The COVID-19 crisis is having immediate effects on councils’ budgets as a result of increases in spending on local services and reductions in income from sales, fees and charges (SFCs) and commercial activities. However, the crisis will cast a longer shadow on councils’ finances. First, reductions in council tax and business rates revenues collected this year will feed through to budgets over the next three years. Second, some COVID-19-related spending pressures and reductions in revenues are likely to persist, and indeed could grow in a few cases. This report considers how councils’ revenues and spending needs may evolve over the period to 2024–25, accounting for both the impact of COVID-19 and the pre-COVID funding outlook.

It is important to note up front that the next few years are particularly uncertain economically and fiscally. How high will unemployment rise, how quickly and fully will the economy recover, and what will this mean for councils’ revenues? To what extent will changes in service provision made in an effort to control the COVID-19 epidemic continue, and what will this imply for service delivery costs? Definitive answers to these key questions are lacking. And even putting the COVID-19 crisis to one side, changes in service demands and costs would be uncertain, given the range of factors that influence them, including trends in ill health, income, wages and productivity. We therefore look at a number of scenarios for the financial pressures councils could face (lower, middle and upper), drawing on councils’ own forecasts, scenarios from the Office for Budget Responsibility (OBR) and other sources. We also highlight a number of issues we feel unable to analyse quantitatively that local and national government may wish to consider when developing plans for the next few years.

A £3bn+ shortfall arising in 2020–21 …

Our first report utilising councils’ forecasts of the impact of the COVID-19 crisis on their non-tax income and spending in 2020–21 estimated that there was a £2 billion gap between the funding provided and the pressures councils forecast. Updated forecasts from councils lead to a very similar estimate. This figure remains highly uncertain though and depends on the extent to which costs fall and income recovers during the remainder of the year: councils’ forecasts imply overall monthly pressures between August 2020 and March 2021 are around 46% of those faced between April and July 2020, but they could be higher or lower.

Our view is that risks are skewed to the upside though, for several reasons. First, councils made these forecasts before local lockdowns (with the exception of Leicester) and the new more stringent national restrictions were introduced and before the recent upsurge in COVID-19 cases, which may put further upwards pressure on spending and downwards pressure on income. Second, councils have increased their forecasts of full-year pressures as time has gone by. And third, as of July at least, there is little sign of abatement in the monthly pressures councils report facing. If monthly pressures average two-thirds of those faced between April and July (rather than 46%), the in-year shortfall in funding for spending and non-tax income pressures would be £3.1 billion (rather than £2.0 billion) if no further funding were forthcoming. A fourth less easily quantifiable upside risk relates to outsourced services such as leisure centres, where evidence suggests councils are unlikely to be including the full income losses and cost increases being experienced by service providers.

In addition to the pressures we have previously examined, councils are also forecasting that they will collect £12.0 billion less in business rates and £1.5 billion less in council tax this year than they were initially planning. However, over 80% of the reduction in business rates reflects the impact of central-government-funded waivers for the retail, hospitality and leisure sectors, and councils only generally keep half of business rates revenues anyway. After accounting for this and the fact that councils are likely to recoup some of the missed business rates and council tax payments later on, falls in business rates and council tax revenues this year are forecast to actually cost councils £0.6 billion and £0.7 billion respectively. Temporary changes to accounting rules will allow councils to spread these impacts over three financial years: 2021–22, 2022–23 and 2023–24.

Central government is providing extra funding to help pay for reductions in council tax bills for low-income households. However, we estimate that this still leaves a net £1.1 billion cut in funding over the next three years as a result of falls in local tax collections this year. Together with the £2 billion shortfall in relation to spending and non-tax income pressures, councils’ forecasts for COVID-19-related financial pressures arising this year exceed available funding by around £3.1 billion. The final figure could be higher or lower – although, as highlighted above, our view is that there is more risk of it being higher. As discussed in our previous report, this uncertainty, together with the highly variable impact across councils, makes addressing this shortfall via up-front grant funding difficult.

