Backgrounder: the essentials of local government finance in England
Author: Mike Woods, LGIU Associate
Date of publication: 16 May 2023
This is one in a series of member-only backgrounders from the LGIU: in-depth introductions for councillors to the work of local authorities in England across key topics. Following the issuing of a new section 114 notice by Birmingham, we have decided to make this backgrounder open to help the press, public and wider sector aware of key finance issues.
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This backgrounder is designed to provide newly-elected councillors and others new to local government with a short, non-technical introduction to the main features of local government finance in England. Topics covered include the budget cycle, revenue and capital, and sources of funding including council tax and business rates, but the main focus is on what to look out for to assess the financial health of your council amidst the challenges of high demand for services and persistent high inflation.
The details of local government finance are complex and this backgrounder does not pretend to be a comprehensive briefing; more in-depth introductions are readily available elsewhere. It assumes a reasonable prior knowledge of the basic structures and functions of English councils, but no more than could be expected of a newly-elected councillor.
What you need to know and what to look for
Despite the recent political turmoil and the shock of the Covid-19 pandemic, the basic financial framework for English councils has not changed. Councils are still under a legal duty to set budgets, provide statutory services and agree amounts of council taxes (either directly for district councils, metropolitan districts and unitaries; or via precepts for counties, mayoral areas and the GLA). Having said that, the pandemic placed huge additional pressures on councils in administering new grants, stepping up services for the most vulnerable, facilitating testing and vaccine programmes, developing communication channels and finding new ways of working with a workforce often disproportionately affected by the virus. Thankfully, many of those immediate pressures have now eased, but they have been replaced by high inflation, higher demand as a result of the cost of living crisis, and difficulties in recruiting and retaining staff. Before these are discussed further, it is important to set the context and explain what to look out for.
Planning and budgeting
Every council must prepare a balanced and robust budget each year. It must be balanced in that expenditure must be matched by funding, and it must be robust in the sense that the sources of funding must be realistic and fairly definite (e.g. known government grants and estimates of council tax and other income) and not based upon hopes or aspirations. It is also important to note that councils cannot normally borrow to support revenue expenditure.
The budget process starts in April or May with departmental finance officers reviewing financial projections in the light of the previous year’s budget outturn. The next step is to identify known budget pressures (perhaps arising from greater demand, higher costs, falling income or new statutory services) and to quantify possible efficiency savings or new sources of funding. Detailed budgets are then built up during the autumn and reviewed, usually with some member involvement, when government grant allocations are announced in the provisional local government finance settlement in December. After Christmas, the financial settlement will be confirmed and budget reports will be prepared for consideration by the executive or cabinet. At that stage, and perhaps earlier, there will be some degree of scrutiny involvement, before the budget is considered at full council usually in February or very early March. This meeting will be a set-piece occasion where the budget and levels of council tax for the coming year will be debated, sometimes at length. If the balance of power in the council is close, there may be a degree of horse-trading at the meeting before the budget and council tax are finally agreed.
Alongside the budget process, councils are required to prepare a “medium term financial strategy” (MTFS), also known as a “medium term financial plan” which projects likely income and expenditure forward for at least three years. In practice, MTFSs tend to be of limited value, firstly because government grant support is currently only decided on a year-by-year basis and secondly, because of the difficulty of predicting future demand and shocks, of which the pandemic is an obvious if extreme example. Where MTFSs are useful is in preparing for changing priorities and identifying future budget gaps, to see where further efficiency savings, service cutbacks and/or council tax increases may be necessary.
Budgets are usually controlled on an authority-wide proprietary financial system on which all financial transactions are recorded. This may be combined with or at the very least have robust links to other financial systems, for example, payroll, council tax, benefits, social care and sundry debtors. Crucially, from your point of view, the system will produce regular monitoring reports which will highlight under- and overspends against the budget at service level, usually on a monthly basis, for reporting to the executive.
So, what should you look out for?
- The annual budget report is a key resource for getting to grips with your council’s finances. The report may be long and complex, but it should be clear and understandable and, if there are passages that seem vague or ambiguous, you may want to question whether there is something the executive or officers are wishing to obscure.
- The report will include a statutory assessment by the Chief Financial Officer of the robustness of the budget and reserves. Look at this section carefully. Is the wording confident and do any expectations placed upon services seem reasonable and achievable?
