Reforming the local government funding system in England

Pete Marland , Chair, Economy and Resources Board, Local Government Association and Leader of Milton Keynes City Council

Council finances in England are under pressure like never before. Reductions in grant funding, increases in the scale and complexity of service demand, and the recent spike in inflation and wage costs have created the perfect storm for town halls. These challenges have been exacerbated by a local government funding system which has not been subject to significant reform since the introduction of 50 per cent business rates retention in 2013/14. Councils now operate in a dated, patched-up system where financial planning is hindered by a drip feed of one-year finance settlements and financial sustainability is increasingly secured by one-off grants or Exceptional Financial Support from Government. These arrangements act as barriers to councils making innovative and meaningful decisions, limit their ability to focus on long-term strategic and economic planning, and undermine their financial sustainability. 

A fundamental challenge facing the sector is that cost and demand pressures are rising faster than funding. While inflation has fallen steadily since its peak in 2022/23, significant cost and demand pressures remain in the system in services such as homelessness, children’s social care, adult social care, and home to school transport, particularly for children with special educational needs and disabilities. LGA analysis shows that by 2026/27 these pressures will have increased the cost of delivering services by 12.5 per cent since 2024/25, leaving councils facing a funding gap of £6.2 billion across 2025/26 and 2026/27 just to sustain services at 2024/25 levels. These pressures come on top of the fact that councils have already absorbed a 22.2 per cent real terms reduction in core spending power from 2010/11 to 2024/25. 

The scale of the pressures facing the sector was demonstrated in February 2024 when the then Department for Levelling Up, Housing and Communities (DLUHC) took the unprecedented step of announcing that 18 councils would receive Exceptional Financial Support in 2024/25 to address financial pressures that the councils considered unmanageable. All but two of these councils had social care responsibilities. This meant that the sector entered 2024/25 with more than 1 in 10 social care councils dependent on a significant one-off relaxation of the financial framework to secure their financial sustainability. The sheer scale of this intervention by the Government indicates the risk of financial failure is potentially becoming systemic. 

Councils need a significant and sustained increase in overall funding to stem the emerging risk of system-wide financial failure and to ensure that councils can meet growing demand for the vital services needed by their communities. But additional funding alone will not address the multiple issues with the funding system. There is growing evidence that the local government revenue funding system itself desperately needs reform. The Secretary of State for Housing, Communities and Local Government (and Deputy Prime Minister) recently acknowledged that there is a need to reform the funding system and address its inefficiencies. 

The lack of certainty and flexibility in the current system reinforce the problems created by cost and funding pressures. Councils need to be given greater freedom to respond to these challenges. Creating a more sustainable funding system for local government has the potential to strengthen the value for money of local spending and, most importantly, improve outcomes for the people and places councils serve. A financially robust local government sector also has the potential to reduce costs falling on other public services and to support the more efficient delivery of key government agendas such as economic growth, crime reduction, supporting early years and education provision, delivering net zero and supporting the NHS. Ensuring local government is financially stable is fundamental to any government being able to deliver its wider policy objectives.

Together the LGA, SOLACE and CIPFA represent the key decision-makers in relation to local government finance at a council level. This paper represents a joint call from the three membership bodies for a cross-party review of, and debate on, options to improve the local government finance system. This has to include a review of council tax alongside other council funding sources, and whether business rates retention represents a viable future funding model. We should look to build a sector-wide consensus on the nature of any proposed reform. 

However, the pressing nature of the sector’s financial problems means there is not the time simply to wait for wholesale reform to be designed and delivered. Change is also needed in the short-term to ensure service and financial sustainability of the sector. In parallel with the conversation on long-term reform, a series of short-term changes to the current funding system need to be introduced now. 

To reflect the need for immediate intervention on one hand, and discussion over potential long-term wholesale reform on the other, this paper sets out a mix of concrete proposals that can be delivered over the short- to medium-term, alongside a call for debate over more fundamental reform of the funding system. The paper focuses on revenue funding and relates to councils’ general fund revenue accounts. It does not set out any proposals for other elements of council finance such as capital programmes or housing revenue accounts, though these are clearly areas where we would be keen for future engagement with Government. 

