Local Government Finance ©James Morrison 2009

Local Government Finance

The Difference Between Revenue and Capital Funding

Local authorities, like most organisations, require finance for two types of spending: revenue and capital. The former refers to the money needed to pay for the day-to-day running costs of the council (e.g. maintenance costs for building and equipment, employees’ salaries, etc), while the latter is money used to fund major capital projects (such as new buildings, roads, etc).

            In general, revenue spending is financed through the regular

income of the council – i.e. council tax, uniform business rates, rents and charges for other services. Capital spending tends to be financed by borrowing, government or European grants and, increasingly, co-financing deals with the private sector which take the form of public private partnerships (PPPs) or, as the system was referred to under John Major’s government, the Private Finance Initiative (PFI).

How Revenue Funding is Broken Down: The Government Grants System

Though it is common for local authorities to complain over under-funding from central government, around 74 per cent of local government spending is actually derived from revenue grants of one kind or another (including redistribution of uniform business rates/national non-domestic rates). Until 1990, the main revenue grant was known as the rate support grant, but this was later renamed the revenue support grant (RSG). In theory, the RSG was meant to make adjustments to balance the level of service need in a given area against the level of income from taxes (i.e. the self-generated resource base) in those areas – thus ensuring that a given standard of service costs more or less the same throughout the country).

            The split between grants and other forms of local government revenue generation was as follows as of April 2008 was:

Grants – 53 per cent

Council tax – 25 per cent

Redistributed uniform business rates – 21 per cent

Reserves and other income (e.g. parking and library fines) – one per cent

Though the RSG is traditionally seen as the most important government grant, it now only makes up three per cent of the overall grant total. A further four per cent goes to the police, while specific grants for other local authority services (including area-based grants for specific vicinities) total 46 per cent.

Specific grants are provided for the following reasons:

·      To help local authorities achieve a specific purpose (e.g. reducing council tax or bringing in uniform standards of domestic upkeep or disabled access provision across the country)

·      To help poorer areas in which the council tax base (i.e. the potential total of council tax obtainable from a given local population) is too low to meet the costs of local needs

·      To reduce the cost of a service which is either spread unevenly across the country (e.g. the maintenance of a major road) or is of benefit to the nation as a whole (e.g. roads or coastal defence)

·      To help fund services for which the government has laid down new specific requirements

How Government Grants are Calculated

The means by which grants are calculated for a given area has long been highly controversial. The level set for each financial year is dictated by what the Government says it should cost to provide a national level of service per adult in each local authority area. In practice, this often arbitrary-seeming allocation is heavily influenced by how much a given council actually spent in the previous financial year. Until recently, this was known as the standard spending assessment (SSA), and came in for huge criticism over the years for its perceived unfairness and inefficiency:

            As of the financial year 2003/4, New Labour replaced the across-the-board SSA system for determining levels of revenue support grant (RSG) with a new measure of the amount each local authority is deemed to need to provide services of an appropriate standard: the formula spending share (FSS). Theoretically, the new system provided a more accurate picture of each individual council’s spending needs in that it takes a detailed look at precise factors in each area, such as population size, social structure and even average income.

            Until recently, the RSG continued to make up the biggest chunk of grant money available to councils. However, in the past few years more and more government grants have been ‘ring-fenced’/passported for specific purposes. Therefore, the majority of government grants are now actually specific grants. There are two broad types:

·      Ring-fenced grants – must be used for a specific purpose only, as dictated by the Government. The biggest example is the Dedicated Schools Grant

·      Unfenced grants – not determined by any formula (unlike all other types of revenue grant), but derived from a residual pot of money available to councils to pay for running costs. Unfenced grants may be spent by local authorities in any way they wish, within reason: they may be directed at a broad spending area (e.g. the Housing and Planning Delivery Grant), but beyond that it is up to the council to spend as they wish, according to local needs and priorities

A reflection of the growing importance of the specific grant is the Government’s decision to introduce a new formula-based system to calculate them: the relative needs formula (RNF), which is used to determine how much each local authority needs for each of its service areas. The division of funding in this way means that the same local authority might well find it receives a significantly more generous settlement for, say, social services than for education (i.e. the RNF covering social services will have picked up that there are a large number of elderly, disabled and/or mentally infirm individuals living locally, whereas the RNF covering education may reflect that there are relatively few school-aged children).

