symposium on local government finance

Symposium on Local Government Finance

J. A. KAY

Local government finance has suddenly become the most acute fiscal problem of the early 1980’s in Britain. In January 1982 the Institute for Fiscal Studies held a conference, to discuss the issues involved. The immediate occasion was the publication by the Government of a Green Paper describing alternative sources of local revenue (Alternatives to Domestic Rates, Cmnd 8449,1981), but the discussion extended to the problems of local government finance more generally.

It is evident that there is schizophrenia in Britain about what we want from local authorities, and from the relationship between local and central government. On the one hand, local autonomy and control of local services is jealously asserted; and on the other, we want central government to procure appropriate service levels, to restrain both local and national tax demands, and to achieve equity between different local authorities and between different groups who receive services from local authorities or finance them. We cannot achieve all these objectives simultaneously; and if we insist on trying to do so we move, as we have, to an ever more irrational and incoherent system of local authority finance.

This schizophrenia was clearly identified by the Layfield Committee in the mid 1970’s; and it is the government’s failure to face up to the issue at that time which is at the root of the breakdown of orderly financial relations between central and local government now. Even yet, the schizophrenia is evident in the search for alternatives to domestic rates. There are two reasons for seeking alternatives to domestic rates. One is a feeling that the problems of central grants to local authorities can be resolved only by giving local authorities greater financial autonomy, which means they must raise more revenue from their own resources and less from central government. Rates are an inadequate tax base for this purpose. The second reason is a desire to punish local authorities for what is seen as persistent financial indiscipline by bringing their revenue-raising activities more in line with the national tax system.

John Kay is Director of IFS.

Fiscal Studies

Alternatives to domestic rates might therefore be seen either as a solution to central government’s inability to implement a stable and satisfactory grant system, or to local government’s failure to achieve a fair and acceptable allocation of the local tax burden among its ratepayers.

THE FUTURE OF CENTRAL GRANTS TO LOCAL AUTI IORITIGS

The problems of the grant system were eloquently described by Maurice Stonefrost, Comptroller of Financial Services for Britain’s biggest singlc local authority, the Greater London Council.

The basis of grant allocation to local authorites has come to seem in. creasingly capricious and subject to frequent and unpredictable change. The grant given to the GLC depends on its expenditure relative to a level which is unattainable and calculated on a basis only tenuously connected with the actual activities of the council. This has a range of undesirable consequences. If rewards and penalties are distributed in an apparently random fashion, then the result is demoralisation rather than the desired behaviour. If the financial outcome for an authority is more sensitive to the politics of grant allocation than to the efficiency of local services, officials and councillors will inevitably divide their time accordingly. If changes in rate levels owe more to changes in the way grant is distributed than to the activities of local authorities themselves, accountability to local electorates becomes ineffective.

These difficulties were recognised by the Layfield Committee, which argued strongly that expenditure and taxation decisions should be taken together at the same level of government. This required either that central government should take direct control of local spending decisions, or that powers of central taxation should be devolved to local authorities. The government rejected Layfield’s conclusions in favour of a status quo which it describes as a ‘middle way’ with elements of both local autonomy and central control. Time has shown that the middle way does not exist as Tony Travers’ account of the evolution of the grant system demonstrates.

Central government has sought to move from this middle way by asserting more direct control over local authority spending levels; but this trend has encountered strong resistance in Parliament and won little support from the conference. Several speakers asked why central government should be concerned to control the level of local authority spending, rather than the level of central contribution to local spending. If there were some rigid limit to taxable capacity, then every pound a local authority raised would reduce the revenue available to central government by a pound; and hence central and local expenditures would be directly competitive. But while it is true that the higher the level of taxation the greater is the cost of raising additional taxation, the magnitude of this effect is small. The burden of taxation rises steadily with its level, rather than reaching some fixed ceiling. If local authorities are required to raise the revenue for additional expenditure from their own resources, there is really no more reason for central government to

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be concerned with their expenditure levels than for it to be concerned about the expenditure levels of any other agents in the economy.

