Tax Increment Financing – like other forms of hypothecated taxation – has long horrified the Treasury. But Stuart Watson finds attitudes changing, in the Exchequer as well as at Westminster and Holyrood

When Nick Clegg announced new freedoms for councils to raise revenues last month, he did so with a slightly apologetic air: “This may not make the pulses race, even at a Liberal Democrat conference,” he quipped.

However, his pledge that the coalition would introduce legislation to allow Tax Increment Financing (TIF) may have raised the temperatures of Treasury officials (see news pages). Under TIF, councils will be able to borrow to fund infrastructure improvements that foster economic development, repaying the loan out of the consequently higher business rates revenues. Proponents of the system argue that it is essential if spending on economic infrastructure is to be maintained in a climate in which property investors are no longer able or willing to put up cash in advance to enable development. However, it is a form of hypothecated tax – a levy from which the proceeds are ring-fenced for a particular purpose – and hypothecation has long been regarded as a dirty word at the Exchequer.

While hypothecated taxes are common in other parts of the world – particularly in the USA – in the UK the Treasury has always been reluctant to concede control over the purse strings. Proceeds from most of the taxes that appear to be hypothecated, such as national insurance and road tax, have in fact been subsumed into the general revenue stream.

Clegg’s announcement on TIF is just the latest sign that attitudes within government are beginning to change. The Labour administration permitted the creation of the Crossrail levy (see box) and Business Improvement Districts (BIDs), within which – given a positive poll among local businesses – a precept is placed on business rates to fund local environmental improvements and marketing.

Nowadays, progress is hastening. Last week the Scottish Government gave the go-ahead for an £84m TIF scheme designed to fund investment in the regeneration of Edinburgh’s waterfront. Meanwhile, Boris Johnson and the Tory-dominated umbrella group London Councils have lobbied for the freedom to launch TIF schemes. This willingness to consider hypothecation is driven partly by ideology – localism makes little sense without some degree of freedom for councils to raise and spend money locally – but also by more practical considerations:“The tighter public finances become, the more you would expect government to come forward with any bright idea they can to minimise the impact on public services,” says Tony Travers, director of the Greater London Group at the London School of Economics. “The Treasury will always want to avoid conceding hypothecated revenues, which is not to say that the exigencies of public spending cuts won’t convince ministers that hypothecation is a price worth paying.”

For his part, Nigel Keohane, head of research at think-tank the New Local Government Network, is excited at the prospect of more revenue-raising powers for local authorities: “We can be confident that it will succeed,” he says. “It has been successful in the US. It could be a very significant step in localising the funding system.”

Meanwhile, opposition in the Exchequer to at least some limited form of hypothecation appears to be weakening: officials and ministers like the fact that the TIF model focuses on funding investments that will stimulate economic development. While Treasury officials are still suspicious about the risks of hypothecation – they argue it can lead to a loss of fiscal control and a less sensible allocation of resources, as well as distorting markets – in private they admit that they are prepared to balance the risks against the potential benefits on a case-by-case basis.

Paul Hackett, a former Communities and Local Government (CLG) special adviser and now director of think-tank the Smith Institute, says that in the past the Treasury frequently talked about the barriers to TIF, but “something has changed now. People are realising that it’s not quite that frightening and they have more trust and confidence in local government to do it.”

The Birmingham and Black Country City Region, a partnership between West Midlands local authorities and other public bodies, has put various versions of its TIF scheme in front of ministers and officials over a period of two years. Project director Simon Murphy explains that the city-region hopes to use TIF to fund transport schemes and the regeneration of the former car plant at Longbridge, and he’s found central government receptive to the idea: invited to join a CLG/Treasury working group on TIF, the city-region found the process “very challenging, positive and constructive”.

Hypothecation is a popular idea with the public, which likes to see a clear link between its tax bill and the resulting public investments. John Whiting, head of policy at the Chartered Institute of Taxation, says this will attract ministers to the concept as it makes taxes easier to “sell” to the population. But many in central government are reluctant to let councils expand hypothecated tax schemes. In August, the Daily Telegraphcarried a story that several councils were set to follow Nottingham’s lead in imposing what it called a “stealth tax on motorists” – a scheme to fund transport infrastructure improvements through a workplace parking levy. The following day, the newspaper was told that transport secretary Philip Hammond had asked officials to draft rules to make such schemes more difficult to implement.

Tom Clougherty, executive director at think-tank the Adam Smith Institute, believes any change of attitude to hypothecation among Treasury officials is only skin deep: “I think George Osborne is not as opposed to hypothecation as previous chancellors, but there is no indication that the department’s mindset has changed,” he says. Clougherty believes that the Treasury will allow little in the way of hypothecation – and “that’s a good thing”, he says: he argues that ring-fencing tax revenues restricts government’s freedom of manoeuvre, and leads to a potential mismatch between the money required for a project and the funds available for it. “Although hypothecation is appealing to the public, it’s not a very good idea,” he says.

For Tony Travers, though, the disadvantages are dwarfed by the extreme pressure on public finances. There will be more efforts to introduce hypothecated taxes, and some of them will succeed, he says: “The Treasury is powerful, but not all-powerful.” ?

Hypothecation in action: the Crossrail levy
Since April, businesses across London have been expected to cough up for the UK’s latest hypothecated tax. Business rate payers in the capital whose premises are valued at more than £55,000 are now required to pay an extra 2p for every £1 of rateable value, in order to defray part of the cost of Crossrail, the £15.9bn East-West rail link that is scheduled to become operational in 2017.
The business rate supplement will raise £4.1bn of the £7.7bn contribution to Crossrail slated to come from the Greater London Authority (GLA). It will remain in place until the borrowing that it finances has been repaid – a period currently estimated at 27-28 years.

The GLA argues that London’s non-domestic ratepayers should contribute towards the project because they will be amongst the biggest beneficiaries from the scheme, which is expected to generate £42bn in economic benefits. However, the levy has been criticised by some business bodies. Last year the British Retail Consortium said that it was “ill-timed” given the prevailing tough trading conditions.

In January, London Mayor Boris Johnson raised the threshold at which businesses become liable for the tax by £5,000, exempting 4,000 small firms which, he said, would otherwise have shouldered a “disproportionate” share of the burden.

Written by Stuart Watson, CSW