Aileen Murphie 01 November 2018

The changing shape of the local government finance system

The changing shape of the local government finance system image

Since 2010, local authority funding has changed substantially in terms of size, source and the conditions attached to its various funding streams.

In the 2010 spending review, the government increased local authorities’ flexibility over how they could spend their resources and respond to local priorities. These changes accelerated the trend of previous governments to increase local authorities’ financial flexibility by reducing the number and value of ringfenced grants.

Business rates: the key to financial survival?

The Ministry of Housing, Communities and Local Government (the Department) changed the funding system to incentivise authorities to increase their own income. Core changes included bringing in the business rates retention scheme, now intended to be raised to 75% by 2020-21 and the New Homes Bonus whereby local authorities received extra funding for every new residential property in their area.

So, the components of local government finance began to change from 2010. Revenue support grant is diminishing until its expected demise in 2020. Council tax is becoming a greater proportion of income, meaning that local tax payers are funding a larger proportion of service spend. And a key point is the increasing importance of business rates to the sector as a whole but also to individual councils’ financial survival.

Local need versus potential revenue

The increasing reliance on business rates raises challenges, the first of which is need locally as opposed to potential yield. The question is whether business rates comprise the right tax to fund social services for the most vulnerable whose needs are ongoing and cannot be met other than via state funding. Business rates yield varies between areas through accidents of history and geography. The size of the social care spend relates to need which is connected with levels of deprivation. Need and business rate yield are not correlated. Using business rates as a major part of local funding means that there has to be a mechanism for redistribution from areas of high yield to those with low currently achieved by means of the system of tariffs and top ups.

A variable picture

The second challenge is the variability in the financial position of local authorities. The NAO report in 2014 on the financial sustainability of local authorities highlighted variable effects from funding reductions across local government which are then amplified by the historical differences between areas. The NAO’s report on the financial sustainability of local authorities 2018 shows the variability of impact continuing. Look on our website for the incredibly useful data visualisation.

The third challenge is that increased economic activity is not linked directly to business rate growth. By allowing local authorities to benefit from growth in their tax base, the government’s expectation is that this should incentivise authorities to adopt planning and economic development practices that promote development and construction. This is expected to deliver economic growth in the form of jobs and increased economic output. But the link between tax base growth and economic outcomes is not direct. There is no correlation between change in an area’s tax base and change in its economic output within the most recent revaluation period.

Controlling for policy changes

An ongoing challenge is that policy changes could impact the amount of money available in 2020 from business rates. Governments over time have granted various kinds of reliefs for various favoured causes: reliefs for small businesses, charities and so on which are intended for a variety of benign policy goals such as supporting local high streets. This makes the quantum vulnerable to policy changes on the run up to 2020 or afterwards.

Lastly, implementation is itself a challenge. The implementation of the 75% business rate retention scheme is likely to be complex and difficult. The Department has been working with the sector which is welcome. However, there are a range of granular decisions on significant issues still to be taken, including the division of business rates within two-tier areas, the level of the safety net to prevent large falls and windfall rises, the proportion of growth that could be retained at a partial reset and precisely how a central approach to appeals could work.

Time is an issue too: the Fair Funding Review on a new distribution formula for local government is due to be implemented in 2020-21 at the same time as increased reliance on locally retained business rates. There are interdependencies between the two projects which need to be properly understood as do the implications of decisions in one project which could affect the other.

The added financial burden of social care

Whatever is decided on the shape of the scheme to retain more business rates locally, it should be noted that the financial position of the local government sector has worsened markedly, particularly for authorities with social care responsibilities. The latest report from the NAO has identified signs of real financial pressure. Financial resilience varies between authorities, with some having substantially lower reserves than others.

Taking a long-term view

There is also uncertainty over the long-term financial plan for the sector. The absolute scale of future funding is unknown until the completion of the next Spending Review. The implications of changes to the finance system are not yet clear. Financial uncertainty, both short term and long term, creates risks for value for money as it encourages short-term decision making and undermines strategic planning.

Overall, the shape and coherence of the local government finance system – the whole mix, including capital financing, leveraging in private investment and extending commercial activity by local authorities - needs consideration, whether through the prism of retaining business rates or more widely.

For more information on the work of the NAO please visit our website or sign up to receive our latest reports and news.

Aileen Murphie, Director DCLG & Local Government Value For Money at the National Audit Office, will be speaking at the Public Sector Solutions Expo Manchester, on how local authorities can achieve financial sustainability through business rates retention.

Book your free place now to access over 30 hours of CPD-accredited content, including over 30 replicable case-studies, and discover solutions that can feed into your efficiency planning and future procurement strategy.

The Public Sector Solutions Expo takes place on 20th November at Manchester Central. Registration is free for public sector professionals.

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