The alternative to centralised expenditure control is to increase local responsibility for raising finance for local services. Kerry Schott’s paper suggests that local authorities are. not unstoppable Juggernauts pressing relentlessly for higher expenditures. They respond to the-currently convoluted-financial incentives which are offered them. What better control mechanism than that they should be required to raise from local residents the revenues for the local services that they provide? This implies substantial reductions in the level of the rate support grant. There have been three traditional reasons for central grants to local authorities. One is concern for ‘spillovers’-items of local authority expenditure which yield benefits outside the boundaries of that particular authority and which will therefore not be undertaken to a sufficient extent, or will prove unfairly burdensome on local taxpayers, if they are financed entirely from local sources. Although this was originally a principal motivation for government grants, arguments of this kind have received much less recent attention. But education expenditure in particular does generate spillovers as well as being the largest single item in local authority budgets and the creation of a nationally organised and financed education service is occasionally canvassed as a solution to the problems of matching local expenditures and resources.

In recent years, the most important kind of spillover has not been in local authority expenditure, but in local authority taxation. Although domestic rates have raised most furore, industrial and commercial rates raise more revenue. Realising that a high proportion of the burden of such rates will be exported outside their boundaries, many local authorities have come to see non-domestic rates as a source of revenue which is costless to local residents. Some restraint is imposed by the existence of a fixed relationship between non-domestic and domestic rates, so that local authorities cannot increase the one without the other, but this relationship has been weakened by subsidies to domestic rate payers, rate rebates and the possibility of controlling the levels of council house rents.

Redistribution is a second reason for government grants. We might ask why government should undertake redistribution between local authorities, rather than directly between individuals. The traditional answer is that without such action a rich man in a poor neighbourhood will have to pay more for the same level of local services than a rich man in a rich neighbourhood. This is not only inequitable in itself but may lead to movements of population which exacerbate the initial problem, as may have happened in the US.

Redistribution therefore seeks to offset two kinds of difference between local authorites. They may have a more or less favourable local tax base than average; rateable values may be high because local incomes are high, or because there is a lot of local office or factory development. They may have a more or less favourable expenditure base; some authorities will have many children, or old people, or have a very dispersed population. In either case,

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Fiscal Studies

the cost (in rate poundage) of providing the same level of local services will differ between authorities. Traditionally, the resources element of the grant dealt with the first problem and the needs element with the second. The new unitary grant combines both.

Because resources are measured by rateable value per head, the system penalises areas where rateable value is high not because incomes are high but because property is expensive-particularly London. This issue has been repeatedly fudged, and although the introdution of unitary grant did lead to large rate increases in London boroughs for this reason a system of multi- pliers is used to diminish the inequity involved.

Neville Topham queried the need for any redistribution between local authorities, noting that differences in local needs and resources tended to become capitalised into house prices. The rich man in the poor neighbourhood may pay less for an otherwise identical property by an amount that reflects the additional tax burden which might be imposed upon him. Hence he is in reality no worse off, and has no incentive to move. It might follow from this argument that redistribution is unnecessary; but it would also follow that if a redistribution scheme exists, for whatever reason, then that too will be capitalised into house prices and to alter it would itself be inequitable.

The third rationale for government grants to local authorities is ‘fiscal inbalance’. If taxes are raised by that level of government which is able to levy them most efficiently, while expenditures are determined at the level of government which is able to levy them most efficiently, there is little reason to expect that tax and expenditures raised at any particular level of government will match. In Britain, as in most countries, tax collection has become more centralised than expenditure decisions, and there is therefore a correspond- ing need for the highest tier of government to return resources to lower tiers (‘revenue sharing’).

There is no ‘middle way’ between local autonomy and central control, and attempts to increase central control have proved both unworkable and un- popular. The alternative is to increase local autonomy and local accountability, and this is best done by reducing as substantially and as quickly as possible the proportion of local authority expenditure financed by central government. That demands both another-and it is to be hoped the last-major revision of the grant system, and an increase in the revenues derived by local authorities themselves.

Spillovers are no longer emphasised as a function of the grant system. Since redistribution between local authorities is with us already, it is neither possible nor fair to remove it. However understanding the force of capitalis- ation arguments should make clear that changes in the grant system produce as much inequity as do deficiencies in its design. The search for ever more fine tuning of the redistributive mechanism would be undesirable even if it were not so demonstrably unsuccessful and so influenced by political arguments. We should seek a simple, broad brush system of redistribution and leave it at that. Such redistribution could occur within the context of a much lower

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average level of government support for local authorities. Indeed it could occur with no net contribution by central government, implying payments from some authorities and grants to others. We should also seek new major sources of local revenue. There seem now to be two serious contenders-a local poll tax and a local income tax-and we discuss these further below.

