6 March 2017

Business rates are locked in the past

By Thomas Aubrey

Most people who work in business and government have probably played the game Monopoly at least once in their lives. In the UK version, Mayfair commands the greatest rent of £2,000 with a hotel, compared to only £450 for Whitechapel Road.

Mayfair was clearly the swankiest district in London back in the 1930s. In contrast, Whitechapel Road was a notoriously poor area producing many of London’s infamous gangsters.

Prime locations command higher commercial rents due to higher demand, which generally translates into higher revenues for local firms. So, when it comes to paying business rates, it is reasonable that locations with higher rents should pay proportionally more.

The challenge, though, is that local economies are part of a complex, dynamic system which can cause rents to change quite dramatically.

For example, if Mayfair continues to become a haven for wealthy individuals to park their capital with the properties left empty, then house prices will continue to rise – but certain commercial rents might fall, given there are fewer people around to consume local services. Conversely Whitechapel, which will benefit substantially from the Crossrail investment, might see rents increase due to rising demand.

The dynamic nature of the economy gets to the heart of the current problem with business rates. The most recent revaluation, which will be introduced in April, will be based on 2015 rents. But it will also be the first for seven years.

The reason the current system is not fit for a dynamic 21st-century economy is its inability to signal to firms the changing nature of rents through time.

The system is based on the idea of setting the rates, then assuming that rents will rise of the subsequent five or seven years. But this idea is without empirical foundation. Between 2007 and 2012, average rents fell by between 15 and 20 per cent between 2007 and 2012 – but business rates actually went up, due to the 2008 revaluation.

Under the new revaluation, the government expects that nearly three quarters of businesses will see their rates remain the same or fall. Hence around a quarter of firms – mainly in the South-East – will see a rise.

It is understandable that firms seeing large jumps in their business rates are furious and are wondering whether they will be able to survive. Yet when ministers delayed the revaluation from 2015 to 2017, it meant businesses in the North and Midlands had to pay an extra £2.3bn, whereas businesses in London saved £1.6bn.

Some business groups are now arguing that rates should not be based on rental values but on the ability to pay.

But the idea that a poorly run firm in Mayfair should pay less than a well-run firm along Whitechapel Road is frankly absurd. What matters is that rates should be linked to actual rental values and updated frequently, providing firms with more efficient price signals.

Business rates also penalises those firms who use less space, making them a regressive tax. Entrepreneurs trying to establish new business models and services end up paying far higher rates per square metre than firms who are greediest for space. The recent increase in the relief threshold does nothing to prevent this, but only creates further distortions to the tax system itself.

Finally, the current system of valuations carried out by the Valuation Office Agency (VOA) is expensive and cumbersome. The VOA is already one of the largest employers of chartered surveyors in the country and finds recruiting sufficient staff challenging. The VOA receives in excess of 8,000 appeals per month and has 3,500 staff. Its gross operating costs are £195m and 72 per cent of these are staff costs.

The current system is so expensive to administer because rateable values are undertaken at the individual property level, which need to be individually checked in the event of an appeal. However, over 70 per cent of all the appeals on the 2010 rating list have resulted in no change, although most do not state the basis for the appeal.

The Treasury’s response to the business rates review published in March 2016 was to accept that valuations needed to be more regular – at least every three years. However, it has completely failed to address how this might be done more efficiently. Their response to more regular valuations has been that this will increase costs. A preferable approach would have been to think about how more regular valuations could be generated more cheaply.

The Treasury must go back to the drawing board. The current tax is designed for a static economy and stems from a desire to maintain stable local government revenues. By digitising the VOA and ensuring that all properties are connected to the system, rental values can easily be updated by firms, leading to big costs savings in the VOA.

This would allow the government to provide annual valuations at the postcode level, thereby capturing average rents per square metre. Moreover, annual valuations will also reduce the number of appeals, greatly reducing costs further: in the Netherlands, the introduction of annual valuations led to a drop of 80 per cent in appeals.

In addition, the regressive nature of the tax should be terminated and replaced with a flat tax, with those requiring more space paying a proportionate amount of tax.

To maintain some stability in income, it is feasible for revenues to be fixed for more than a year even if valuations change. But it is absolutely critical that firms are able to benefit from market signals to enable them to make better-informed choices.

Otherwise we will end up with business rate valuations – and indeed council tax bands – as outdated and distorted as the values on that Monopoly board.

Thomas Aubrey is director of the Centre for Progressive Capitalism and founder of Credit Capital Advisory