Complexity 

Councils receive revenue income from a range of sources (Figure 1). These include government grants, transfers from the NHS, business rates, council tax, income raised from service users, and additional income such as that generated by councils’ investment and treasury management activities. 

Figure 1: Council revenue funding sources as a share of total revenue income – 2013/14 and 2022/23

Differing responsibilities mean that the significance of funding streams varies between different council types. Further variation in the relative importance of funding streams between councils is driven by differences in their areas’ assessed needs and the income generating capacities of their local taxbases and economies. Historic decisions about council tax and the local government funding system also play an important role. The implication here is that reform needs to view council funding in the round; focusing on one aspect of the system may benefit certain places and councils but deliver no change or even lead to unintended consequences in others. 

Given the current challenging state of council finances, interventions focused on individual elements of the system may be necessary in the short-term. But care needs to be taken to understand the distributional impacts these changes might have over the longer-term. And ultimately, longer-term reform needs to understand and incorporate the interaction of all funding streams and their relative importance to different local areas and regions.  

The last major reform of revenue funding arrangements took place in 2013/14 with the introduction of the system for 50 per cent local retention on business rates. However, the needs formulae that underpin 50 per cent retention date back even longer to reviews carried out in the previous decade and before. Since 2013/14 there has been limited reform to the system and instead multiple planned changes have been delayed (National Audit Office, 2021). As a consequence, key elements of the funding system, including the data and formulae at the heart of the allocation model, have not kept pace with changed patterns of need and demand locally (IFS). 

Despite a lack of reform since 2013/14 there have nonetheless been marked changes in the significance of different funding streams (Figure 1). Over recent years locally-generated income from sources such as council tax, sales, fees and charges, and investment income has become a more significant component of councils’ income. In contrast, government grants, some of them generated from business rates, often distributed on the basis of assessed need, albeit not updated recently, are relatively less significant. Overall, local sources of income have become more significant in the system while the role played by assessed need in allocating resources has reduced. 

Any long-term reforms must address the long-term stability and sufficiency of the various income sources used to fund councils.  

The system has effectively been drifting for a number of years. Despite this, substantial changes have taken place in the significance of different funding streams within the sector. But arguably these have been as much by default as conscious design in line with a clearly articulated strategy for reform. 

An example of this drift is the growth of council tax as a funding stream. Its growing importance to councils’ budgets, partly due to the introduction of the adult social care precept, means that in the absence of alternative funding streams, failing to raise the council tax rate annually will have substantial implications for most budgets. However, raising the rate perpetuates the cycle as it further reinforces the importance of council tax in councils’ funding baselines and amplifies the need for future council tax increases. 

The growing importance of council tax as a funding source also means that the weaknesses in the tax are more problematic and pronounced. For instance: council tax: raises different amounts of money in different parts of the country, unrelated to need; is based on 1991 property values and has not been revalued since then; and is viewed by some as regressive in relation to property values (IFS 2020). The Levelling Up, Housing and Communities Select Committee recently stated that council tax is outdated, regressive, and long overdue for reform (LUHC 2024). 

The increasing importance of council tax as a funding source alongside the failure to update the system, including the underlying data and formulae, has contributed to a growing separation between councils’ income and their levels of assessed needs. For instance, the IFS has estimated that only 39 local areas out of 150 in England receive a share of funding that is within 5 per cent of their share of estimated spending needs. While more-deprived areas receive more funding, they do not receive as high a share of the national funding pot as the formulae used in official spending needs assessments suggest they should. 

Drift is also apparent in the business rates retention system. The new system introduced in 2013/14 allowed councils to keep 50 per cent of business rates growth above their initial baseline, subject to a levy. There were supposed to be periodic resets where accumulated growth in individual councils would be redistributed across revised baselines for all councils. But no resets have taken place in over a decade as planned reforms to business rates retention have been repeatedly delayed.  

