NHS funding and investment: Is the dog wagging the tail or the tail wagging the dog?

The regimes

The relevant capital / revenue regime

Economic operators must both receive and spend money in order to function. This is no different for public bodies. This is no different for public bodies.

Expenditure will either be categorised as:

• 1. revenue spending: expenditure on day-to-day operating costs like goods/materials/non-pay costs, services and staff costs; or
• 2. capital spending: expenditure on an assets / long-term investments like physical infrastructure, IT transformation and some elements of intellectual property like patents.

The benefits of revenue spending are realised directly as the expenditure occurs. This means that revenue spending is spread over time. Capital spending often requires early, one-off expenditure on land, construction materials and equipment, where the benefits of the spending are realised over time after the initial investment. Capital expenditure is therefore often linked to specific programmes, whereas revenue spending is often more general.

The Department of Health and Social Care (“DHSC”) sets budgets for both revenue and capital expenditure for the NHS each year. Capital expenditure is capped at the capital departmental expenditure limit (“CDEL”). The DHSC is responsible for making sure capital expenditure does not exceed CDEL. Likewise, revenue spend is capped at a revenue limit (“RDEL”).

Most revenue spending is off-balance sheet, from an accounting perspective, as a short-term liability. Most capital spending is on-balance sheet, as a long-term asset / liability. Accounting approaches vary from sector to sector, and there are numerous grey areas and devices available to determine whether something can be treated as revenue or capital.

The Government’s Private Finance Initiative of the late 90s onwards converted what could have been capital expenditure into revenue expenditure, by amortising the cost of the asset constructed over the term of the concession or operating contract let to manage that asset. Operating leases were also historically considered revenue spending. However, following the introduction of IFRS 16, operating leases are, for the most part, treated as capital, meaning they now fall within CDEL as opposed to RDEL.

The relevant VAT regime

Services (which are revenue spend) procured by NHS providers generally receive favourable VAT treatment. This is on the basis that the public sector has historically been incentivised to outsource services in areas where the private sector can deliver economies of scale and service improvements.

Section 41(3) of the VAT Act 1994 allows the Treasury to issue a Direction which sets out the services on which VAT can be directly refunded if they are provided to certain public bodies by another entity (the “Contracting Out Direction”).

This means VAT can be fully recoverable by health bodies on a specified service where that service is provided to it by another entity as opposed to delivered in-house.

The issues

According to Lord Darzi’s Independent Investigation into the NHS in England (the “Darzi Report”), published in September 2024, a £37 billion capital shortfall has accrued in the NHS over the last 15 years.

In recent history, capital has been increasingly diverted to plug revenue expenditure for a number of reasons. The shifting treatment of operating leases referred to above has also created pressure on the CDEL limit. The NHS estate has declined, and technological advancement has lagged behind other sectors, due to underinvestment. The Darzi Report referred to the NHS funding regime as “dysfunctional”, and implored investment in both capital assets and tech to shore up the health service and ensure its fitness for the future.

A recent NHS Providers survey of NHS finance directors recently reported that only 3% of finance directors considered the capital regime to be fit for purpose. Lack of investment and ‘capital raids’, alongside the unpopularity of the rules, have influenced behaviours and driven an approach over several years of seeking workarounds to meet the requirements of the regime. In certain cases, the application of a workaround could make the difference between a project being affordable or deliverable, or not.

This means the tail is often wagging the dog – the overriding objective of a commercial arrangement or project becomes achieving a certain accounting or tax treatment, potentially to the detriment or even the exclusion of other considerations.

Conclusion

Private investment in social infrastructure offers far more than a tool to keep capital expenditure off the national balance sheet. The best examples of private investment and public/private collaboration deliver positive outcomes by making the best of both the public and private sectors’ different talents, resources and capabilities, whilst working towards a shared goal.

Likewise, NHS subsidiaries can deliver benefits greater than VAT savings, like more investable / bankable commercial models, greater flexibility to incentivise staff, and ringfencing of risk, resulting in greater ability to generate income for reinvestment into the NHS.

Any changes to funding regimes and approaches this will require careful consideration and consultation. Likewise, valid routes to financial efficiencies should not be removed. However, it looks to be time for the dog to start wagging its tail (as opposed to vice versa) to deliver long-term value for populations and both the public and private sectors.

Blake Morgan has significant expertise in both the private and public healthcare markets. Find out how more about our services and how our team can benefit providers here.