The review, ordered by Gordon Brown, the chancellor, and John Prescott, the deputy prime minister, is also expected to allow councils to start charging for rubbish collection, social care and rush-hour car travel.

At a later stage, charges could potentially be levied to pay for extra police and teachers, if there is a demand from local voters.

The review, being conducted by Sir Michael Lyons, the acting chairman of the Audit Commission, will put Brown under pressure to declare his solution to the thorny issue of council tax reform in the run-up to the Labour leadership election.

The outcome could reverse two decades of tight Whitehall control, originally imposed to tackle the excesses of "loony left" councils such as Liverpool and Lambeth in the 1980s, and strengthened to even out a "postcode lottery" in services.

In March this year, Prescott, then responsible for local government, capped high-spending councils, including Medway and York, when they planned inflation-busting rises.

In an interview with The Sunday Times, Lyons said: "Capping isn't the answer. All the capping does is keep all the pressure in the system. It doesn't solve any of the problems."

At the moment, wealthier southern councils claim they subsidise their poorer northern counterparts through a complex and opaque system of grants.

Lyons wants councils to be given discretion both to raise their taxes and to cut their services, enabling them to compete to offer the most competitive taxes and charges for residents and businesses. He said: "I think local tax wherever possible should be spent locally.".

He said he was watching "very carefully" the introduction next year of a system in Northern Ireland where everyone pays a percentage of the value of their house in council tax.

In the rest of Britain, council tax is paid in one of eight bands, tied to the value of homes in 1991, with the level varying between local authorities. The government recently delayed revaluing Britain's housing stock until after the next election, and Lyons appears unpersuaded by the arguments for an additional band for expensive properties.

In the interview, Lyons said that "too much had been asked of [council] tax" and that reform of the system was now essential. He said that "council tax can't be the only tax which takes the pressure".

Under his reforms, local services could be funded through a mix of local council tax, new top-up charges and higher national taxes. In the interview, Lyons explained why additional national taxes, such as Vat or income tax, may be needed to prop up the beleaguered council tax system.He said: "It [council tax] has been used as the release valve for all of the pressures of trying to spend more on and improve public services. I've drawn attention to the fact that national taxation makes a remarkably modest contribution to local services."

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