            The “major service areas” covered by RNFs are as follows: education, social services, police, fire, highways maintenance, environmental, protective and cultural services (EPCS) and capital financing.

            Another factor affecting how much local authorities receive in grants directed at specific service areas is the relative resource amount (RRA), which calculates the amount of income each local authority can be expected to raise for itself from council tax, and subtracts this from the RNFs for which it would otherwise qualify from government. The RRA is, thus, a ‘negative’ figure: if a local authority area has a large council tax base (pool of households eligible to pay council tax), it arguably needs to receive less money from government than one with a smaller base but relatively high service demands (e.g. a rural area with a high number of elderly residents).

            The allocation of these formula grants – a generic terms describing all revenue grants that are determined by means of a formula – often leaves some local authorities doing significantly better than others. To ensure those councils that do less well out of these grants than others are treated fairly (in so doing stemming controversy) the Government uses a process known as floor-damping. This is the practice of giving every authority at least a minimal year-on-year real terms increase in grant.

            Once a local authority has been told by the Government how much it stands to receive in its grants for the coming financial year, it will often decide a rise in council tax is needed to make up for the fact that those grants do not cover its needs. In such cases, marginal changes in grant settlements have a disproportionate impact on the level of council tax paid by households (as grants make up a larger percentage of council budgets than tax). This relationship is known as the gearing effect.

Disadvantages

·      A system of annual calculations can complicate and delay the budget process

·      By taking a council’s previous expenditure as an indication of its needs for the following year, SSAs arguably encourage councils to spend more than they need in one year to ensure they receive at least as much as they might need for the following one

·      SSA-based decisions fail to allow for unexpected budgetary needs that were not foreseen or faced in previous years

·      It is often difficult to fathom why some criteria has been used in the calculation of the SSA

·      The capping regime has progressively distorted council’s spending patterns to such an extent that they can no longer be regarded as reliable indicators of local need

·      Much of the data still being used in relation to local population size and other demographic considerations hails from the 1991 census

How Local Govt Revenue Spending is Broken Down

Education – 37 per cent

Social services – 17 per cent

Housing benefit – 12 per cent

Police – 11 per cent

Culture, environment and planning – nine per cent

Highways and transport – five per cent

Central services (IT, administration, marketing, press) – four per cent

Housing – two per cent

Fire – two per cent

The Evolution of the Local Taxation System

Local taxation is levied on residents of any given area by the so-called “collection authority”. This will be one of the following types of local council: unitary authority, London borough council, metropolitan borough council or, in two-tier areas, the shire district/borough council. In two-tier areas – i.e. those within which there is both a shire district/borough and a county council – the issuing authority will include in its bills a precept covering the cost of services provided by the encompassing county council. Precepts are also issued on behalf of police, fire and civil defence authorities.

The Rating System

From 1601 until 1990, the principal means of raising finance for local spending was through the so-called rates – a form of household taxation based on the rateable or rentable value of their properties. This system was seen to have the following advantages and disadvantages:

Advantages                                                           

·      Cheap to administer and collect            and predictable income source

·      Difficult for people to avoid paying rates as property, unlike people, is immobile

·      Simple, well understood system

·      Theoretically fair, in that owners of larger properties were more likely, on balance, to be wealthier than those of smaller ones

Disadvantages

·      As only about 25 per cent of the electorate received a bill (it only went to the property holder/owner), lodgers and tenants who paid indirectly often did not appear on the electoral roll and therefore did not have a sense of holding the council to account at elections

·      Rates paid on property did not take account of the use of services or ability to pay (an oft-quoted example was that of the elderly widow occupying the same-sized property as a group of solicitors – and forced to pay the same rates as they did collectively)

·      Rates were seen as a disincentive to home improvement, as any major property refurbishment was likely to hike the rates bill

The Community Charge (Poll Tax)

Dubbed by its critics the “Poll Tax”, the community charge was introduced in 1990, primarily as a means of increasing local government revenue by bringing into the scope of local taxation a number of people who had previously slipped through the net (e.g. young people still living at home and lodgers or tenants). Hugely controversial, it lasted for three years only – from April 1990 to April 1993 – and was seen to have the following advantages and disadvantages:

Advantages

·      A boost to local finances, as the number of bills sent out hugely increased to reflect the fact that all adults, rather than properties/householders only, were being charged

·      Notionally “fairer”, in that the burden of paying for local services was spread across all adults, including ones who had been “invisible” before, rather than just those in charge of properties

·      Brought greater accountability as, in charging individuals, it gave them all a right to voice their views at the local elections

Disadvantages

·      Many practical difficulties, including the fact that, as people move about, it is hard to keep track of them

·      As people had to fill in forms accepting liability for the Poll Tax, there was a huge disincentive for them to register – meaning that many councils ended up collecting barely half of what they owed

·      Seen as hugely unfair in numerous respects: for the first time, students were forced to pay local taxation, albeit at a reduced rate; people on wildly varying incomes found themselves falling into the same broad “bands”, meaning that they received identical bills; and tenants unable to afford to buy their own homes often found themselves paying a Poll Tax rate commensurate with that of the far wealthier individuals who owner the homes they rented

In response to the mounting hostility against the Poll Tax, which resulted in what, at the time, were the biggest peacetime demonstrations ever in Britain, the then Conservative Government ended up increasing its grants considerably to allow for a gross reduction in Poll Tax bills of £140 a person. This was financed by a 2.5 per cent increase in VAT – and, in the end, only 14 per cent of local expenditure was ever paid for the Poll Tax, compared to the 21 per cent which hailed from uniform business rates.

Council Tax

In many ways a throwback to the rates, council tax is again largely based on property values – though this time the capital value, as opposed to the rentable value, of houses and flats. However, it is actually more of a hybrid tax in many ways, in that it was originally conceived as having a 50 per cent property element and a 50 per cent personal element and today contains a number of exemptions and reductions that moderate precisely what different householders pay relative to each other.

The personal element of the tax is based on the assumption that two adults occupy the property. The most common forms of reduction are as follows:

·      Single person discount, which amounts to 25 per cent of the value of a full council tax bill. On the other hand, council tax bills are not increased if a property is occupied by more than two people

·      Some residents are “disregarded” for the purpose of calculating council tax bills. These include the severely mentally impaired, carers and students

·      “Reductions for disabilities” scheme, which reduces the banding of houses in bands B to H if they have been adapted to meet the needs of a disabled person. It exists to ensure that a house isn’t unfairly included in a higher band by dint of containing such modifications

·      A 50 per cent discount for owners of unoccupied dwellings (however, this system has led to controversy in a number of instances: in Wales, local authorities concerned about the growth of “ghost villages” in areas where many properties were kept as second/holiday homes have in the past been granted discretion to charge more than this 50 per cent minimum)

·      Other dwellings are exempt entirely from council tax – e.g. halls of residents provided for students, unoccupied dwellings, etc

·      A council tax benefit system exists for those on low incomes

·      Transitional relief was also provided for those whose local tax bills suddenly leapt as a result of the abolition of the Poll Tax

How Exactly the Council Tax Works

Council tax bills are issued not on the basis of individual valuations of each property, but on that of broad “band” groupings. Band D is considered the “average” band, and at present the valuation system works as follows:

Band A – up to £40,000 in value in England (£30,000 in Wales)

Band B – 40,001-52,000 (30,001-39,000)

Band C – 52,001-68,000 (39,001-51,000)

Band D – 68,001-88,000 (51,001-66,000)

Band E – 88,001-120,000 (66,001-90,000)

Band F – 120,001-160,000 (90,001-120,000)

Band G – 160,001-320,000 (120,001-240,000)

Band H – over 320,000 (over 240,000)

The width of each band gets larger the higher the value of the properties covered. The reason why bands were set up in the way they are was to avoid the necessity of frequent re-valuation and to aim to people in broadly similar properties in a particular local authority area to be paying broadly similar bills.

            Properties are allocated to specific bands by Commissioners of the Inland Revenue, via a recently formed Valuation Agency, but ultimately under the direction of the Secretary of State. At present, around 25 per cent of homes fall in the lowest band country-wide, while in the north-east this proportion rises to 60 per cent.

