Academics at the London School of Economics have discovered a link between spending per pupil and exam and test performance once children's poverty levels are taken into consideration.
Previously, figures showing the higher the expenditure per pupil, the worse the results, have been used by successive governments to peg education spending. But researchers say this is because councils with the highest spending also have the most disadvantaged children.
Tony Blair and former education minister Stephen Byers have said that poverty must not be used by schools to excuse poor results.
But the new analysis by Anne West, Hazel Pennell, Tony Travers and Robert West of the LSE's Centre for Educational Research, suggests that a local authority's poverty level is the best predictor of the proportion of pupils who will gain five good GCSEs.
The report says: "Once poverty was controlled for, educational spending per pupil was positively associated with national testexamination performance at the education authority level."
Anne West, project director, said that the research shows the Government should target even more money on areas of poverty. She said the redistributive element in local government funding was not as sophisticated as it should be.
Their research showed that the number of pupils from families on income support was a better indicator of educational disadvantage than the Additional Educational Needs Index which is used to calculate authorities' costs. It includes factors such as the proportion of children in single-parent and ethnic-minority families.
Dr West said the complexity of local government spending has made it a difficult area for research and too often the crude figures on spending and exam outcomes have been used.
She said targeting funding on local authorities with poor exam results would be politically unacceptable as it appears to be rewarding failure. Instead the Government should give more money to councils based on the cost of educating children from disadvantaged backgrounds.
The Government is targeting deprived areas in its initiatives, including education action zones and Excellence in Cities.
Estelle Morris, school standards minister, said the Government had spent significant extra money on schools and that the packages in Excellence in Cities, including mini action zones, will help to address urban needs.
Neil Fletcher, education secretary of the Local Government Association, said he was pleased with the findings. "LEAs would welcome the opportunity to be able to target funding to need - it would be another arrow to our bow. It would be better than relying on the current funding formula which just counts pupils, and the bidding system for extra top-up money."
The LSE analysis, funded by the Economic and Social Research Council, also found the proportion of children with special needs statements is not related to other indicators of need, such as poverty. This is a surprising finding which the authors believe is due to middle-class parents being more adept at using the system to ensure additional cash for their children.