...and a growing underlying funding gap

The outlook for local government revenues and spending needs in subsequent years is also highly uncertain. However, without additional funding and/or flexibility over council tax rates, it is highly likely that councils will have insufficient revenues to keep pace with rising spending needs.

This was true even before the COVID-19 crisis. Increases in the demand and cost of key services, most notably adult social care services, were always likely to outpace increases in local tax revenues if council tax increases are effectively capped by the default 2% referendum limit in future. This reflects the impacts of a growing and ageing population, the (welcome) survival of people with more complex social care needs for longer, increases in the number of children requiring protection or care, and increases in the costs of service provision driven by the combination of substantial planned increases in the National Living Wage and low productivity growth.

The COVID-19 crisis is likely to worsen some pressures but may lessen others. Higher unemployment is likely to push up the number of households entitled to council tax support, reducing the amount of tax collected by councils. An increase in business rate appeals and higher rates of business failure are likely to reduce the yield from business rates. Other income and spending pressures could also persist to some extent. On the other hand, lower inflation and slower growth in average earnings (and hence the National Living Wage) could dampen some cost pressures.

Our medium-term analysis makes use of three scenarios – lower pressures, middle pressures and upper pressures – where we vary assumptions on revenue growth, demand growth and cost (and productivity) growth.

Our middle scenario suggests that the spending needed to maintain services at their pre-COVID-19-crisis level could exceed available revenues by £3.3 billion in real terms (£3.5 billion in cash terms) in 2024–25 if council tax is increased by 2% a year and grant funding is increased in line with inflation. Slower productivity growth, bigger increases in demand for children’s services, and larger and longer-lasting impacts of COVID-19 on incomes and costs result in a gap of £7.4 billion in real terms (£7.9 billion in cash terms) in our upper scenario. Councils may also have to find an additional £0.3–£1.2 billion in funding for higher pension contributions from April 2023 onwards given the latest OBR scenarios for the stock and commercial property markets. And benchmark prices used previously in analysis by the Competition and Markets Authority and the Local Government Association suggest councils were underpaying social care providers by
£1.2–£1.4 billion in 2018–19, potentially growing to £1.4–£1.7 billion in real terms by 2024–25. Such underpayments might eventually pose problems for sustainability.

How to tackle this funding gap?

One option would clearly be not to. But that would lead to further cutbacks to service provision, on top of those driven by a 17% reduction in net spending on services between 2009–10 and 2019–20. Outside of social care, spending on many services has fallen by more than 40%, and an increased fraction of spending is concentrated on those with the most acute needs, such as children in care, adults with severe disabilities and the homeless.

If central government did want to provide further funding, a range of options are available, either separately or in combination. First, the referendum limit on council tax could be raised or scrapped, with each additional 1 percentage point increase every year for the next four years raising approximately £1.2 billion by 2024–25. However, councils serving more affluent areas can raise more from council tax than those serving more deprived communities (especially outside London). This means that unless there were redistribution of existing funding, reliance on council tax increases to meet rising spending needs would see increasing inequalities between more affluent and more deprived areas.

The second approach – increasing grant funding – would allow central government to target funding at more affluent or more deprived areas as it saw fit by varying the formula used to allocate the grants. However, such an approach would mean less discretion over tax and spend levels by councils, and require higher taxes, lower spending or more borrowing by the national government.

Third, the government could give councils additional tax-reform and/or tax-raising powers. This could include additional powers over council tax and business rate exemptions, discounts and reliefs, but also new local taxes. Such an approach makes more sense, the greater the weight placed on giving councils incentives to grow local economies and tax bases and discretion to vary tax and spending levels. But as with reliance on council tax increases, it is less sensible the greater the weight placed on redistribution and consistency of funding and service provision across the country.

