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1 The Lyons Inquiry

1.1 The Government established the Inquiry into Local Government Funding led by Sir Michael Lyons in July 2004 following the report of the Government's review of the balance of funding for local government services between central and local taxes. The Inquiry has been asked to report to the Chancellor and Deputy Prime Minister by the end of December 2005.

1.2 Sir Michael announced in October 2004 that he was inviting representations from interested parties, saying:

"As part of this process, we will not only be seeking written evidence, but also holding a series of meetings around the country to develop a broader understanding of the issues as they affect different regions and local communities. After this phase of evidence gathering, which I would expect to take several months, we will use that evidence to inform our detailed analysis of options which will address the issues I have been asked to tackle."

1.3 So far, the Inquiry has not held any meetings locally, although the Chief Executive met Sir Michael Lyons with other representatives from the Society of Local Authority Chief Executives in London on 8 February 2005.

1.4 The Inquiry's terms of reference are set out in Appendix 1. Sir Michael has published the following questions which he would like respondents to consider in the context of the terms of reference.

"Those with an interest are invited to look at the Inquiry's terms of reference and contribute their views and experience. The Inquiry would welcome evidence which bears on the questions underpinning its terms of reference:

· what are the most pressing issues affecting the present system of local government funding? How might they be resolved, and what are the advantages and disadvantages of particular options? Who would be affected and how? In particular:

· how should council tax best be reformed?

· what is the case for providing local authorities with increased flexibility to raise a larger proportion of its funding locally, or additional revenue?

· what other sources - including local income tax, reformed non-domestic rates and other local taxes and charges - could be used to raise supplementary revenue for local authorities? How would they work and what would be their advantages and disadvantages? Would a particular combination of options work better than others?

· what are the implications for the financing of possible elected regional assemblies?

· what are the priorities for analysis within the terms of reference?"

2 Response to the Lyons Inquiry's questions

2.1 Cabinet agreed a response in September 2003 to the Government's initial balance of funding review. The points made then still stand and are summarised in the following paragraphs. It is suggested that these points, together with any further issues raised by Cabinet, should be forwarded to the Lyons Inquiry.

2.2 The council tax should be retained but it should be reformed so that annual increases in the tax are generally more in line with inflation which would help those on low and slowly rising incomes.

2.3 Local government should control a larger proportion of its income and be less dependent on Government grants. A major change to the balance of funding is necessary to give local authorities the capacity to deliver the services that local people and the Government require. This change can be achieved by:

· transferring business rates to local control, thereby improving the balance of funding to 50:50, subject to linking the increase in business rates to an appropriate index of cost increases for local government agreed with the Government. This will improve the `gearing' ratio whereby a 1% increase in spending not covered by Government grant currently results in a 4% increase in council tax on average

· fine-tuning the council tax, by revising the top and bottom valuation bands and by increasing the number of bands to make it less regressive. However, the potential impact of the council tax revaluation from 2007/08 is a major concern for Hampshire if above-average increases in house prices in the South East allow the Government to transfer even more of its grant away from Hampshire. The introduction of regional valuation bands could help to moderate some of the effects of the revaluation and make the banding more equitable between regions. It would allow houses of a similar size in the South East and the North, say, to be allocated to similar valuation bands in terms of the amount of council tax payable, even though South East properties have a higher market value.

· improving the council tax benefit system to give better protection to those on low and slowly rising incomes by raising thresholds, for example, on the level of savings allowed before entitlement to benefit is reduced

· reversing the `resource equalisation' introduced in the revenue grant distribution system in 2003/04 or, at least, not making further resource equalisation adjustments in the future.

