A taxing problem

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The UK’s current business rates system is not fit for purpose – it is unfair, inefficient, and overcentralised. In this paper, we propose a new business rates system that combines a land value and a business property tax. Our proposed system is fairer, more efficient, and gives more control to local authorities.

The current business rates system faces three deep-seated, overlapping issues.

First, they are economically inefficient as they tax economically productive activity at the same rate as unearned increases in land value. Improving a property leads to an extra tax liability, which effectively discourages property improvements.

Second, the system of redistributing tax revenue between local areas allows a few local authorities to gain from runaway growth while leaving others short of the cash they need to provide vital services. Meanwhile, Metro mayors, combined authorities, and the local government sector have been given greater responsibility and democratic accountability without greater tax raising and/​or spending control powers.

Third, while local authorities remain chronically underfunded, the current system does not redistribute enough to those who need it. Between 2009/​10 and 2019/​20, local authority core spending power was reduced by 16% and recent funding increases only plugged urgent gaps. The unfairness of the current retention system means that the overall pot of funding from business rates is misallocated, with poorer councils only protected if their business rates income in a given year falls by more than 7.5%. This means that essential local services face reductions in poorer councils, while wealthier ones are allowed to benefit disproportionately.

We test our proposed new system with an illustrative revenue-neutral modelling of the following rates and policy parameters:

• Replacing business rates with a two-rate property and land tax. We set a higher rate of 54% on commercial rental land values, levied on land owners, and a lower rate of 35% on rental property value, levied on the occupiers of commercial property. After initial implementation, we propose that local councils are given discretion over rates on commercial property, on a similar basis to council tax today, while the central government retains control over the rates on land value.
• Redistributing local government taxes. We propose that business property taxes be retained locally on a similar basis to council tax, but that land value revenue be redistributed across the country according to need. This simplifies the system overall with the complicated business rates retention system no longer required.
• Phasing in the new system. With the Covid-19 shock followed by the energy shock and the cost of living crisis, these reforms should be gradually introduced to avoid sharp changes in bills for businesses and local government funding.

Our illustrative policy modelling shows that replacing business rates with a two-rate system would yield the following benefits:

• Increased economic efficiency: Increasing taxes on windfall gains from land ownership while reducing taxes on building and improving commercial property would increase the economic efficiency of taxation. Extending land value tax to unused land (based on best-permitted use) and removing empty property reliefs would incentivise more efficient use of commercial land and buildings.
• Improved fairness for businesses: With a higher tax rate on the share of rateable value attributable to land value, the rate on property could be set substantially lower than current business rate multipliers. This means that businesses would see liabilities from investments and improvements that increase commercial property values.
• A fairer distribution: With a higher tax rate on land and land value concentrated in wealthier areas, particularly London, the new system supports levelling up by reducing overall tax levels outside of London. Around 75% of local areas outside of London would see an overall fall in their business rates. Runaway growth for the richest councils is also reduced under the NEF system, as councils would retain only the growth in the property tax – a significantly smaller share of rateable value in wealthier areas with high land values – allowing for greater redistribution within the system.
• Increased local authority control: Local authorities would be given control over business property tax on a comparable basis to council tax, which would mean far greater control compared with business rates today. This would provide increased control over local taxation, reducing reliance on Whitehall overall. It should also come with greater control over local reliefs and exemptions, allowing councils to better target incentives at particular activities, such as revitalising high streets and supporting environmentally friendly investment, balanced with the ability to set higher rates otherwise.

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