            The calculation of the rate of council tax – set against a datum point of Band D - follows this formula:

(the amount the authority intends to spend)-(non-council tax revenue

                                                Council tax base

In the run-up to the official launch of the 2005 General Election campaign, the Liberal Democrats recently announced plans to introduce a long-mooted local income tax if they were elected, to ensure that local taxation becomes more responsive to individuals’ ability to pay.

Some other useful terms in relation to the calculation of council tax:

• Valuation officer – civil servants employed by district councils in two-tier areas or unitary authorities to decide which property band a home should fall into for council tax purposes and which billing category a business premises should be included in
• Listing officer – an employee of the Valuation Office Agency (an executive agency of the Inland Revenue [now called Revenue and Customs]). He or she is responsible for compiling a valuation list which includes in it all the bandings of property in a given local authority area
• District valuer – individual with overall responsibility for valuations for local taxation purposes for an entire region (e.g. the North of England – Roger Haworth)

The Government has last resort powers to prevent local authorities charging excessive council tax rates. Under the Tories, universal “capping” of council tax rates was introduced at various stages – regardless of the differential needs and financial pressures of different councils – but Labour has instead introduced reserve powers to stop individual authorities going beyond the bounds of what is deemed reasonable.

Uniform Business Rates (UBR)/National Non-Domestic Rate (NNDR)

Introduced alongside the Poll Tax, this takes the form of a tax levied on the occupiers of commercial and industrial property. When devised, it was intended as a “pooled” charge that would protect businesses and local authorities from the wide disparities in the value of local rate bases. However, as it is set by central government, the uniform business rate has become extremely controversial: many smaller businesses find it hard to pay rates that are set on a “universal” basis according to the size and value of the properties they occupy, when they may be in less prosperous areas or poorer situations than others who pay the same rate. In addition, when uniform rates were introduced many businesses faced huge increases in their bills, as the previous valuation had been in 1973.

            The process by which uniform business rates are calculated is as follows:

·      Properties are valued and given rateable values by the Valuation Office Agency, and the values are prescribed on the basis of the sums properties could have been let for in 1993 (on occasion, however, the Secretary of State has agreed to prescribe more recent dates, and in addition he or she will hear appeals

·      Each year, the government sets a national multiplier (i.e. the rate in the pound at which the rates should be charged), and this differs between England and Wales. The system works as follows: a business with a rateable value on its premises of £50,000, against a national multiplier of 50p in the pound, will pay £25,000

·      Properties exempt include churches, agricultural land and buildings, and charitable buildings

The Budget Process at Local Level

As with most other organisations, the financial year for local authorities runs from April 1 to March 31. However, councils normally plan their capital projects three to five years ahead and, under the New Labour government, grant “settlements” for local authorities have been allocated on a rolling three-year basis in the manner of the comprehensive spending reviews instigated at national level by Chancellor Gordon Brown. The process by which spending is decided and provided for is as follows:

·      The council holds a provisional meeting early in a given financial year to draw up an overall budget strategy for the next one

·      A separate follow-up meeting is held to decide the levels of council tax needed to help finance expenditure for the coming year

·      The full council meetings follow on from earlier meetings of what, until recently, was normally known as the policy and resources committee (in new-style local authorities, it is the Cabinet that fulfils the role of primary budget-setter)

·      Council leaders or, in the case of the post-LGA 2000 councils, elected mayors have to obtain formal endorsement of their Cabinets for major budgetary decisions

·      Once an overall budget strategy has been decided on, broad revenue and capital estimates for the following years have to be ironed out (this usually happens in the summer months)

·      After numerous meetings of various departmental committees and the Cabinet/full council, significant adjustments normally have to be made around December, when the Government often announces the following year’s revenue support grant (i.e. how much money it is willing to allocate direct to the council the following year)

·      By January or February, the council is usually in a position to iron out its final draft estimates for revenue and capital spending

·      February – the full council will have its say formally at a special meeting, deciding definitively on the levels of spending and council tax for the next financial year (budgets are normally approved in broad terms, but often with some modifications)

·      Once the final precepts have been set by the council, theoretically the deal is signed and sealed. However, a succession of Acts have made it possible for governments to “cap” the level of local taxation, forcing councils to find economies elsewhere to ensure that local taxpayers are not over-charged for their services. This power was first introduced by The Rates Act 1984 and has since been supplemented by The Local Government Finance Acts 1988 and 1992, which extended this power to cover the Poll Tax and council tax respectively

Revenue Budgets

Each local authority’s revenue budget must contain a minimum revenue provision to enable the council to systematically repay any outstanding borrowing debt (equivalent to two per cent of housing debt and four per cent of debt for other purposes each year). In addition, it must contain provisions for meeting the interest on long-term capital borrowing – normally known as “the revenue implications of the capital programme”. Any interest incurred in such borrowing is known as the debt charge.

