The government has today announced a radical shake-up in the way education, housing and social services are funded. In an apparent retreat, ministers have backed away from plans to impose direct funding of schools - an idea backed in the past by David Blunkett. The new plans are set out in an ambitious government Green Paper released today and are the biggest change to local government finance since the poll tax reforms.

In what will be seen as an attempt to bridge the divide between Westminster and local government greater discretion will be given to local authorities over how money is spent for specific services. Controversially, councillors will be given the right to raise additional funds by levying local supplements to the business rate which is set nationally.

Business rate supplements could be set at one per cent a year for five years before central government would review the scheme. The supplements will only be levied in areas where the local authority has support from businesses, although there is some debate as to whether this is before or after the rate has been raised.

The British Chambers of Commerce have raised concerns over the cost to small businesses, but ministers believe giving local government the right to raise additional money after consulting with the private sector will improve relationships between both sides and complement other proposals to give local government more leeway in meeting central government objectives.

The comprehensive spending review in July announced that the government would allow local authorities to enter in to local public service agreements (PSAs). The concept was first promoted by the Local Government Association's "Joining up the jigsaw - taking forward the local challenge" initiative earlier this year.

The idea, which will be expanded in the green paper, is that local government can negotiate with central government to deliver targets in key areas which reflect both Whitehall and local needs. As a reward for taking on this new role the local authorities will be given financial incentives plus more freedom to decide on local targets and delivery. The strategies will rely on developing local partnerships of public, voluntary and private sectors to decide on targets and how local services are delivered. Key areas highlighted by the LGA are education, jobs and crime.