2.4 In addition, the Government should:

· not transfer the funding of any further services away from local government, such as schools, because their needs are best assessed locally and in view of the complexity of school funding. The Government's proposals to fund schools with a ring-fenced `dedicated schools grant' from 2006/07 will not improve the gearing ratio in practice as a 1% increase in non-schools spending will still lead to the same cash increase in the council tax as now. The gearing ratio can only be improved by widening the local tax base, for example, by returning business rates to local control

· not introduce a local sales tax or a local income tax. An additional local tax affecting individuals, such as the local income tax, could complicate the calculation of local tax rates leading to a further reduction in transparency. A local income tax could also, as a direct tax, act as a disincentive to economic growth

· not introduce a range of minor taxes, such as on tourism, which are unlikely to raise significant income and would have a disproportionate effect on public perceptions of the extent of local taxation.

2.5 The final question raised by the Lyons Inquiry concerns how elected regional assemblies should be funded. The Inquiry published its questions before the result of the referendum on a North East assembly was known. Although there is now no immediate need to decide how to fund elected regional assemblies, it may be worthwhile confirming to the Lyons Inquiry that the County Council opposes elected regional assemblies and that there is no need for a further tier of government. The functions proposed for regional assemblies should be carried out by upper tier local authorities, such as the County Council, and funded from the council tax and re-localised business rates.

3 Local Government Association's Combination Option

3.1 At its meeting in February 2004, Cabinet considered a discussion document prepared by the LGA on its proposals for a combination of local taxes, including the council tax, localised business rates, a local income tax (which initially could be assigned revenues from national income tax) plus a basket of possible smaller taxes such as a tourism tax. The LGA believes that for the local government finance system to serve local democracy and local accountability, it is essential that local authorities are able to collect a greater proportion of their own income.

3.2 Cabinet agreed a response to the LGA in February 2004 that supported:

· the retention of the council tax, reformed to make it fairer

· the re-localisation of business rates, but with safeguards to protect local businesses from excessive increases.

3.3 Cabinet were concerned, however, about the following issues, some of which have been raised earlier in this report on the suggested response to the Lyons Inquiry:

· the introduction of a local income tax, which could complicate the calculation of local tax rates leading to a further reduction in transparency and, as a direct tax, act as a disincentive to economic growth.

· the assignment of national revenues as a first stage in a move towards a local income tax, as this would be an ineffective way of increasing local autonomy

· the inevitable losers under any new system, who are likely to be vocal in their complaints

· the disproportionate effect on public perceptions caused by introducing a range of minor taxes that are unlikely to raise significant income.

3.4 The report on the Government's initial balance of funding review commented that the LGA's Combination Option needed "to be tested carefully with detailed modelling at individual authority level." The LGA has developed such a model and published its findings but has not released the results for individual authorities.

3.5 The LGA's model, which is based on 2003/04 figures, reverses the balance of funding between central and local taxes so that about 75% of local government revenue spending would be raised locally from:

· a reformed and more equitable council tax which would provide the same level of income as now (about £18bn in 2003/04). Options for the reform could include increasing the number of bands and regional bands. In order to increase take-up, council tax benefit would change from a means-tested benefit to a means-tested entitlement, although how this would work is not defined

· a local income tax (or initially, assigned revenues from national income tax) to provide a similar amount to that raised by the council tax, £18bn

· business rates, unchanged apart from moving to local control, raising £14bn. The LGA proposes removing the existing statutory limit to the annual increase in business rates of the retail price index, although the LGA accepts that there would have to be safeguards to protect businesses

· a basket of other smaller taxes and charges.

3.6 Government grant would halve from about £36bn, including specific grants, to about £18bn. If distributed as a general grant rather than as specific grants, this would be sufficient to equalise differences in authorities' resources and needs. But it would leave a small number of authorities with more income from their local taxes than they need to finance their formula spending share (FSS) - in effect, they would receive negative grant. The LGA suggests that this surfeit of local income should be transferred to low needs authorities. In the LGA's model, there are 14 `negative grant' authorities, including central London authorities that benefit from very high levels of business rates and whose residents are high earners, as well as Buckinghamshire, Oxfordshire, Surrey and some of the Berkshire unitary authorities. It is not clear how this can be explained to the taxpayers in those areas.

