Smith Contributions - Tax and Spend - and Borrow

The devolution of income tax has received considerable attention in the discussion surrounding the Smith Commission. In the fourth of the extracts from our recent e-book, Dr Angus Armstrong argues that devolving taxation without borrowing powers will leave nobody happy.
As things stand, of the public funds deployed in Scotland, the vast bulk of the spending is done by devolved and local government but virtually none of the revenues are raised by Scottish authorities. The difference between devolved spending and local revenue raising is made up by the block grant from the UK government to the Scottish government. Even had the ‘new’ taxes due to be devolved as of the Scotland Act 2012 – a replacement for Landfill Tax and the existing Stamp Duty, followed by the Scottish Rate of Income Tax – already come on stream, they would only amount to 15% of identified spending in Scotland. By contrast 69% of identified spending is controlled by either the Scottish Government or local authorities (SGLA). 
There are a number of problems with this disparity, not least the lack of accountability entailed in politicians spending money when they have not been directly involved in raising it. Because the bulk of the Scottish government’s resources are set by the size of the block grant, with very limited borrowing powers, the Scottish Government has to operate a balanced budget  whether it likes it or not. Funding the Scottish Parliament by means of a block grant has various benefits in terms of avoiding wasteful tax competition and ensuring a uniform macroeconomic policy and maximal sharing of risk. However, it also means that the Scottish Government is not accountable for raising or lowering taxes or changing borrowing to pay for its spending decisions. It is mostly tasked with spending an allocated amount of funding. The Scottish Parliament essentially operates within a balanced budget construction.
The suggestion of devolving income tax has been widely discussed and seems to have taken on a totemic significance in terms of determining politicians’ commitment to devolution. However, devolving income tax without borrowing will do little to enhance the accountability of the parliament to the public. If income taxes fall short of spending plans, perhaps due to a recession, the Scottish government will have to either cut spending or raise taxes which would weaken the economy further, or borrow. And for any significant amount, this remains a Treasury decision.   The only way for Scotland’s politicians to be accountable is for them to be able to take decisions on which they can succeed or fail. This requires fundamentally changing the Parliament’s near total dependence on a block grant decided by the Treasury which in turn means the ability to borrow. If Scotland has to borrow from capital markets then this would introduce some market discipline rather than negotiation with the Treasury. .
Attempting to resolve that purely by devolving income tax, however eye-catching such an act would be, would violate at least three economic principles and possibly undermine the integrity of the union. First, high income earners are particularly mobile and there is a real risk of creating inefficient tax competition. Second, income tax yield is highly dependent on the local economy. This may introduce macroeconomic stability problems. An adverse shock leading to a sudden fall in taxes would require fiscal tightening perhaps leading to a deeper downturn. If higher earners migrate then this could worsen the outcome further. Third is the issue of equity. Is it reasonable that Scots would pay no income tax towards central UK government services? And can Scottish politicians expect to decide Scottish income taxes and also have a say on income taxes in the rest of the Union?
Devolving income tax on its own – without borrowing powers – would amount to attempting to impose a symmetric solution on an asymmetric problem. If borrowing powers are not extended along with the income taxes, the real economic power will remain with the UK government despite the headlines.

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Angus Armstrong's picture
post by Angus Armstrong
National Institute of Economic and Social Research
26th November 2014

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