Beyond business rates?

We will be emailing out the December issue of C’llr magazine to our members this week. As usual it is packed with an interesting mix of articles – a smörgåsbord of topics taking in among other things: housing; regeneration through investment in tourism; universal credit; and an entertaining stroll down some seaside piers. Our special focus for December is a series of articles on local government finance. As a taster here is one of the articles from that feature.

With a national roll out of 100 per cent business rates retention unlikely in the next few years, David Phillips from the Institute for Fiscal Studies asks if it is worth looking to the longer term and more radical tax devolution.

Two years ago, the then Chancellor George Osborne announced councils in England would keep 100 per cent of business rates revenues and general grant funding would be abolished by 2020. The 2017 general election threw these plans into disarray. The government is continuing to pilot the 100 per cent business rates retention scheme (BRRS), but plans for a national roll-out are on hold. Power to cut the tax rate (the ‘multiplier’) also cannot be devolved without primary legislation.

Many in local government are disappointed. But perhaps this pause is an opportunity. Not only to consider the rationale and design of the 100 per cent BRRS but also to ask: should local government have a stake in other taxes too?

The driving force behind the BRRS is that if councils see their budgets rise and fall as local business rates revenues rise and fall, they’ll have stronger incentives to boost the local economy as this would grow their tax base. This is a laudable aim. And there is international evidence that these sorts of incentives can matter. However, the relationship between business rates and local prosperity isn’t perfect. Lots of small businesses are exempt from business rates. If local businesses use their space more efficiently or more local residents find well-paid jobs in neighbouring areas, rates revenues won’t increase. Indeed when they looked, the National Audit Office and House of Commons Library couldn’t find a link between business rates growth and wider economic growth over the last few years. Could devolving a wider mix of revenues provide broader-based incentives for growth? Take income tax. A number of countries – including Denmark, Sweden and Switzerland – have local income taxes. And up until 2008, it was Liberal Democrat policy to replace council tax in England with a local income tax (the SNP previously had similar plans for Scotland too). Unlike business rates, local income tax revenues would rise if more people got jobs in existing business premises or neighbouring areas. Take sales taxes. Outside the EU, the UK could reduce the rate of VAT and allow councils to set a local sales tax on top. Unlike business rates, revenues would rise if like-for-like sales in existing shops increased, not just if new shops were built. And a local share of corporation tax could reward councils for growth in profitable and high value-added businesses that use relatively little or inexpensive property (such as internet businesses or high-tech manufacturing). These taxes are also what’s called buoyant: revenues go up automatically as incomes, sales or profits go up, and when the economy is growing, they tend to grow faster than inflation. You don’t need the pain of manually increasing tax rates each year like with council tax or business rates. Devolving a portion of income, sales or profits taxes may therefore help councils escape the financial straightjacket imposed by rules on increases to their existing taxes.

But devolving additional taxes would also bring big challenges. First, the flip-side of buoyancy is that revenues would fall if incomes, sales or profits fell, like in a recession: councils’ budgets would be exposed to greater cyclical risk. As with business rates there would also be a risk of long-term divergences in funding as tax revenues grow rapidly in some council areas and less rapidly in others. Estimates by the Centre for Cities, for instance, show tax revenues growing strongly in London between 2004 and 2014 but falling in much of the rest of the country.

Powers to vary tax rates would give councils greater control over their levels of funding, and influence over the local business environment. But there would be a risk that competition on tax rates could drive down revenues as councils chase high-earners and businesses by cutting rates. It would be administratively burdensome for companies to account for their sales and profits on a council-by-council basis, and difficult for HMRC to verify what companies report and tackle tax avoidance.

These sorts of issues are likely to be most problematic for taxes on profits and sales. On the other hand, income tax can be more easily allocated to an individual based on where they live: this is what happens with Scotland’s new income tax powers. So if we were looking for another big tax to devolve, at least partially, to councils, could income tax be it?

Doing this would be a big step. As with business rates retention, we would need to think carefully about the right balance between redistribution and incentives for growth. But a local income tax could provide councils with broader-based incentives for promoting local prosperity than business rates alone, and a more buoyant tax base. Is it therefore time to investigate the appetite for looking beyond business rates?

David Phillips is Associate Director for local government finance and devolution at the Institute for Fiscal Studies.