Key findings

  • Council tax is the largest source of revenues for local government, funding approximately half of council spending. Councils will raise less in council tax this year than the £27.9 billion they had budgeted, due to failed payments and the cost of providing discounts on bills to residents with low income. Accounting for the likelihood councils will recover some lost income, and for an additional £500 million provided by government to fund council tax discounts, we project councils to lose out on £493 million in council tax revenues in our central scenario. This loss will be spread across the next three years, affecting councils’ main budgets from 2021–22.

  • Councils also forecast they will collect £12.0 billion less in business rates from local businesses this year. The vast majority of this is due to additional reliefs this year which have reduced the bills for many in the retail, leisure and hospitality sectors to zero. Central government is compensating councils for the cost of these reliefs. Councils have also deferred some payments and faced other losses. Accounting for the likely recovery of some of these losses and that, like business rate revenues, these will be shared between local and central government, we project councils to lose out on £602 million in retained business rates revenues in our central scenario. As with council tax, this loss will affect their main budgets in the three years from 2021–22.
  • Councils also forecast spending pressures of £5.0 billion and non-tax income pressures of £2.9 billion this year. We estimate that government has provided £4.2 billion in grant funding and a further £1.6 billion in other non-grant support to help councils manage these pressures. Taken together, this implies an in-year funding shortfall of approximately £2 billion in council budgets this year, although uncertainty about pressures and funding availability over the remainder of the year means there is scope for the gap to be much bigger or smaller.

  • Turning to the medium-term outlook, our middle scenario implies that councils’ revenues will increase by 16% in cash terms and 4% in real terms between 2019–20 and 2024–25. This is under the assumption that council tax rates are increased by 2% a year and grant funding is increased in line with inflation from 2021–22 onwards. It also accounts for an increase in the cost of council tax support and downgrades to business rates revenue forecasts in line with the central scenario in the OBR’s July 2020 Fiscal Sustainability Report.
  • Our middle scenario implies that councils’ spending needs will increase substantially faster: by 23% in cash terms and 11% in real terms between 2019–20 and 2024–25. This assumes demand for adults’ and children’s social services increases by 2.2% and 2.0% respectively, with demand for other services increased in line with population growth. Unit costs are assumed to grow largely in line with earnings, implicitly assuming zero productivity growth, in line with post-2010 trends. Changes in working and shopping patterns are assumed to lead to income from transport services falling by 10% permanently, increasing net expenditure. But other COVID-related costs are assumed to have fully abated by 2024–25.

  • These projections for revenues and spending imply a notable funding gap. They suggest that councils would need an extra £3.3 billion in real terms in 2024–25 to maintain services at their 2019–20 level. They would also need an extra £2.5 billion, £2.1 billion and £2.9 billion in 2021–22, 2022–23 and 2023–24. The fact that the gap initially falls is because our scenario assumes more of the revenue falls and spending increases associated with the COVID-19 crisis persist in the shorter than longer term.

  • These figures are highly uncertain though and will depend on how revenues, and service demands and costs, evolve. Our upper scenario incorporates the effects of a slower economic recovery, faster demand growth, bigger wage increases to maintain headroom above the National Living Wage, falls in productivity of 0.5% a year, and larger and longer-lasting increases in costs as a result of the COVID-19 crisis. It implies a funding gap of £7.4 billion in 2024–25. However, even with a stronger economic recovery, slower demand growth, productivity increases of 0.5% a year, and no lasting effects of COVID-19 on costs – a concurrence of good outcomes that we consider unlikely – we estimate a funding gap of £0.5 billion in 2024–25 in our lower scenario. We therefore consider it very highly likely that councils will be unable to maintain pre-crisis service standards without additional funding.

  • Two further spending pressures may also be worth considering. Based on the prices councils pay for adult social care services and benchmark prices needed to meet costs and provide a suitable return on capital for suppliers, councils underpaid by £1.2–£1.4 billion in 2018–19. This could increase to £1.4–£1.7 billion in real terms by 2024–25. Councils may also need to increase their pension contributions as a result of the COVID-19 crisis. Falls in asset prices alone could increase costs by £0.3–£1.2 billion in real terms for 2023–24 onwards.