Marcus Buist argues that Scottish business rates distort economic activity by reducing incentives to improve properties and due to the lengthy gaps between revaluations and proposes abolishing the system, considering a number of alternatives.

Introduction

Although the UK as a whole is at last escaping recession, there is great regional disparity in the growth figures. Scotland has performed relatively well through all of this, but despite strong growth in some sectors the recovery remains uncertain.  It is clear that the current level of poundage in Scotland, though no higher than the level in England, has forced many firms to close, and hampered the ability of many other firms to save or to invest in restructuring the supply side of their business. A large number of empty commercial properties have become involved in a rates trap, whereby the revenue gain from returning them to the commercial market would be less than the amount they currently earn from any long term lease they may be under while sitting empty. The scheduled 5.6% rates increase from the first of April 2013, will exacerbate the problem, imposing an effectively arbitrary burden on private firms. Although the Scottish Government has determined to delay any reappraisal of business rates until 2017, it is vital that proper consideration is given to which reforms, if any, should be implemented. The substantive area for debate, however, remains the structure of local government finance.

Property taxation as a whole is essentially a Medieval and Victorian solution to the problem of local government finance, and is perhaps no longer appropriate given the increased demands on public spending and the changed business environment.  Additionally, it is unclear whether devolving powers over the level of taxation to local government would encourage fiscal responsibility or instead permit a short term binge of ‘tax and spend’ that would go unpunished at the ballot box. While local accountability and local control are at the heart of our philosophy, this principle is secondary to our desire for low taxation as a means of maximising personal freedom.  It is impossible to argue, from a truly liberal perspective, that semi-local socialist fiefdoms should be allowed to impose whatever burden they chose on taxpayers, or that this form of local control should trump control by the most local of all agents: the individual themselves.

Why Abolish Non-Domestic Rates?

The desolation of the Scottish high street is a social as well as economic tragedy.  Like council tax, business rates are levied on the basis of property value and not income. As a result, falls in consumer spending and profitability have no impact on the tax status of commercial properties. As town centre businesses operate the most valuable properties in proportion to their incomes, their share of the burden of rates is disproportionally great. The price of maintaining a presence inside towns and cities can become discouragingly high, leading to closures of ordinarily profitably stores. This exodus from the central business district further reduces the appeal of surviving businesses, leading almost inevitably to further closures and further unemployment. It is unsurprising that a sense of ennui and malaise should set in amongst local residents experiencing this process.

Property taxation requires regular revaluations of commercial property in order to accurately assess a fair tax bill. These valuations, however, are costly in both political and financial terms and so are routinely postponed.  Consequently, long term shifts in business activity and property value go unnoticed by the assessors, further distorting the link between ability to pay and the actual rates payment. A similar problem has emerged with the council tax system, which bases its charges on the domestic property market of 1991. The subsequent boom in property asset values was uneven across the country, though particular pronounced in the south east of England, London and Aberdeen. Homes in these cities are charged on the basis of valuations they have long since superseded. Businesses and homes located in beyond the areas that most immediately benefited from the credit bubble might well wonder why the tax system should deny them a competitive advantage through lower rates bills.

The retail letting market in Scotland has moved in the direction of long term leases to chain stores. These leases are often high value, and thus represent a sustainable means of paying the rates. As consumer demand falls however, and firms seek to consolidate their business, many of these stores will be closed even while the lease is maintained. The high level of poundage prevents long term rental agencies from returning their empty properties to the market at lower rental values. The present system encourages these landlords to keep existing leases in place in order to raise sufficient sums to pay rates, even if that property remains vacant. These leases remain unbroken as rental agencies are unable to find new customers for their properties, as prospective business are both unable and unwilling to pay the overhead cost of rates.  The business demand for property in recession is all too often depressed bellow the fixed costs of rates, and as with all interference with natural market pricing, business rates suppress the latent urge to regenerate empty properties. While there are reliefs offered to reduce the rates trap, these have been recently curbed from a 50% reduction to a new regime whereby firms are liable for a full 90% of the charge.  CBI Scotland have rightly labelled this “a tax on distress” as it hampers the efforts of new enterprises to regenerate business areas that been made vacant.