3.7 The LGA proposes that the local income tax would only be levied by upper tier authorities such as county councils, unitary authorities, metropolitan districts and the Greater London Authority. It would not be accessible to shire districts, London boroughs or police and fire authorities. Shire districts would be restricted to the council tax only.

3.8 The local income tax would initially average about 3.5p in the £ and would be matched by a reduction in the national income tax rate. The LGA sees the principal advantages of introducing a local income tax as its buoyancy and equity, in contrast with the council tax, and the diversification and flexibility that it would give to local authorities' tax raising powers. Rather than council tax payers being faced with large and disproportionate increases for additional local spending, this burden could be spread across one or all of the council tax, local income tax, business rates and a range of minor taxes and charges such as a tourism tax. According to the LGA, the combination of taxes would provide a financial system that is more accountable, buoyant and transparent.

3.9 The LGA model reduces the gearing ratio (the ratio between the increase in local taxes that results from a 1% increase in spending that is not matched by additional Government grant) from an average of 4:1 to about 1.5:1.

3.10 The LGA accepts that the impact on individual tax payers will vary. It has provided some examples of the effect on individual tax payers. The proposals are more progressive, with high earners making a greater contribution towards the cost of a 1% increase in expenditure above FSS than under the existing system. In part, this is because council tax benefit would be an entitlement, not a benefit, under the LGA's proposals ensuring maximum take-up. Businesses would also contribute to local increases in expenditure above FSS for the first time since the nationalisation of business rates.

3.11 The LGA believes that the combination option could be introduced in 2006/07 on the basis of an assignment of revenues from national income tax. A switch to a full discretionary local income tax could follow in 2008/09.

3.12 If the Government goes ahead with proposals to transfer the funding of schools (estimated by the LGA at £22bn) to a ring-fenced specific grant, the LGA considers that the combination option would still be feasible. A reformed council tax could be combined with either localised business rates or a local income tax.

4 Commentary

4.1 The LGA argues that a consensus is developing within local government behind its proposals for a Combination Option. The further details in its most recent paper do not, however, answer the County Council's concerns raised when the LGA first published its ideas in January 2004, particularly about the introduction of a local income tax and whether a combination of local taxes would improve transparency. It is suggested that the County Council's concerns are forwarded again to the LGA as a response to its latest paper, and that they are copied to the Lyons Inquiry.

5 Recommendations

5.1 The recommendations are contained in the decision sheet summary which precedes this main report.

Section 100 D - Local Government Act 1972 - background papers

The following documents disclose facts or matters on which this report, or an important part of it, is based and has been relied upon to a material extent in the preparation of this report.

NB the list excludes:

1. Published works.

2. Documents which disclose exempt or confidential information as defined in the Act.

TITLE FILE

LGA's paper on The Balance of Funding - Implementing the Combination Option, December 2004

i:\ . . . . \ian\docs\bal of funding cabinet 11feb05.doc 28 January 2005

Appendix 1

Lyons Inquiry into Local Government Funding - Terms of Reference

The full terms of reference are to:

· consider, in the light of the report by the Balance of Funding review, the detailed case for changes to the present system of local government funding;

· make recommendations on any changes that are necessary and how to implement them; and

· take evidence from stakeholders.

In particular, the Inquiry will:

· make recommendations on how best to reform council tax, taking into account the forthcoming revaluation of domestic property;

· assess the case both for providing local authorities with increased flexibility to raise additional revenue and for making a significant shift in the current balance of funding;

· conduct thorough analysis of options other than council tax for local authorities to raise supplementary revenue, including local income tax, reform of non-domestic rates and other possible local taxes and charges, as well as the possible combination of such options; and

· consider the implications for the financing of possible elected regional assemblies.

The Inquiry will also consider, as appropriate, any implications that its recommendations have for other parts of the United Kingdom.