With the announcement of the fiscal devolution roadmap back in March, and Andy Burnham’s clear desire to decentralise power in the UK, fiscal devolution is on the Government’s agenda. Centre for Cities’ new briefing – Fiscal devolution for England – presents evidence supporting this decision and answers five key questions that any reforms will need to consider.
The UK is the most fiscally centralised country in the G7
The UK, and England, is the most centralised country in the G7. In the UK, 95 per cent of tax revenue goes straight to central government in Whitehall, while just 5 per cent goes to sub-national government (metro mayors and local councils). Figure 1 shows that this makes the UK the most fiscally centralised country in the G7, twice as centralised as the next most centralised country: Italy.
Figure 1: Fiscal devolution correlates with high wages and the UK lags its peers
In the UK, nearly two thirds (62 per cent) of sub-national government funding comes from grants determined by central government in Whitehall. As a result, sub-national government is more dependent on central government grants than in any G7 country.
Fiscal centralisation is likely holding back local and national growth
This has implications for national economic growth. International evidence indicates that the UK’s centralisation is holding back economic growth. Developed countries that empower sub-national government by decentralising control over tax revenue tend to have higher levels of GDP per capita.
In the UK, fiscal devolution – without changing local tax rates – could help generate economic growth through four mechanisms:
1. Fiscal devolution creates local incentives to pursue growth
Fiscal devolution connects sub-national government funding to the local economy. By devolving taxes to the local level, places pursuing policies that generate economic growth are financially rewarded by the uplift in tax receipts that growth generates.
2. Fiscal devolution lets sub-national government use local growth to finance investment
When sub-national government funding is supported by local taxes, as opposed to central government grants, and tax revenues are not erased by ‘resets’ in funding, places are better able to borrow against the uplift in local tax revenues that large-scale investment generates. This is known as Tax Increment Financing and is common in countries such as the US but rare in the UK because of fiscal centralisation.
3. Fiscal devolution helps sub-national government make growth inclusive and sustainable
When sub-national government funding is supported by local taxes, revenues increase when the local economy grows. This helps sub-national government make growth inclusive by allowing it to reduce local taxes or expand public services. For example, sub-national government can help alleviate affordability pressures by unlocking investment in social housing or improve access to employment through spending on public transport.
4. Fiscal devolution supports local accountability and autonomy over funding
Under a more fiscally devolved system of sub-national government funding, local policymakers can be held more effectively accountable for their decision-making. Under the UK’s current system of centralisation and grant-dependent funding, sub-national government is heavily constrained by the annual funding commitments of central government. This reduces local policymakers’ agency and limits accountability to residents.
Fiscal devolution needs to be designed for growth and fairness
Reforming local finance is always tricky, but with clear principles in mind, reforms to expand fiscal devolution need to answer the following five questions. To maximise growth and maintain a fair level of funding across the country, these are our recommendations:
1. What level of sub-national government should fiscal devolution focus on?
Focus on metro mayors and expand to local authorities later: metro mayors control geographies that are much closer to real labour markets, meaning they are better geographically positioned to generate economic growth. There is also much less variation between metro mayors’ tax bases than between local authorities, making concerns about equalisation less of an issue.
2. Is it better to devolve a share of local tax or allocate a share of national tax?
A share of tax receipts generated in the local area should be devolved rather than a fixed share of national revenues. Sharing tax revenue generated within a mayor’s boundary, rather than designating a portion of national receipts, offers much stronger local growth incentives because it prevents free-riding.
3. Which taxes should be shared?
Income and corporation tax sharing, with some further business rates devolution, should be the next priority for fiscal devolution. Income and corporation tax are both buoyant – receipts increase with economic growth – and are geographically complementary. Income tax is high in residential suburban areas, while corporation tax is high in commercial city centre areas.
4. How much tax revenue should be devolved?
Only 1 per cent of national income tax is needed to advance fiscal devolution. If all of the Mayoral Strategic Authority’s annual grants were replaced with local income tax, this would require an average of 3 per cent of the locally raised amount each year and cost just 1 per cent of national income tax receipts. If corporation tax was shared too, and business rates were devolved further, this could be even lower.
5. How can fair funding be maintained alongside growth incentives?
Equalise some of the growth to guarantee a funding floor without removing incentives. Fiscal devolution to the mayors should come with a system of equalisation that guarantees a funding floor within the tax-sharing element. But it is important that a substantial amount of tax base growth retention is guaranteed to generate the benefits of fiscal devolution. Full periodic resets should not be part of the system.
For more detail on the points described above, and further evidence supporting them, check out the full briefing – Fiscal devolution for England.