Property taxes are out of step with modern business environments. Large profits may be made in industries with a lower rateable incidence than less profitable businesses that are still dependent operating out of rateable properties. The total effect of NDR skews the market and places a regressive burden on many key industries. This economic distortion not only blunts growth, but harms the social fabric by penalising small and traditional businesses. While the promotion of low taxation is vital for the creation of jobs and wealth, market distortions created through an uneven tax base and a complex system of reliefs are not to be welcomed.  As the current system of reliefs is complex; the administrative cost to business in determining which reliefs are available is considerable. In addition, taxpayers are required to fund the administrative cost to the Scottish Government and unitary authorities. When spoken to, few council workers in either finance or business rates departments seemed to understand even the basic outline of how business rates are collected; a finding which confirms the present inadequacies in the structure of local government finance. Equally, the tax advantage for charities damages the ability of for-profit business to compete on the high-street. This can lead to high-streets being stripped of all shops bar those who operate with charitable status. The current patchwork of reliefs distorts the market by favouring certain industries for political reasons. The Renewable Energy Relief, for instance, encourages the construction of inefficient forms of renewable power at the expense of potentially cheaper alternatives. This relief benefits the already wealthy over smaller businesses, which are less able to afford entry into the renewables market. The cost of multiple reliefs comes at the expense of lower marginal rates of poundage which would be of benefit to a greater number of businesses. While the Scottish Government may wish to boast that the reliefs programme is more generous than equivalent schemes in England, this claim has to be balanced against the reality that this political gesture comes with the opportunity cost of fairer taxes for everyone.

Conversely, any desire for reform must be measured against the political and financial cost of restructuring the tax system. Tax simplification can easily be labelled a tax increase by political opponents, as in the case of the “pasty tax” and the “granny tax” following the 2012 budget. The desire for reform of the operation of reliefs must be measured against considerations that rural areas and selected small businesses benefit from targeted reliefs, and that challenging these business perks, if handled indelicately, could be politically difficult. Many of these businesses are vital community hubs; closure of these businesses due to higher rates bills would have considerable social implications.  Any reforms would have to be piloted with considerable care in order to ensure that they carry public opinion with them. The political dimensions of reform will most palatable if marketed as a means of saving jobs and high streets from continued decline, emphasising the positive role for economic freedom in revitalising Scotland’s excluded towns. Policy implementers face a further dilemma, as once there is common agreement on the need to abolish rates, the issue of with what should they be replaced emerges. As no option offers an immediate panacea for growth and revenue, the decision as to which policy option should be selected is difficult indeed.

The Next Steps Forward: Options for reform

The rates system is unfair, and illiberal. Non-domestic rates should be replaced with an alternative form of business taxation based on income, land value or total sales. These alternatives could potentially use existing information such as VAT returns or corporation tax receipts to calculate the local tax due. This should ideally save additional administration costs that would be necessitated by taxing business on some new basis.  It might be possible to abolish business rates altogether if a proportional increase was made to the headline rate of corporation tax or significant cuts were made to public spending. This could further save on administration costs and the dilemma of double taxation of income. Unfortunately, this model would eliminate the possibility of local control and accountability.

Abolition with an Increase in Corporation Tax:

Such a model provides the greatest administrative savings for both private and public sectors. Moreover, the corporate tax model is more responsive to market forces than business rates. Resultantly, businesses would be more able to absorb economic shocks, while providing a proportionally fairer rate of tax for the high street. Conversely, increases in headline rates of corporation tax may discourage business investment in Scotland, putting certain Scottish businesses at a competitive disadvantage when compared to other EU and UK companies. Further, this option jars with the present localism agenda, taking little account of regional variations or preferences. Regrettably, tax avoidance by major firms might well discredit this form of taxation, as small and medium sized enterprises perceive themselves to be paying an unfair proportion of the overall tax take. The greatest concern by far remains that firms might relocate elsewhere or decline to invest further in any Scottish centres of industry. Scotland’s market share of UK wide FDI employment has risen in recent years to 16% of the UK total, with 30% of this investment directed at manufacturing. Scotland is therefore highly dependent of foreign direct investment; any shift in investment behaviour away from manufacturing in Scotland would be harmful Scottish employment and prestige. It might be possible abolish rates outright without raising taxes, but only if the Scottish Government or 32 local authorities were prepared to find £2.252 billion in savings, which would cover the tax take for 2011-12. While public spending at national and local levels remains wasteful, this reduction in would still be a considerable undertaking. There is currently little appetite in Scotland for further reductions in public expenditure, beyond the still popular reductions in welfare spending being pursued at Westminster. This option is equally impractical and sadly must be dismissed at the present time.