THE FUTURE OF DOMESTIC RATES

Domestic rates occasion much criticism. Often this criticism is less than coherent, and it sometimes seems that a principal reason for the volume of protest is simply that rates are an unusually transparent tax; there are few other cases where individual taxpayers are personally and directly respon- sible for making payments. The major objections expressed are that the burden of rates is independent of the number of earners in a household; that they bear heavily on people (such as pensioners) who live in property which is large relative to their incomes; and that they are inequitable as between individuals who live in different parts of the country with different property prices.

As Christopher Foster noted, the essence of all these criticisms is that domestic rates are not an income tax; and any attempt to modify domestic rates to respond to these criticisms would have the effect of turning them into something close to an income tax. If this is the basis of the argument on which domestic rates are to be replaced, then there is one and only one alternative tax that meets the bill, and that is local income tax.

Gordon Hughes’ paper raises some doubts over the validity of the arguments generally raised against the rating system. Income is a measure of taxable capacity, but it is nst the only one or necessarily the best. Income, supplemented by information about housing consumption, may well give a better guide to a household’s standard of living than either of these variables alone and this is what a tax system which includes both national income tax and domestic rates achieves. The argument stresses the importance of look- ing at the impact of local authority taxation as part of the tax system as a whole, and not in isolation. Perhaps the strongest, and most frequently expressed criticism of the Green Paper was that it failed to see local taxation in this wider context.

Local income taxes are used to finance local services in many other countries. There are, however, peculiar administrative difficulties in implementing a local income tax in Britain. The reason is that while almost all other countries make rough and ready deductions of income tax from pay and assess liability by means of an end-year tax return and assessment, the British system attempts to secure exact deductions of the tax due and exempts most taxpayers from an annual return. It is easy in other countries to incorporate the assessment and collection of local income tax in the annual return; in Britain it would be necessary to establish place of residence in a separate enquiry and notify this to employers for each one of their employees indi-

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Fiscal Studies

vidually. Even in the modest proposals of the Layfield Committee, it was estimated that this would require a 15% increase in Inland Revenue staff and expenditure.

There is an obvious alternative, which is for Britain to move over to collecting its income tax in the same way as everyone else. The Green Paper notes this possibility, but observes that ‘Major issues of tax policy and administration would be raised which would need to be examined thoroughly and in detail on their own merits before any change of this kind could be made’ (para 6.23). If this statement was intended to be a preliminary to such a thorough examination, it would have been one of the most encouraging statements in the Green Paper; but there is no indication that it is anything of the kind. The reference to thoroughness and detail appears not as a prelude to action, but as a reason for inaction. The best test of the sincerity of the government’s intention to seek alternative sources of finance for local authorities is the date and speed with which it begins detailed consideration of the implications of a universal end-year assessment system.

The second alternative to domestic rates is a poll tax. A poll tax could not replace rates, unless levied at unimaginably high levels, but it could supplement existing sources of local authority finance. There are two major objections to it. The first is that it is regressive. This could be overcome by adjusting the national tax and benefit system by increasing income tax allowances and benefit rates. What matters from the point of view of social and economic policy is not the progressive or regressive impact of every individual element of the tax system, but the impact of that system as a whole. It is perfectly possible, and may be necessary, to have a regressive local authority tax system within an overall progressive tax structure.

The second problem follows closely from the first. A general poll tax could be a cheaply administered revenue raiser for local authorities. But would it be possible to implement such a tax while resisting pressure to exempt old age pensioners, low income earners, pregnant women and so on? If not, we could easily end with a tax system that presented all the administrative burden of a separately administered local income tax with none of the advantages of equity and flexibility which an income tax itself would offer.

Although much disagreement remained, a programme on the following lines seemed consistent with the main arguments presented. The present impasse between central and local government is best resolved by reductions in the rate support grant, in the hope that accountability for local expenditure will be more successfully imposed by local electors than by central government. This demands new sources of local government revenue, which might both supplement and replace the existing rating system. A local poll tax could make a modest but relatively quick contribution; more major changes require a longer term movement towards a local income tax. The most promis- ing basis for operating such a tax is in conjunciton with a new national income tax system incorporating universal end-year assessment.

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symposium on local government finance

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