The lack of reform over recent years means not only that the burden carried by council tax-payers has increased, but also that the funding system is out of date, opaque, and overly complex. It also limits the ability of councils to be more self-sufficient by raising income from other sources. There should be a cross-party review of, and debate on, options to improve the local government finance system. We should look to build a sector-wide, cross-party consensus on the nature of any proposed reform. 

In summary: 

While there is a strong case for wholesale reform of the local government funding system, the pressing nature of the challenges faced by the sector means that immediate interventions to help stabilise councils’ finances are also needed. 

While acknowledging and welcoming the additional funding in the 2024 Autumn Budget, there remains a significant gap in day-to-day spending that needs to be addressed. We think there are a range of interventions the Government could take now to simplify and create certainty within the funding system, realign funding with assessed need and add certain flexibilities to current funding sources. 

Councils’ ability to deliver the high quality, value for money services needed by their residents is dependent on both the sufficiency and certainty of their funding. But at the current time council funding is neither sufficient nor certain. Rather councils’ ability to mitigate the funding and demand pressures they face has been hampered by one-year funding settlements and continued uncertainty over funding reforms.  

These act as obstacles to councils making innovative and meaningful decisions, limit their ability to focus on long-term strategic and economic planning, and undermine their financial sustainability. The potential to deliver maximum value for money is held back by uncertainty and a limited ability to plan for the future. For instance, councils may end up planning on the assumption that they will have less funding available to them than is the case, needlessly scaling back non-statutory services and making redundancies. 

Providing certainty over funding and finance reform would be a step forward. Councils would be able to prepare for the impact of the reforms, establish multi-year transformation programmes and enter into longer-term contracts with suppliers and providers. These benefits can be secured by the Government providing: 

Alongside the introduction of greater funding certainty there should also be a move away from piecemeal pots of funding allocated through wasteful competitive bidding processes. Research published by the LGA in 2020 found that there were nearly 250 different grants provided to local government, around a third of which were awarded on a competitive basis. LGA research estimated that the average cost to councils in pursuing each competitive grant was in the region of £30,000 costing each local authority roughly £2.25 million a year chasing down various pots of money across Whitehall. 

Regardless of whether grants are allocated based on need or through competitive bidding Government should look to reduce the use of formal ring-fences and grant conditions. The steady return of grant conditions undoes much of the progress made in the early 2010s when the Government removed ring-fences and combined individual grants into larger ones to reduce reporting burdens and provide flexibility to councils in how they used funding (National Audit Office, 2014). 

The Ministry of Housing, Communities and Local Government (MHCLG) has recognised this as an issue and introduced a funding simplification doctrine in 2023. Nonetheless the objective of reducing ringfencing and the number of grants needs to be implemented with more urgency. The Government should:

While there is a broad acceptance that ‘need’ must sit at the heart of any funding system for allocating local government funding, there is less agreement on how this critical concept should be defined. But this should not prevent us from recognising that the current arrangements have become so dated that they do not even align with the definition of need hard-wired into the system’s own funding formulae. 

In November 2024 the Government announced that from 2026/27 it will move gradually towards an updated allocation system for council funding. This will build on the proposals set out in the previous Government’s Review of Relative Needs and Resources (the ‘Fair Funding Review’). In our view, it is important that rather than simply updating data in the existing model any new approach should include a comprehensive review of formulae and, in particular, ensure that both deprivation and population changes are primary drivers. The IFS, for instance, has argued that changes to the activities that public service providers spend their money on, and changes in the technology and processes by which they carry out their work, mean that the relationship between local characteristics and spending needs will have changed. 

Consideration should also be given to the base year used in any assessment of need. Relative need within the formulae is often measured by patterns of historic spending across councils. However, the impact of funding reductions since 2010/11, have fallen disproportionately on deprived areas (IFS, 2019). Using spending data that includes the impact of these funding reductions will have an impact on which indicators would appear in any formula and the weight given to each indicator. 

Consideration will also need to be given to transition times if we are to move to a new system. 

