Localising business rates could just institutionalise a two-tier system with affluent councils breaking away from their more deprived cousins, says Dan Corry.

The review of council resources is the major attempt by the Coalition to do something about local government finance - other than just cutting it and it could be crucial for the future of local government.

Full localisation of business rates could benefit inner London authorities such as Tower Hamlets

Launching the review in March, Secretary of State Eric Pickles was quite clear about the aim: ‘At the moment there is no motivation for councils to support local firms or create new jobs. One of the best ways we can change that is to free councils from their enslavement to Government grants and put them in control of their own destiny.’

A world where councils have no desire to promote economic success would clearly be mad. Some policy thinkers, especially of the centre-right have worried that far from encouraging growth the system of needs-based equalisation positively encourages councils to have low income populations and as Localis put it ‘demonstrate how deprived and therefore worthy of central funding they are’.

This is a bit far fetched and exaggerates the degree to which the current system does not financially incentivise councils. Much of the finance that is allocated by central government to local council areas is calculated on a per capita basis (as with schools for instance) so that more population (attracted by growth and jobs) means more money.

But in addition, there is no real powerful evidence that local people or elected councillors are dissuaded from making moves that are good for growth and business purely because of a lack of financial incentives (and to the degree they are this is mainly about planning).

A bigger problem is that they do not have enough powers and freedoms to promote economic growth and would do so if they did – financial incentives or not.

Nevertheless the basic problem off a lack of incentives to growth in the local government finance system led the Labour government to bring in the Local Authority Business Growth Incentive Scheme (LABGI).

Unfortunately this scheme turned out to reward growth in too minor, too complex and in too unpredictable a way to have any chance of really influencing behaviour.

So that is why we arrive at the idea of localising business rates as a better potential answer. This would please the Secretary of State by creating a proportion of ‘self-funded’ councils who no longer need funding from the centre: Sir Michael Lyons’ 2007 review estimated that 65 councils took in more business rates than their budget requirements (with close to half in London and the south east and none in the north east). But many councils also have low business rates bases so would be in trouble.

Broadly the impact of a full localisation overall might be:

• Major gains for the City of London and Westminster
• Gains for boroughs like Tower Hamlets, Camden and possibly some other inner London authorities
• Probable gains for major thriving northern metropolitan areas like Manchester and Leeds
• Possible gains for some high tech growing authorities like Cambridge, Swindon and Reading
• A large group for whom the change does not make a great difference either way
• Losses for authorities representing older industrial communities – the ‘outer mets’ - and in places like Blackburn and Hull and NE Lincolnshire

Now a ‘local fundamentalist’ would be happy with this. But to most, allowing such inequity purely on the basis that some council areas have, access to great resources and some to much less for purely historical and locational reasons, is not tolerable.

So we get into the issue of the government having to decide what it really wants to do about equalisation. Ultimately this comes down to a trade off in values and practicalities between letting councils keep the fruits of their labours and instead equalising away their ‘success’ to give poorer areas some help.

A valiant attempt to get round the disincentive effects of equalisation has come recently from Localis (‘The rate escape: freeing local government to drive economic growth’). They envisage councils making an offer to central government as to how much they will pay them in return for being able to keep all their business rates for a period (in the ‘Localis’ language, they ‘buy out’ of the system). For deficit councils the offer would be negative (i.e. how much they would need to receive from the centre to opt out).

Such a system depends on detailed and undoubtedly fraught negotiations with the Government (HMT) on the exact terms of the buy-out, which makes it still feel like a servant-master relationship. And it has other complications.

Other less ambitious approaches involve less than full localisation of the business rate with potential pooling across local authorities at different spatial areas or approaches that follow the LABGI principle of rewards for growth in business rates rather than just their scale. Exactly what Nick Clegg was pointing towards in his recent LGA speech was unclear.

Precisely how it will play out depends on the details: get it right and we have a better system with a better central–local balance. Get it wrong and we institutionalise a two tier country with well heeled councils breaking off from their less well-off cousins – a small group of autonomous authorities with a strong tax base and a large group permanently dependent on the centre.

We must also never forget that for the more deprived areas of the country business rates is at best a marginal issue: localising business rates will not transform Middlesbrough or Stoke. Other policies are needed.

But trying to do something here is part of a sensible agenda, giving councils more feeling that they make their own bed to lie in, not blaming the centre all the time for what they cannot achieve.

To be meaningful and have the incentive effects that people hope for there needs to be some degree of cross-party consensus so that local government and business has some certainty to plan upon.

The coalition Government would be wise therefore to try and find ways forward that command support across councils of different political control in different circumstances. If the reform is only supported by those better off councils then it will not survive a change of Government.

These are not easy decisions and rushing change without consensus might be just as ill-advised as the inertia and stasis that has characterised the lack of change in this area for the last few decades.

Dan Corry, FTI Consulting and former Downing Street and Treasury adviser. This article is based on ‘The Case for Consensus: Reforming Local Government Finance’.