Osborne’s fiscal devolution must go much further to transform local growth
The chancellor’s decision to devolve the full revenues from business rates to local areas is a radical step forward for England’s regions. But for local leaders to increase investment in infrastructure, they need to be able to set rates locally and borrow against these revenues. Without this flexibility there will be only minimal increases in investment. Full fiscal devolution to local authority partnerships that reflect local economies, if done after resolving longstanding flaws with the tax itself, could enable areas to generate up to an extra one per cent of revenues above their current trend rates. This would enable councils in London to finance large-scale projects such as Crossrail 2 or those in Manchester to fund a major regional transport hub.
At the upcoming spending review, all eyes will be on how deep the cuts will be, and which departments will be most affected. The Department for Local Government and Communities has already committed to spending cuts of 30 per cent over this parliament. This is on top of cuts over the past five years which have already impacted local services such as day centres, libraries and museums including in David Cameron’s own constituency. It remains to be seen to what extent these cuts will also damage long-term growth. Growth is dependent on local economies being able to create the right conditions for local firms and workers to produce and sell value-added goods and services. This task has been constrained by Britain’s political culture of centralisation – a major reason why growth has been so imbalanced over the last few decades.
Osborne appears to have recognised this, and has shown willingness to implement ideas generated elsewhere to address woeful levels of investment. Last month he announced the setting up of the National Infrastructure Commission, a commitment in Labour’s manifesto. In his party conference speech, he announced plans to devolve the revenues from business rates to local government so that extra income can incentivise investment to drive growth. This was a central recommendation of the Adonis Review, which Policy Network published. The devolution of business rates will start to transform England’s political and economic landscape more than anything proposed so far in the name of the ‘northern powerhouse’. But this needs to be accompanied by a major shift in the way local economies finance investment if they are to have anything like the economic levers used by their competitors across Europe and the US.
Business rates are a tax based on property values charged on shops, offices and factories. The tax is expected to generate £23bn in England this year. For the past couple of decades, local government collected revenues and passed them to central government, which then redistributed them back again. A study by the London School of Economics found that since this change in 1990, local authorities increased restrictions on planning which led to less business development. The Coalition reversed this policy in 2013 by allowing local authorities to keep half of the revenues. They are now set to keep the rest by the end of this parliament.
Osborne’s decision marks a welcome break with England’s uniquely centralised political system. It will mean that local authorities will have a much greater share of the financial returns from economic growth. This could tip the balance in favour of difficult decisions required to promote growth, on things such as planning and housing. But there remain some issues for these benefits to become a reality.
Given the small scale of England’s local government structures, the coalition government encouraged local authorities to work with adjoining authorities and pool business rates. However, fewer than a quarter have done so since 2013. This has limited the gains from this policy shift for three key reasons. First, local economies transcend administrative boundaries. The gains and losses from local decisions are rarely limited to a single local authority area or spread evenly across neighbouring authorities. But each authority stands to gain from a growing economy. Burgeoning cities may need new housing beyond their borders, while rural and suburban authorities may want more jobs in urban areas.
Second, pooling will help them to manage the risks that revenues will fall. Twenty-nine of the 327 local authorities saw the total business rate revenues collected in their areas fall between 2008 and 2012. In Sefton, which is part of the Liverpool City Region Combined Authority, revenues on average fell by five per cent per year between 2008 and 2012. Whereas neighbouring Liverpool city council, a fellow member of the combined authority, saw revenues increase at a rate of almost five per cent per year.
Third, having geographic scale is crucially important for raising the revenues necessary to invest in major infrastructure projects – one of the core arguments for devolving fiscal revenues. There is no extra funding upfront as revenues from business rates are replacing central government grants. Hence, local authorities need to grow their tax base to fund new investment. Any extra revenues will be small initially, so local authorities should pool resources and borrow against future revenues to fund upfront investments. But without full control to set the local rate of tax with local stakeholders, the ability to borrow for investment will be curtailed.