Business Income Tax

BIT shares in many of the advantages of the previous option; however, it could additionally be altered in line with local decision making. Despite these advantages, intelligent solutions would have to be found to avoid the problems of double taxation of the same income at national and local level. Furthermore, taxes levied on profits are relatively easy to avoid and evade. Tax avoidance not only robs government of revenue, but is unfair to businesses that pay the intended amount. BIT could prove to be distortionary, favouring large companies who are more readily able to advantage of loopholes in tax policy. As a local tax however, it would remove the need for raising the marginal level of nationwide taxes. Further, it might induce a culture shift in local authorities, as they are weaned off dependency on block grants. Central grants encourage a statist mind set, by creating a political pressure for ever more spending that seems, at least to local electors, to be ‘free’. When councils are required to raise their own revenues, incentives emerge to be efficient with their resources in order to tax their residents less.

Land Value Tax

Although LVT is essentially a property tax, it is levied on the value of the site, and not the capital value of the property built over it. Consequently, the tax penalty for improvements is removed.  Taxes, when levied on income, naturally discourage productive enterprise; a land value tax by contrast punishes economic inactivity. Beyond the economic impact of such a reform, there may also be a resulting change in values. The philosophical underpinnings of LVT are largely conservative, valuing hard work and individual enterprise in the tax code. Though it can be postulated that the tax system should be morally neutral, these are undoubtedly positive behaviours that are essential for the functioning of a truly liberal society. As this is reform would represent a tax reduction and not a direct subsidy, its moral favouritism partly justified.  The practical points of implementation however, may prove more difficult. It is incoherent to imagine how the value of a site can be considered as being distinct from the improvements made around it; in essence all property taxes have to factor in the capital value of the property being taxed. It would be absurd to assert that the values of sites in commercial city areas are worth equivalent sums to sites in deprived or rural areas. Therefore, implicit in LVT is a further burden on prosperous or commercially viable business sites which are necessarily more valuable. Certain industries, such as agriculture are land intensive, and might be rendered unviable by this shift in taxation. Nor is it clear that once taken out of productive use these sites would be returned to economic activity. Such pressure on rural areas could result in land having to be sold for development, harming green belt or rural areas. It is doubtful whether LVT would aid town centre regeneration, as non-domestic rates already penalise the owners of vacant properties, containing congruent incentives to maximise profit over the value of property. It is the long term lease arrangements in combination with high fiscal overheads that prevents the return to commercial use, and these problems could not be ameliorated by this selected model of taxation. Indeed, as property taxes as a whole discourage landowners from letting properties to new owners as the rental income is often lower than fixed sum they pay in rates; this problem may well be aggravated by a land value tax. Moreover, the policy would require routine revaluations which are politically treacherous. Without these revaluations however, accurate taxation of land would be impossible. LVT would prove a politically and economically disruptive policy that suffers too many of the faults of NDR to be worth the cost of reform.

Local Sales Tax

A local sales tax could be modelled on, and take advantage of the existing system for calculating and collecting VAT. It should therefore have only a minimal impact in terms of business administration costs.  VAT contains effective anti-avoidance measures, by compensating businesses for tax already paid. As such, businesses have an incentive declare their full liability. By comparing LST returns against VAT returns, local finance departments could be relatively certain that they were being paid the full sum due. Unlike VAT, it would be possible to operate LST without repaying firms for the tax already paid, reducing further any manipulation of the tax system by predator firms. The standard VAT exemptions could broadly be maintained, including the threshold for payment, this would effectively act as an allowance for small and rural businesses. Sales taxes do not penalise either work or capital accumulation, having the advantage of being the most economically efficient method of raising revenue. In the long run, this will provide for higher growth rates and employment. As income and capital taxes reduce the ability of companies to restructure their production, they greatly slow the ability of an economy to recover from an economic recession. Unlike taxes on business, sales taxes are more readily noticed by the public; as a consequence this option best supports local accountability.

Why Localism?

