How to bridge the funding gap

London's transport finances may be difficult now, but they are set to get much worse. The answer is

Ask Londoners what should be done about transport in their city and they are likely to say: "Make it more reliable, less crowded, more frequent and cheaper." Ask London politicians what they would like to achieve and they will probably say much the same thing, as would the chief executive of Transport for London (TfL), Bob Kiley, the bus and Tube bosses, their staff and even government ministers. So if we are all agreed, why does it not happen?

It mostly comes down to money. Nobody seems to be in a position to pay what it would cost. Reduce fares and there will be more passengers, but revenue will fall and you will need more subsidy. Also, crowding will get worse. Put on extra bus services and both waiting times and crowding will improve, but costs will increase more than revenues and you will need more subsidy. Replace worn-out and failing railway equipment or obsolete road traffic control systems and reliability as well as capacity will improve, but you will need more subsidy for a period of years to pay for it. Enhance an overcrowded Underground station or build a new line and you will need a great deal more subsidy.

London ought to be able to afford better transport. The UK is one of the world's richest countries, and the capital is its wealthiest and most productive region. There is pride in London as a great world city, and the Treasury is concerned about the productivity of our economy. Yet employers large and small complain bitterly about lost productivity because of the difficulties of getting their staff to work and transporting their goods. A root cause of this sorry state of affairs is the confusion about who exactly is responsible for London: is it central government or the London Assembly and Mayor?

TfL - which is responsible, under the chairmanship of the mayor, for the capital's transport system (excluding commuter rail) - is a huge business with a turnover of about £5bn a year. The public think that bus and Tube fares are high by international standards, yet they cover less than half the business's running costs. The contribution made by local sources of income such as the congestion charge (£78m after the cost of running the scheme) and domestic property taxes (£66m) is really quite small. Most of the difference is made up by grants that are determined by central government.

The dominant role of central government goes further. Major new infrastructure projects such as Crossrail, Thameslink 2000, the East London Line, tram schemes in west London and elsewhere, as well as major road improvements, will go ahead only if the Department for Transport and, ultimately, the Treasury agree to provide the funding. The Thames Gateway Bridge will now be debated at a public inquiry, but only because government has promised to make the necessary funds available.

The problem is that when central government created the devolved Greater London Authority in 2000, it made it weak and largely beholden to Whitehall. One result was the imposition by central government of the binding, 30-year public-private partnership contracts for the Tube. But other crucial consequences are the lack of discretion enjoyed by the Mayor over local sources of income and the absolute discretion Whitehall has over grants both for maintaining the current service and major new projects.

The finances may be difficult now, but they are set to become a nightmare in future years. Under TfL's business plan, this year's manageable deficit of £45m is set to reach more than £900m in 2006-07. This is due to increasing expenditure on the one hand, and the government's stated intention to reduce grants on the other. To maintain current levels of service, to correct historic neglect, to accommodate the capital's anticipated population growth (expected to increase by 10 per cent by 2016) and to make modest service improvements, TfL estimates that annual expenditure needs to rise by around £1bn by 2006-07.

Costs are expected to rise mainly because of payments committed under the Underground PPP contracts but not covered by the government, Underground pensions liabilities, increases in the unit costs of bus operation and expansion of the bus service to meet new demand. Income is expected to rise less than costs because of shortfalls on Underground revenues, because the Mayor is unlikely to want to increase fares dramatically, and because many worthwhile service improvements do not pay for themselves. If the government goes through with reducing grants, TfL will have to alter its plans significantly in order to eliminate the deficit. That would be extremely painful for London's transport system.

The government is reconsidering the grants as part of the current review of public spending, and the outcome for transport will be announced in the autumn. The signs are not promising. The Chancellor, Gordon Brown, has pointed to problems with rising public debt, and there is electoral pressure not to raise taxes. Worse, national spending on transport has been fixed for a number of years by the Treasury's commitment to the ten-year transport plan, and the funding demands from the national rail network have grown out of all recognition from what was expected when the plan was set.

A wider problem is that national transport has been a loser in the competition for limited public funds because higher priority has been given to departments such as Health, Education and Defence. The fact that parliament does not favour the capital over other regions has compounded the problem.

London's transport system thus suffers from too much centralism in government, which has left local authorities ineffective. Perceiving local government as failing, central government has long retained rigid controls over investment in local infrastructure, and it has come to provide the greater part of all the resources that local authorities have at their disposal. Thus, if extra local investment is achieved, it is at little cost to the local population, and there ceases to be local debate about what is needed and what local people are prepared to pay for.

Part of the solution for London must be to restore control over investment to local government, making it fully accountable for its decisions and Londoners liable for the costs. The new prudential borrowing framework for capital finance, which came into operation in April 2004, offers an opportunity for significant improvement. Local authorities will be able to borrow to the extent they judge, using independently set criteria, to be prudent. They must take into account their current state of indebtedness and forthcoming revenues, including grants and council taxes.

This reform could mark the start of a new era, providing local authorities are left to their own devices. But borrowings have to be repaid, so the total debt is constrained by the annual cash flow available to service them. This cash can come from only three sources: grant from national government (ultimately, national taxation), charges to users or local taxation.

The only real potential for increased revenues through charges to users lies in extending the congestion charge. The successful scheme in London covers a limited area and produces relatively small revenue after covering the costs. Applying the charge to a larger area would not only further reduce congestion and encourage the switch away from car use, but also raise more money, providing that a sufficiently low-cost technology could be found to make it work. New taxes on commercial properties are under discussion, with the aim of retaining for public use a portion of the financial benefit due to improved transport infrastructure. These are interesting ideas, but it is unlikely that they would boost cash flow sufficiently to enable the prudential borrowing regime to raise anywhere near the sums needed.

The simple truth is that if we want more infrastructure and better maintenance, it will have to be financed by some form of taxation, local or national. And if the Treasury does not divert sufficient national taxation to urban transport, then the only alternative is for local taxation to bear the burden. Local taxes, along with local decision-making, are commonplace in other parts of the world, ranging from local employment tax in France to sales taxes in New York. This is not to deny that there is a place for national funding and influence. Both Paris and New York City receive federal and state funding. Yet they also benefit from significant sources of discretionary local tax income.

If local expenditures were more closely related to local sources of income, then both residents and businesses would have a renewed interest in holding local government to account. That and transparent long-term investment funded by borrowing on the financial markets, audited and regulated under the prudential borrowing regime, would be much more effective than the current methods used by central government. And transport in London might once again set standards for the rest of the world to follow.

Stephen Glaister is professor of transport and infrastructure at Imperial College London, and a non-executive board member of TfL