- How is any funding gap being filled? If the gap is being filled from reserves how much is left and is there any warning about reserves being depleted? If the gap is being filled by one-off funding sources, or by innovative accounting treatments, remember these are unlikely to be available in future years, and could be questioned by your council’s external auditors.
- During the rest of the year look at budget monitoring reports. Are they being produced regularly (best practice is monthly)? Are they sufficiently detailed to identify the source of under- and overspends (adult social care is often a source of overspends)? If there are overspends how large are they compared to the corresponding budget, and do any mitigating actions look achievable?
Revenue and capital
So far we have looked at the revenue budget, i.e. spending on day to day activities, but the annual budget will also include a section, or a separate report, on capital expenditure, that is, expenditure on long-term assets including land, buildings and infrastructure. For expenditure on an existing asset to be categorised as capital it must make the asset last longer, increase its value or make it more useful to the user. For example, replacing dilapidated windows in offices would make those offices last longer and would be capital expenditure, but routine painting of the window frames would be classified as revenue.
The annual capital report will set out a programme of capital expenditure that may extend for a number of years. Capital expenditure may be funded from revenue and receipts from the sale of other properties or from reserves, but the main source, particularly when interest rates are low will be borrowing. Things to question include:
- How big is the capital programme? Does it look over-ambitious? Are there any obvious vanity projects? Has the programme been scaled back to meet the constraints of a post-covid world?
- What are the sources of funding? Is the programme too reliant on capital receipts from the sale of other properties? Are timescales for sales realistic?
- Unfortunately, it is not always easy to differentiate between revenue and capital and, given the pressure on revenue budgets, there may be a temptation to classify revenue expenditure as capital to take advantage of relatively cheap borrowing and reduce pressure on the revenue budget. Even in the example above, one could argue that painting window frames actually enhances the value of offices and should be classified as capital. Look for any obvious evidence of questionable classifications – if there are any, there could be a risk of problems at the next external audit.
The money to pay for local government services come from four main sources: central government grants, council tax, business rates and fees and charges.
Central government grants have historically been the most important source of funding and can be split into two types: specific grants to fund specific activities and general (or formula) grants. As mentioned earlier, grant allocations for the coming financial year are announced in the annual provisional local government finance settlement (usually in December) and confirmed in late January or early February. In the past, settlements were often announced for two or three years, but more recently they have been only for one year, which makes medium-term financial planning more difficult. Additional grant allocations during the year are rare, but during 2020-21 and 2021-22 large additional grants were provided to help councils cope with Covid-19. Leaving aside one-offs like Covid-19, the main issues with grants are the totals allocated and the way they are shared out between councils.
Council tax now makes up a much larger proportion of local government funding. This is as a direct consequence of cuts to grants over the past decade coupled with a relaxation of referendum rules in recent years which until 2023-24 allowed above-inflation council tax increases. Central government’s preferred measure of council resources is “core spending power” (the total of government grants, council tax and business rates). In 2015-16 council tax made up 49 per cent of core spending power, by 2021-22 that had risen to 61 per cent; for 2023-24 the percentage has dropped back slightly to 57 per cent, largely as a result of extra grant funding for social care. In 2023-24 most authorities increased their council taxes by the maximum allowable.
General government grants are allocated on a formula basis. The formulas are contentious because they have not been updated since 2013 and they take no account of changing demographics or demand pressures over the past decade. A “Fair Funding Review”, which was supposed to introduce new simplified formulas to distribute funding more fairly, was announced in 2016, but has been repeatedly delayed, and will now not be concluded in this parliament.
Business rates used to be quite simple. All the amounts collected by billing authorities (districts, mets. and unitaries) were passed to central government and redistributed to councils as part of the annual financial settlement. However, since 2013-14 a business rates retention system has been in place under which business rates are shared between central and local government. The rationale behind the new system was to incentivise councils to encourage business growth in their areas because they would benefit directly from that growth by retaining a share of the extra business rates generated. In practice, the system is horrendously complicated, with different proportions retained depending on the type of authority, where it is situated, and whether it has grouped together with other councils in a “business rates pool”. The biggest criticism of business rates retention, apart from its complexity, is that there is little evidence of a redistributive effect and the biggest rewards tend to go to councils that already have the most buoyant economies. Alongside the Fair Funding Review, the previous government also committed to a review of business rates retention, with a view to moving to 100 per cent retention. Again, that review has been put off until after the next general election.