Devolving power over local government finances is usually met with only lukewarm support. In Scotland, prominent business groups, such as the CBI have opposed it as a measure of reform. As with the community charge, there is a risk that centre-left authorities, of which there are many in Scotland, raise spending in the run up to the introduction of the new tax. The resulting tax levied on businesses would be unexpectedly high, with the political fallout damaging the central rather than local government. This could result in the whole package of reforms being abandoned, with damaging consequences for Scotland’s high street. If voters do not change their vote according to the actual policies of their council, then the devolutionist agenda will have failed to provide the keystone of accountability. These problems could potentially be resolved by introducing a nationwide cap on the level of poundage. Rate capping is an established policy in Scotland, having been applied to domestic rates through-out the 1980s. This would prevent local authorities from raising their charges above a certain amount; ensuring individuals would be protected from irresponsible behaviour by certain authorities. A further measure of mandatory spending restraint during the transition period may also be necessary in order to avoid opportunist increases in taxation justified by higher spending.

By contrast, there is also great opportunity for certain local authorities to pursue measures to increase our freedom from taxation, as councils compete to attract businesses to their area. Not only would tax policy be changed, but additionally the other policies of local authorities towards businesses and consumers. Transport and parking present major problems for town centre shoppers, often these difficulties are the result of a local decision that was made regardless of the impact it might have on the business community. With greater financial dependence on these same businesses, it will be in the interests of ever council to ensure that local enterprises continue to flourish. Simultaneously, the dependence on central authority will be reduced. With the reduction in financial powers over local authorities, these bodies will be free to innovate with new methods of providing public services. Scotland lags far behind Europe and the UK in the structure of its public bodies, freedom to change will at least provide a certain impetus to reform in the interests of higher quality.

The pooling of resources nationwide is a palpably unfair policy. The popularity of localism must be that money raised in one area should be spent in that same area. Major cities such as Edinburgh and Aberdeen, and rural authorities such as Perth and Kinross lose millions of pounds in revenue to both the Scottish Government and to spendthrift neighbours. This is partly concealed in the official figures which show revenue collected by local authorities gross with any public utility revenues they may collect from other authorities. This method of calculating the tax take by local authority is used for Fife; South Lanarkshire; Highland; Renfrewshire; Falkirk; and West Dunbartonshire. In the case of South Lanarkshire, when revenues are collected net of public undertakings, an almost balanced account is revealed to include a shortfall of £153 for the financial year  2011/12 rising to £165 million in 2012/13. This is a deficit that must be paid for by the hard-pressed rate payers in other authorities. While this generous donation is coerced from other councils, net recipient authorities will make little attempt to be prudent with their spending. When this fact is fully known, residents cheated of revenues by nationwide pooling of resources will recognise the need for powers and resources to be devolved.

Final thoughts

It seems clear that the best interests of Scotland demand reform of business rates. That power should be devolved is a vital part of the process of transforming the culture of Scottish political life; centred on the principle that power should be held closest to the people that it affects. Local authorities have endured decades in which there has been an erosion of their powers and responsibilities. It is no coincidence that as the size and impotence of local government has grown they have seemed ever more distant and less able to govern. Restoring the place of local government in Scotland is predicated on greater financial independence and freedom to respond to diverse local social and business environments. It may be possible to avoid the pain of a new tax if business rates are retained but with significant alterations to their structure. If property taxation is to be implemented, it must be coordinated with real market conditions and values rather than the results of long redundant revaluation reports. Moreover, any system of reliefs must be considerate of the impact that such policies have in disrupting the overall market. The renewables subsidy, which offers discounts of up to 100% off rates, must be discarded, and many other rates amalgamated so as to offer a clearer picture of how much firms really owe. Yet ultimately, this patchwork solution to local government finance will never be as satisfactory as the abolition of rates. Of the replacement options, a local sales tax is preferable to any local corporation tax. Sales taxes carry less of a fiscal deadweight to private enterprise, and are therefore more likely to promote the values that are necessary for success. Moreover, a sales tax linked to VAT returns will be more likely to reduce avoidance, ensuring both a more equitable environment for firms that do pay the amount due and maximum returns for the community.  The level of sales tax would be held down by the Scottish Government nationally, which would ensure investors and foreign business could be guaranteed a reasonable tax climate, while also allowing prudent authorities to do yet more to protect town centre shops. Scotland’s towns and small cities have for too long been held back by the heavy burden of business taxes, tax freedom will allow for local renewal and a release of Scotland’s enterprising and creative potential. It is in this spirit that I consider reform of rates an urgent national priority.