wishful thinking? We shall see.

Richard Baron is taxation executive with the Institute of Directors.