The need for greater fiscal freedoms
Britain’s overly-centralised fiscal system has stunted local growth. Local economies struggle to fund infrastructure without the ability to borrow against future tax revenues. This is commonplace in the US and parts of Europe where local authorities issue bonds to fund major infrastructure projects. In doing so they borrow against the future uplift in revenues – such as from new office and retail premises – brought about by this investment. In England, many local authorities lack the scale to do this and remain dependent on national government, which can increase rates to deter borrowing. Around three quarters of councils’ long-term borrowing is from the national government’s Public Works Loan Board (PWLB).
Another issue is due to the system introduced in 2013 to limit inequalities in business rates revenues across different areas. No council lost out at first as existing redistributions continued. A complex system of ‘top-ups’, ‘tariffs’ and a ‘safety net’ fund seek to limit differences over time. On balance, the system provides some measure of protection without undermining the incentives it is there to create. But it uses projections of future revenues for each local authority that are reset after seven years. This means that a successful area could have their revenues trimmed after this period. Extending this period to around 20 years would provide the certainty required for funding large-scale infrastructure projects.
Where councils work together to set up formal ‘combined authorities’ that cover local economies with enough scale, they should also be able to set their business rates multiplier. The multiplier determines the proportion of a business’ rateable value paid in tax. Scotland, Wales and Northern Ireland have these powers – and many combined authorities represent bigger economies. Instead, Osborne has only offered combined authorities with metro mayors the ability to increase rates up to a cap of two per cent where there is support from local businesses. But local elected politicians should decide the rates they charge, and put this to a vote of local businesses as the chancellor has proposed. The London Chamber of Commerce’s research has shown that businesses are willing to accept higher rates if those tax receipts are reinvested in the local economy.
Without the ability to control this rate, the level of investment will be curtailed, as local authorities need to have the full flexibility over their rates to ensure they are able to attract long-term financing at reasonable rates. By specifying the rates, central government is only constraining a local authorities’ ability to increase borrowing to fund capital investment, thereby limiting its growth rate. Central government needs to let go of the idea that it knows what is best for local economies, a concept not too distinct from the attempts by the Soviet Politburo to set local production targets and prices. Locally-elected politicians have greater knowledge of what is required to grow their economy than ministers sitting in Whitehall. And critically, prudential rules govern all of their borrowing to ensure the debt is affordable and can be paid back.
Geographic scale also has a major impact on business rate revenues over the long term. Our model assumes that, with full fiscal flexibilities, local authority control will increase business rate revenues by an average of one per cent per annum above trend rates of growth. This is due to the improved incentives for local authorities to increase the amount of space allocated for businesses and residents, after having invested in appropriate infrastructure.
The projections show that all the current and proposed combined authorities stand to generate extra revenues above their trend rate of growth. The West Midlands Combined Authority, which signed a devolution deal with government this week, would gain £600m in extra annual revenues by 2040 and £6.8bn in extra revenues over the 25-year period to 2040. The other ‘core cities’ of Greater Manchester and West Yorkshire would gain £5.3bn and £5.0bn respectively across the period to 2040. While the proposed combined authority for Hampshire and the Isle of Wight, which includes Portsmouth and Southampton, would gain £3.7bn.
Greater London, given its size and growth rate, stands to gain an extra £8.8bn per year by 2040. The extra revenue of £69.7bn over the 25-year period could fund Crossrail 2, and a new wave of infrastructure investment for housing, without central government grants. London has long benefitted from major investment from central government, which should now be deployed elsewhere. Osborne is therefore right to retain stamp duty for now as a central tax to redistribute income from London to other parts of the country.