Overall, we urge the Government to work with the sector and take the following steps to update the current system for allocating council funding: 

Over 70 per cent of council revenue income currently comes from three sources; council tax, retained business rates and sales, fees and charges income.  

The efficacy of all funding sources and possible options for their reform must sit at the heart of the debate on long-term reform of council funding. But while this discussion takes place there are options for smaller scale reforms to these core funding sources that will be of value to councils. 

The Labour Party manifesto has committed the Government to replacing the business rates system. Clearly this will form a key component of a future debate on wholesale reform of the funding system for councils. However, in the interim we believe that there are improvements that could be made to business rates that will help to resolve many of the problems with the current system from the perspective of councils. For example, by giving councils more flexibility on reliefs and allowing them to set their own multipliers. 

Councils also need immediate clarity on the future of the business rates retention system. A replacement for business rates and the creation of new funding arrangements for councils will not be an overnight exercise. In the interim the sector needs to know whether there are any plans to change elements of current rates retention system. In particular, it is imperative that the sector has clarity on a timely basis on the Government’s plans for any reset in accumulated business rates growth, and any future resets. 

To address current issues in the business rates system and provide clarity on business rates retention the Government should: 

• Give councils more flexibility on business rates reliefs such as charitable and empty property relief
• Undertake a review of exemptions such as where businesses happen to be located on farms. 
• Undertake clampdowns on business rates avoidance along the lines of those introduced in Wales and Scotland to ensure that the rules on reliefs such as empty property and charitable relief are applied fairly. 
• Give councils the ability to set their own business rates multiplier, or at the very least be able to set a multiplier above and below the nationally set multiplier. 
• Clarify its plans for, and the timing of, any reset of accumulated business rates growth at the earliest opportunity as part of a broader effort to provide certainty to the sector on planned reform. 
• Introduce a transitional mechanism as part of any reset to ensure that local authority services that residents rely on are not put at risk. 

In 2022/23 sales, fees and charges generated over £12 billion in income for councils, roughly similar to the amount generated through the retained business rates system.  

But despite the significance of this funding stream, councils do not have the ability to set fees for many crucial areas of their activity such as planning. To address this the Government should: 

Some areas may be open to the idea of new levies like hotel or tourism taxes. These should be matters for local control and may make a useful contribution in local areas and for certain authorities, but introduced on their own they are unlikely to make a material difference to fixing the financial crisis facing the sector. 

New proposals for revenue streams should be assessed against the extent to which they contribute to a system that raises sufficient resources for local priorities in a way that is fair for residents and gives local politicians the tools they need to be the leaders of their communities. For councils, it is also important that the tax system, including business rates, provides as much certainty as possible. While no single funding source will meet all these criteria, in the round revenue income sources for councils should reflect the following principles: 

It is vital that any discussion on council funding focuses not just on how best to fund councils’ current activities, but also considers whether there are other areas of existing public spending that would be best devolved to councils. Equally, any reform of council funding should also consider how spending is best co-ordinated across the range of public bodies delivering services locally. 

For instance, there is strong evidence that devolving employment and skills funding locally will deliver better value for money schemes that are more aligned to local needs. For example, across England £20 billion is spent on at least 49 nationally contracted or delivered employment and skills-related schemes or services managed by nine Whitehall departments and agencies, multiple providers and over different geographies. Similar issues are apparent in relation to the Government’s programme to deliver net zero. 

As with reform of the council funding system, developing and designing measures to further devolve funding and promote place-based financial models is a long-term task. But there is no reason to delay. As part of this debate Government should: 

• Consider assigning each local area a proportion of nationally collected taxes. It would be for local politicians in partnership with local providers to decide on priorities and the allocation of funding. 
• Consider alternative sources of income for local government including an e-commerce levy with the funding retained by local government. 
• Consider introducing multi-department place-based budgets, explicitly built around the needs of diverse local communities using equality impact assessments – with a shared financial and governance framework which will mean that services can better align with local priorities and local duplication of efforts can be eliminated.