            Over the years, a variety of tools have been used – and, in some cases, abused – by councils in their efforts to balance their revenue budgets:

·      In a given financial year, a council is allowed to transfer money from one budget to another if one department’s responsibilities prove to be more costly relative to others than at first envisaged. This is known as virement

·      Where it quickly becomes obvious that spending in one area is likely to exceed the initially designated budget, the relevant department can apply for a supplementary estimate (if approved by the relevant committees, Cabinet and/or full council, this extra money normally has to be found from savings, balances or under-spendings in other areas)

·      In addition, councils have been known to try to increase income within a given financial year by levying a supplementary precept or tax over and above the council tax it initially set. Councils were barred from doing this by the Local Government Finance Act 1982

·      However, local authorities are entitled to introduce lower taxes – or substitute precepts - should they choose to within the year

·      By October or November time, it is usual for the council’s performance thus far during the financial year to be reviewed against its original budget plan – governments have been known to clamp down hard on local authorities’ financial management at this revised estimate stage if there is evidence its cash controls are poor

The Gearing Effect

When Council Tax rises by what appears to be a disproportionate amount, this is sometimes – though by no means always – attributable to something called the gearing effect.

As the council has been unable to raise additional money through its government grant (this being been calculated on the basis of the previous year’s spending), it has no choice but to significantly increase its council tax precept if it is to find additional money to finance revenue spending.           

Council Tax provides only 27% of a council's funding but it is the main area that the council can actually influence.

If a council wishes to raise the amount it can spend above the level of Formula Spending Share (FSS), it needs to increase its Council Tax.  This means that marginal changes in spending have a significant impact on the level of Council Tax.  This relationship is known as the gearing effect.

Below is a simple example of how the gearing effect works:

• Total FSS = £100m
• Of this the Council Tax provides £27m

If the council wants to increase its spending by 1% to £101m this will have to be funded through a Council Tax increase if there is no increase in Government Funding.

The percentage increase in Council Tax will be:
                £1m / £27m = 4% increase

Other Local Government Revenue

In addition to council tax, uniform business rates and revenue grants, local authorities derive income from the following sources:

·      Council house rents

·      Leisure service use (e.g. swimming pools, sports centres, etc)

·      Collection of trade refuse

·      Car parking tickets, fines, etc

·      Income from private contractors

·      The European Social Fund – provides grants to individuals, companies, voluntary groups and local communities in deprived areas of the EU to improve skills, training and employment prospects

The Capital Budget

Spending on investments intended to last a long time, like land, road, buildings and major items of equipment – the so-called “capital programme” or capital expenditure – is financed using one of the following methods:

Borrowing within credit approvals – A system introduced in 1990 to switch the emphasis from controlling local government expenditure to controlling borrowing. This borrowing is limited by three main factors: (a) the council’s basic credit approval (BCA), which is an aggregate figure decided by government departments which issue annual capital guidelines (ACGs) relevant to the areas of activity they cover; (b) any supplementary credit approvals agreed later in the day, in relation to specific projects (e.g. the allocation of Windfall Tax revenues to help finance the New Deal for Schools programme; and (c) grants for specific projects. Despite the fact it incurs interest and can take many years to pay off, borrowing is often seen as being desirable, in that it ensures that as many as possible of those who will reap the benefit of investment in local services will pay for them - by spreading the costs over a number of years. Local authorities can borrow from the following sources: the Public Works Loan Board (PWLB), the money markets, banks in the City of London, the Stock Exchange, or the European Union. Any “interest” paid by local authorities, schools or specific service providers in respect of loan repayments and arrears incurred in financing local services (e.g. school repairs funded through private sector loans) is known as debt charge