However, the story is not as positive in all parts of the country. The councils in Leicester and Leicestershire have proposed to set up a combined authority. This area would generate extra revenues of less than £100m in 2040 and incremental revenues over the 25-year period of only £1.1bn. This is in part because five of the eight local authorities saw their revenues fall between 2008 and 2012. It is also because of a lack of scale, with more than 16 per cent of the residents of Leicester and Leicestershire working outside of the region. This includes around 4,500 people who commute to Nottingham, the most popular destination. As well as not capturing the business rate revenues from these employers, this means that a Leicester and Leicestershire combined authority would lack the ability to improve the transport infrastructure used by many of its workers and residents to get to and from their jobs. If the proposed D2 (Derby and Derbyshire) and N2 (Nottingham and Nottinghamshire) combined authorities pooled revenues with Leicester and Leicestershire, in 2040 they could generate £300m in extra revenues and £3.7bn over the 25-year period – more than three times the level for the Leicester and Leicestershire region alone. These extra revenues would permit greater levels of investment to support the local economic region, rather than ring-fencing smaller pots of funding by administrative boundaries.
Cambridge and Peterborough is a striking example of a region that has moved towards greater scale. Talks over greater cooperation began a few years ago with a region involving only Cambridge city council and South Cambridgeshire. Since then, six local authorities and Cambridgeshire county council have come together to bid in the ongoing round of devolution talks with central government. Our forecasting shows that this larger region could generate £1.9bn in extra revenues over the period to 2040 compared to just £1.0bn for the smaller region covering just southern Cambridgeshire. Yet, council leaders came together with businesses to agree an even larger region for the area’s local enterprise partnership, which includes Peterborough’s travel-to-work area. A deal to pool revenues across this area could unlock £3.1bn of extra revenues over the period to 2040, fostering far greater levels of investment for major projects across the region’s economy.
Reforming a flawed tax first
Beyond issues with Osborne’s approach to devolution are longstanding flaws with the way business rates are currently levied. In March, the Coalition issued a consultation on changes to the system. This noted that “there is agreement across business sectors that the business rates system is in need of reform”. Any reforms should be undertaken before control over further revenues passes to local government.
As we highlighted in our response to the government’s consultation, the infrequent revaluations of business properties is partially responsible for higher levels of unemployment and insolvencies during economic downturns. GVA, a property research firm, estimated that average rents fell by around 15 per cent to 20 per cent between 2007 and 2012, but despite this business rates increased. This is because the last revaluation occurred in 2008. The decision by ministers to delay a revaluation until 2017 has also meant that businesses in the north and midlands have had to pay an extra £2.3bn, whereas businesses in London saved £1.6bn.
Our analysis also shows that the current tax is regressive. Smaller businesses – which are above the relief threshold that exempts the smallest businesses – pay a far higher amount per square metre than larger firms. In cities where there is increasing pressure on land values, it makes little sense to reward those firms who use more space. Furthermore, this penalises many innovative entrepreneurs trying to establish new business models, particularly in retail, which is the largest employer in the UK generating 2.7 million jobs.
We have proposed a simpler, annualised system of business rate valuations that links rates to actual rental costs. As was also recommended by the British Retail Consortium, this would be undertaken by postcode rather than for individual properties. The current system of valuing individual properties is complex and expensive, harming attempts to close the UK’s budget deficit. A similar overhaul in the Netherlands led to an 80 per cent fall in the number of appeals and significant cost savings. The tax should also cover land, which will help to encourage more land to be made available for house building. Vacant land still has a rental value, so there is no reason why it should not be taxed.
By proposing fiscal devolution, the chancellor has gone some way to silence those who have criticised the substance of his ‘northern powerhouse’. But the limited fiscal flexibilities on offer will curtail the large scale infrastructure investment needed across England to drive growth. Northern councils will be watching closely as this policy unfolds as they have a far larger infrastructure deficit than London. So too will northern businesses, who were hit hardest by a failure to reform business rates. Councils across most of the major northern city regions are now working together across local economies with sufficient scale. This is a landmark shift from England’s system of powerful central government and weak, geographically small local councils. Empowered with new fiscal freedoms, they could finance a new wave of infrastructure investment from the bottom-up.
Thomas Aubrey is director of the Centre for Progressive Capitalism and chief executive and founder of Credit Capital Advisory.
Alastair Reed is a senior policy researcher at the Centre for Progressive Capitalism.
This image is Manchester City Centre by Stacey MacNaught, published under CC BY 2.0