The separation of capital and revenue is one of the key rules of local government finance. If you sell the school playing fields (capital), you can’t spend the proceeds on teacher’s salaries (revenue), but you can spend it on a new sports centre (also capital). The idea of course is that teachers need paying every year and so the one-off lump sum from the playing fields would run out at some point, leaving a hole in the revenue account.
Expenditure is capital if it creates a fixed asset in accounting terms, i.e. something that provides service or financial benefits for longer than one year. The government also rules that certain other expenditure is capital – such as grants to other bodies towards their own capital expenditure. Income meanwhile is capital if it comes from selling something that would be capital to buy.
Now, the government has recognised for a while that expenditure can be one-off but not meet the rules to be classed as capital. Redundancy costs are a good example of one-off revenue expenditure that will save revenue money in future. Training staff on a new IT system that increases efficiency is another. Local authorities are therefore currently permitted to use capital income to cover these costs under the “flexible use of capital receipts” regime. This is due to expire in 2025 but could easily be extended.
But revenue is still very tight for many local authorities, with costs rising faster than income, so the government is exploring other ways to loosen the revenue/capital divide. These include widening the types of one-off expenditure covered by the existing flexibility. For example, inflation has been very high recently, but is expected to fall, and so you could call a proportion of the cost increases one-off. The same goes for variable rate interest costs. As long as the costs are truly one-off, this seems an easy win.
Capital, but not revenue, expenditure can also be funded from borrowing. This is only temporary funding though, as lenders eventually require loans to be repaid, and so the permanent financing tends to come from revenue, but spread over many years via Minimum Revenue Provision (MRP). Government is exploring the option of allowing one-off revenue costs to be funded from borrowing if an authority has run out of capital receipts as well as revenue income. Paying for today’s costs many years into the future is only prudent if those upfront costs will bring long-term benefits, so this option will need to be carefully considered.
Some local authorities have borrowed heavily and invested the money in property in recent years, despite the obvious risks involved and claims by Government and CIPFA that it was against the rules. A third flexibility mooted by the Government is to class the proceeds from selling these investment properties as revenue rather than capital income. Presumably they would require the debt to be paid off first, with only the profit going into revenue reserves. But this could be seen as rewarding those local authorities that have pushed the envelope against government advice, so might be a step too far for some.
Either way, it is clear that government is open to novel suggestions for solving the local authority funding crisis – i.e. ideas that don’t involve national and local taxpayers stumping up ever more cash.
The government’s call for views on capital flexibilities is available here. We will send our formal response to our clients shortly, but please get in touch if you would like to share your views for inclusion in our response.