• Capital receipts – i.e. money raised through the sale of capital assets like land or buildings. Capital receipts are divided into two parts: (a) the usable part and (b) the reserve part. The latter, as its name suggests, must be set aside by the council to pay back existing borrowing debt (a restriction on its use which is seen by some to discourage the disposal of surplus assets), while the former can be used to supplement BCAs to invest in new buildings, land, etc. The Secretary of State determines the percentage of usable capital receipts at any given time. In 1998, the agreed percentage was 50 per cent – except, controversially, for the receipts from the sale of council houses, only 25 per cent of which could be used

·      Capital grants – In addition to their RSGs, local authorities are sometimes allocated grants to help finance specific projects or meet specified local needs. These can come from government departments, public bodies that distribute National Lottery money, or through hybrid arrangements that combine SCAs with government grants (e.g. the Transport Supplementary Grant, Single Regeneration Budget grants, etc)

·      European Union – Money can come from, among other pots, the European Regional Development Fund (for specific infrastructure projects and industrial development); the European Social Fund (for training and employment initiatives aimed at young people); and Structural Funds covering a variety of “objectives” (among them the oft-cited Objective 5b, which was used to help fund socio-economic spending in deprived areas, including North Devon)

·      Finance from private sources – In the past, this tended to take the form of an offer of development land and/or funding for capital works like road access or traffic management from a private company, in exchange for its ability to recoup its investment at a later date by running a profit-based business related to the land in question (so-called “planning gain”). Today’s favoured system takes the form of contentious private finance initiative/PFI and public private partnership/PPP arrangements for building new schools, care homes etc

·      Lotteries – Local councils are permitted to run their own lotteries under strict conditions outlined in the terms of the National Lottery

·      Local Strategic Partnerships – In January 2001, the Government launched a new £36m Community Empowerment Fund designed to encourage community and voluntary organisations to cooperate in LSPs designed to tackle social deprivation. The fund is distributed through the Government Offices for the Regions and aims to give £300,000-plus to each of the designated LSP areas

Among its vast array of provisions, the LGA 2000 outlined the following proposals for the future of local government finance:

·      The council tax would be retained in its current form and there would be no revaluation of the 1991 base (in the run-up to the 2005 election, Labour proposed abandoning this pledge and revaluing properties, but this unpopular idea was dropped in the wake of the party’s victory)

·      There should be increased stability in the allocation of government grants, and the methodology used to calculate SSAs should be kept stable for a period of three years

·      Crude universal capping systems for local taxation should be abolished

·      Local referenda should be held on issues affecting spending and council tax decisions

·      Annual elections should be linked to councils’ budget decisions

·      Local councils should be asked to meet the cost of paying council tax benefit over a certain threshold

·      The national business rate should be retained, but moves should be made to reduce its burden on small businesses and there should be a new power for councils to introduce their own supplementary rate subject to specified constraints

·      Links between local authorities and business interests should be strengthened

·      Capital finance should be rationalised to create a system which encouraged more strategic and corporate planning

·      Improved asset management needed, if possible by introducing asset registers, management plans and performance indicators

·      Enabling better forward planning, perhaps by issuing supplementary credit approvals for more than one year

·      Making allocations on the basis of a council’s capital receipts fairer

·      Further developing the PPP system and encouraging other types of partnership between the public and private sectors

Out Goes “Capping”, In Comes “Passporting”

Though New Labour has publicly distanced itself from the “crudeness” of capping council tax and council spending, in practice it has introduced another, more covert, means of directing local authority expenditure: so-called “passporting”. This is a means by which money is “top-sliced”, or “ring-fenced”, from the general revenue support grant given to a given local authority to be used only for a specific purpose.

Passporting is arguably a means by which the Government can get away with massaging the figures for public spending. In February 1999, for example, a £50m additional grant for schools was very publicly allocated by Ministers as an “increase” in the value of the revenue support grant. In reality, however, this money was provided by taking it away from other local government services – a sleight of hand derided by Sir Jeremy Beecham, leader of the Local Government Association, who accused Ministers of “holding local authorities to ransom” by a “smoke and mirrors trick”.

© James Morrison 2007