The next occupant of Number 10 will find the welcome mat is frayed and the fiscal cupboard is bare. A breaking report from the Treasury’s internal working group, obtained by this newspaper, reveals a staggering £9bn black hole in council tax revenues across England and Wales. Local authorities, already stretched by social care costs and rising inflation, are buckling under the weight of a system that was never designed for the 21st century. The Treasury, in a desperate bid to avoid a wave of municipal defaults, is now exploring new fiscal powers that would sit outside the European Union’s state aid rules which, post-Brexit, still cast a long shadow over Whitehall’s ambitions.
Let us be clear: this is not a crisis of immediate liquidity, but a structural rot. The council tax system, a relic of the 1990s, is indexed to property values from 1991 in England and 2003 in Wales. House prices have soared, but the bands have not been revalued. The result is an inelastic revenue stream that falls short of the escalating demands placed upon it. The Institute for Fiscal Studies calculates that if council tax had kept pace with house price growth, local authorities would be sitting on an additional £9bn. Instead, they are turning to central government with outstretched hands.
The Treasury’s exploration of new fiscal powers is a fascinating, if dangerous, game. The EU’s state aid framework, which the UK has largely replicated in its own subsidy control regime, prohibits selective financial advantages to specific sectors or regions. But the Treasury is now eyeing a mechanism that would allow it to grant fiscal flexibilities to struggling councils without triggering state aid challenges. This could involve a new form of “fiscal devolution” that allows councils to levy local sales taxes, tourist taxes, or commercial property surcharges. The logic is sound: if you can’t raise the taxes that people pay on their homes, tax the people who visit them or the businesses that profit from them.
But here is the rub. The market will not wait for Whitehall to untangle this knot. Gilt yields have been volatile as investors price in the risk of further fiscal deterioration. The 10-year gilt yield, already elevated due to stubborn inflation and the Bank of England’s tightening cycle, could spike if the Treasury is perceived as losing control of local government borrowing. A default by a large authority like Birmingham or Manchester would send shockwaves through the UK’s municipal bond market, which remains opaque and illiquid. The capital flight we saw in the wake of the 2022 mini-budget was a warning. A repeat could permanently damage London’s reputation as a safe haven.
There is also the question of moral hazard. If the Treasury rides to the rescue of every council that overspends, where is the incentive for fiscal discipline? The answer, I suspect, lies in the political calculus. A Conservative or Labour government facing a cost-of-living crisis cannot afford to be seen as the party that let the bins pile up and the care homes close. The new PM, whether it be Sunak, Starmer, or another, will have to choose between raising taxes nationally, cutting spending elsewhere, or allowing local authorities to turn the screw on residents and businesses.
The most likely outcome, in my view, is a messy compromise. The Treasury will grant limited fiscal powers to a few pilot councils, allowing them to impose a local tourist tax or a small commercial rate surcharge. This will buy time, but it will not solve the underlying problem. The council tax system needs a fundamental overhaul: revaluation, more bands, or abolition in favour of a proportional property tax. Until then, the £9bn gap will only grow, and the next PM will find that the biggest crisis is not the one on the doorstep, but the one on the spreadsheet.
