Devolution Commission reflections: Proposals for Taxation

Published: 19 March 2014
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The final report of the Labour Party’s Devolution Commission, published yesterday, contains two main proposals on taxation. Firstly, that the Scottish Parliament’s powers over income taxation should be enhanced with the ability to: vary income tax rates by up to 15p in the pound, compared to the 10p that would be implemented in 2016 as a consequence of the Scotland Act 2012; make the Scottish income tax system more progressive (but not less) by allowing upward variation (only) in the higher rates of tax relative to the basic rate.

Secondly, the proposals involve no further devolution of other taxes, so that corporation tax, VAT revenues and Air Passenger duty, for example, remain reserved to Westminster.  Charlie Jeffery’s blog outlines the details and compares the proposals with those already in the public domain, noting that the plans for further devolution in the event of a “no” vote are the most modest of those revealed   by pro-union bodies  so far, with the Parliament effectively raising around 40% of its spending.  Indeed it is possible that the Conservative party, whose plans will be known in May, could also “out devolve” the Labour Party on taxation.

We shall turn to what is distinctive about the Labour Party’s plans shortly, but one of the striking things about the pro-unionist positions on tax is the consensus – that apparently also includes the Conservatives - on the desirability of extending  the tax powers of the Scottish Parliament. This is particularly striking given that the rather more limited powers that the Parliament currently enjoys, to vary the standard rate by up to 3p in the pound, have never been used.

As under the Scotland Act, the Scottish Government will be compelled to set the rates of income tax that will apply to Scotland. The default position under these proposals would be that the rates of income tax in each of the three bands would be reduced by 15 pence in the pound and the amount that the Scottish Government receives through the Barnett formula (which would be retained under these proposals) would be reduced accordingly (we assume on the basis of a measure of actual tax revenues raised). If a Scottish rate of 15% was set total tax rates in Scotland would again be equal to those in the rest-of-the-UK (RUK) and revenues would be unaffected. However, a higher rate would result in higher expected income tax revenues and higher government expenditure and vice versa for a rate below 15%.

Although the system precludes complete inertia in terms of tax-rate setting, the Scottish Parliament will, of course, understand what action is required to maintain the parity with RUK tax rates that successive Scottish administrations have decided is desirable.  What would be the consequences of actually using the wider tax powers that pro-union bodies wish to see introduced?

A balanced increase in government expenditure and income taxation is likely to have macroeconomic consequences: Scotland is a small, open regional economy and will remain so.  At the macroeconomic level, an increase in government expenditures stimulates the demand side, but a rise in income taxation would normally be expected to have adverse competitiveness effects. Overall, the outcome depends on the relative sizes of these influences.

Positive net outcomes are more likely if people value the services that the increased expenditures provide, and the more they are willing to reflect that valuation in a moderation of their wage claims. The” social wage” values government as well as private consumption expenditures. Attitudes really matter in governing the likely macroeconomic outcome of a balanced budget change. If people really want a high-tax/ high-spend Scandinavian model, and are prepared to pay for it, it seems they may be able to have it while enjoying an expansion in economic activity. Some may, of course, choose to leave Scotland in these circumstances, but others may choose to move here.

However, there would be risks in raising taxes and revenues. Firstly, people may respond differently to different types of government expenditure – and perhaps more positively to health and education than to defence. Secondly, any expenditures that contribute directly and positively to the supply side, most obviously public capital expenditure, would also increase the probability of a positive outcome by counteracting the adverse competitiveness effects. Thirdly, different households may respond differently to altered incentives. Migration is known to be selective in age and skill (and income levels), and there is a concern that those on the highest incomes may also be the most mobile.

All of the pro-union bodies’ proposals would allow a marked shift in the direction of Scandinavian countries or, less likely, in the direction of low tax/ low spend economies. While Labour’s proposals are the most modest of the plans revealed to date, they would have been regarded as radical not so long ago. There is no doubt that they would allow a very significant shift in the levels of taxation and spending, and so in the nature of Scottish society, although the Scotland Act itself is responsible for much of the push in this direction. However, no party has yet committed itself to using the extensive powers to effect such a transformation.

Labour’s rationale for not going further with tax devolution is the idea of a social union in which all in the UK should enjoy comparable levels of key public services such as health and education, although of course the allocation of expenditures is entirely at the discretion of the Scottish Government, and depending on precise definitions, this could be used to justify a range that would encompass rather more (or indeed less) devolution of taxation.

The most distinctive feature of Labour’s tax proposals, beyond their comparative modesty in relation to other pro-union plans that are in the public domain, is the proposal to allow only an upward movement in higher rates of income tax relative to the base rate, increasing the progressivity of the system in order to avoid tax competition. There is little doubt that this is the direction of change that Labour envisages. In fact, any tax differential could be construed as “tax competition” among regions given that labour remains free to move between Scotland and RUK.

There appears to be an underlying presumption of highly mobile rich group and the rationale presumably parallels that for corporation tax, of a potential “race to the bottom”. However, the extent to which migration responds to the social wage rather than the real take home wage is important here since under the proposals income taxes and expenditures have to move together. It seems there is more concern about the prospect of an influx of the rich to Scotland (and their impact on the UK tax system) than it is about the prospect of outmigration of such individuals, perhaps because of the differences in scale of the two economies and the possibility that Scottish residents may care more about the social wage.

The Barnett formula is to be retained, despite the shift towards greater income tax powers and  associated responsibility for raising own revenues. Precisely how the adjustments to Barnett are to be made matters, however. For example, if the effects of a differential tax rate are to be calculated using some comparatively mechanistic formula, rather than actual tax revenues, the incentive to “grow the economy” will be no greater as a consequence of the increased tax powers. Increased participation rates, for example, could lead to higher “expected” tax income and a lower Barnett settlement. Would an outmigration of the rich lead to lower expected tax revenues and a compensating Barnett adjustment? Regardless, it seems likely that Barnett would come under greater strain with this (and indeed the other) proposals for greater fiscal devolution.

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