Some of the main things to look out for or to question include:
- How does your authority’s council tax compare with those of similar authorities? Is it higher or lower than average, and are there any good reasons for differences?
- What is your authority’s policy on council tax increases? Has it increased council tax in 2023-24 by the maximum allowed under the referendum rules? Has the authority published a policy on council tax increases for 2024-25 and beyond?
- One way of assessing efficiency is to look at council tax and business rate collection rates. Ask whether they’ve recovered after the shock of the pandemic and how they compare with similar authorities. High collection rates are a good indicator that your finance function is being well run.
- Fees and charges are often subject to national limits, but look to see whether income is being maximised and, if not, are there good reasons. Look at parking fees, are they reasonable or are they putting off visitors and stifling shopping centres? Do they seem higher or lower than those in surrounding areas?
- What is your council’s investment policy? A few councils borrowed extensively in recent years to purchase commercial properties to provide investment income, but have had problems when investment returns failed to match expectations. Has your council made similar investments? If so, do returns look healthy?
There are three red flags to watch for which can indicate that your council’s finances are in serious difficulty. These are:
- Qualified accounts – your council’s accounts will be independently audited each year by one of the large audit partnerships. The auditor will issue an annual external audit report which will comment on the financial health of the council and may identify areas for improvement. External audit reports can be forbidding documents and it is probably not worth reading them in full, but it is important to know whether the auditor has “qualified” the accounts, i.e. identified one or more serious weaknesses that need addressing urgently. Instances of qualified accounts are still rare but have been increasing in recent years.
- Section 114 notices – if a chief financial officer (CFO) judges that his or her council is unable to set or maintain a balanced budget, he or she may issue a Section 114 notice. Such a notice is only issued when problems appear very serious, not because of a minor potential overspend. The notice gives the council 21 days to consider a response but during that time spending and other financial activity is suspended. A Section 114 notice implies that the council has failed to heed previous warnings and has not appreciated the seriousness of the budgetary position. It is usual for both the external auditors and government officials to be involved at this stage. Section 114 notices are thankfully still rare, but in recent times there have been well-publicised notices issued in Croydon, Thurrock and Slough. In order to help their finances, all three authorities have been allowed to increase their council taxes for 2023-24 by higher percentages than allowed under the normal referendum rules.
- Capitalisation directions – when a council gets into serious financial difficulty the obvious question is how to help them get out of it, and it may be that simply reducing expenditure will not be sufficient to get the budget back into balance. In such cases, minsters are reluctant to give cash bailouts but may issue capitalisation directions which allow specific revenue expenditure to be considered as capital, so that the council can borrow to fund it. Capitalisation directions may follow from Section 114 notices, but a notice is not always a prerequisite. During 2020-21 pressures caused by the pandemic triggered several capitalisation directions, but others have followed. For 2023-24 directions are expected for Slough, Croydon, Thurrock, Cumbria and Westmorland & Furness.
The past few years have been very difficult for local government, and many challenges remain. A recent survey by LGIU suggests that senior council officials’ confidence in the sustainability of local government finances is very low. Repeated one-year financial settlements have made long-term financial planning difficult, and the combined effect of a stagnant economy, high-inflation, demand pressures and problems in recruiting and retaining staff are adding to the challenges. Meanwhile, urgently needed reforms to the funding formula, council tax and business rates remain a distant prospect.
So, although a few authorities may buck the trend, at least in the medium-term we can expect higher council taxes, further cuts in services and reductions in reserves. No doubt the majority of councils will continue to muddle through, but we may see the need for some more high-profile bail-outs along the way.
Government provided an extra £1.55bn to help with the pressures of the pandemic in 2021-22 and further funding has been provided in 2022-23 to reduce council taxes for those in the lower bands and to provide targeted welfare support to low income families.
Despite additional funding, the extra burdens of the pandemic have added to the financial pressures faced by local authorities, and those pressures seem likely to increase as service demand remains high, the economy remains stagnant and higher inflation impacts upon the costs of providing services.
Further links and guidance
The Local Government Association’s A councillor’s workbook on local government finance, though a little out of date, is still helpful if you wish to explore the subject further. LGIU also publishes regular briefings and roundups on relevant issues.
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Collection: cost of living crisis
Many global economies are going through a ‘cost of living crisis’. This collection showcases the different components and the critical role of local government in the midst of these rising concerns. Read it here.
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