ANNEX B: THE COMMISSION'S INCOME TAX RECOMMENDATIONS
- Under the Commission's recommendations, the Scottish Variable Rate of income tax would be replaced by a new Scottish rate of income tax, collected by HMRC, which would apply to the basic and higher rates of income tax on earned income. To make this possible, the basic and higher rates of income tax levied by the UK Government in Scotland would be reduced by 10p.
- If the Scottish Government wished to maintain an identical income tax rate in Scotland relative to the UK as a whole, the framework would be that set out in Table 1 below. It is important to note that Scotland would only be assigned 1/4 of revenues generated from the current higher rate, and only 1/5 of all revenues generated from the new top rate of tax, scheduled for introduction in 2010-2011.
Table 1 - Summary of The Commission's Proposals
Basic Rate (20%)
Higher Rate (40%)
New Top Rate from 2010-11 (50%)
- The Scottish Government's share of Scottish income tax revenue under these proposals is illustrated in Figure 1. Approximately 44% of total income tax receipts raised in Scotland would accrue to the Scottish Government under the recommendations. This would correspond to approximately 14% of the total Scottish Government budget in 2008/09.
Figure 1 - Distribution of Income Tax Receipts under the Commission's Proposals (2008/09)
Source: Survey of Personal Incomes - Scottish Government Calculations
Accountability, Transparency and Economic Efficiency
- As set out in the earlier National Conversation paper Fiscal Autonomy in Scotlland1, accountability and transparency are vital in ensuring public support and trust in the political system, better governance and in delivering efficient policy choices and strategies.
- At the same time, a financial framework that encourages efficiency is vital to creating an environment conducive to best practice, innovative policies and enhancing competitive advantage.
- But, accountability and efficiency are limited in this framework.
- Firstly, it is not entirely clear that the proposed system represents a fundamental departure from the current framework. The Barnett formula will remain the single most important determinant of the Scottish Government Budget and will continue to be set at the discretion of the UK Government. At the same time, the process for varying income tax in Scotland is likely to remain similar to that under the current Scottish Variable Rate ( SVR). The UK income tax rate will remain the baseline to which all changes are compared. For example, the choice to set a rate of 8 pence under the Calman proposals will be similar, in decision making and thought process, to setting a reduced rate of 2 pence via the Scottish Variable Rate. With expenditure pre-commitments, limited additional sources of revenue, a tight fiscal settlement and a like-for-like reduction in the block grant, the effective scope for differential income tax policy in Scotland vis-à-vis the rest of the UK is likely to be severely constrained.
- Secondly, key fundamental principles for establishing economic efficiency are not satisfied in this framework. For example, under the Commission's recommended income tax system, tax decisions by one government will create 'externalities' in terms of the amount of revenue collected by the other. Economic theory clearly demonstrates that such arrangements can lead to peculiar outcomes and efficiency will not be obtained.
- Illustrative Example: (based upon the Commission's own illustrative example) - Scottish Government cut income tax by 2 pence. The example provided in the Commission's report demonstrates that the receipts accruing to the Scottish Government would fall by approximately £800 million between year 1 and year 2 as a result of this decision, as illustrated in figure 2. However, the Commission failed to consider the long term impact of a change in income tax, and this can have very significant implications. For example, suppose that following the cut in income tax, in subsequent years, total income tax revenues collected in Scotland rise by 3% a year in real terms. This figure is for purely illustrative purposes. The impact on the tax revenue accruing to the Scottish and UK Governments is illustrated in Figure 2.
Figure 2 - Illustrative Example - Impact of a 2p Tax Cut by the Scottish Government on Income Tax Receipts under the Calman Proposals
Source: Scottish Government Calculations. The numbers used in this example are for illustrative purposes only.
- Result: decision by Scottish Government to reduce the rates it controlled would permanently reduce its share of total Scottish income tax receipts. Therefore, although in year 5 total income tax receipts in Scotland would have returned to their year 1 level, there will have been a permanent relative transfer from the Scottish Budget to the UK Government. In this scenario, receipts accruing to the Scottish Government will have fallen by £500 million between year 1 and year 5. Receipts assigned to the UK Exchequer will have risen by £600 million. Clearly financial accountability is not obtained.
- In effect, under the Commission's proposals, the Scottish Government would incur the short run cost in year 2 from reducing the tax rate, but it would be the UK Government which received the majority of any benefit in future years if the policy successfully increased tax receipts. This may raise questions of credibility and accountability.
- In contrast, as highlighted in Figure 3, all the costs and benefits of the proposal would be captured by policy makers under a system of full fiscal autonomy. The system is therefore more efficient, more likely to encourage best practice and to deliver greater financial accountability.
Figure 3 - Illustrative Example - Impact of a 2p Tax Cut by the Scottish Government on Income Tax Receipts under full fiscal autonomy
Source: Scottish Government Calculations
- Furthermore the transparency of the system proposed by the Commission, a vital condition for ensuing financial accountability, is open to question. Taking all the Commission's proposals together, a system which retains the Barnett Formula, alongside a complex mix of devolved taxes, HM Treasury discretion, tax assignment, tax sharing and reserved taxes, may in fact hinder transparency rather than improve it.
Implications for Public Spending
- Ensuring predictability in public finances is a vital pre-condition for delivering efficient public services and facilitating sustainable economic growth.
- The Commission's proposals could expose the Scottish Budget to a significant degree of volatility, with only limited levers to mitigate these effects.
- Under the Commission's proposals, the Scottish Budget would be dependent upon the revenue raised from one particular element of the tax system. In contrast, most governments utilise a basket of taxes for funding. Diversification can provide greater stability and predictability in budgeting.
- For example, between 2008/09 and 2009/10, UK income tax revenues are forecast to fall by £13 billion. Under the framework proposed by the Commission, and assuming that the impact in Scotland was the same as in the rest of the UK, this could have resulted in the Scottish Government Budget falling by £400 million during 2009/10, at precisely the point of the economic cycle where an increase in government spending is necessary to support the economy and offset the fall in private sector demand.
Figure 4 - Annual Growth in UK Income Tax Receipts
Source: ONS Public Sector Finance Statistics, Scottish Government Calculations
- The possible implications of fluctuations in revenue for public services can be mitigated through effective management of borrowing and end of year flexibility. But these powers are severely constrained under the Commission's proposals for borrowing autonomy.
- Under the Commission's proposals, Scotland would only be able to borrow for capital investment and management of 'cash flow'. However, borrowing to facilitate automatic stabilisation is explicitly ruled out.
- There is therefore a risk that without cyclical borrowing powers, an economic slowdown could put pressure on the Scottish Government budget, and could force a future Scottish Government to cut public spending or raise taxes at the wrong point in the economic cycle. At a given point in time, the ability to borrow for cash flow purposes may already be being used to account for different periods in collection of revenue and therefore there will be no scope to use this mechanism to protect public services.
- In addition, the unique nature of the Commission's proposals mean that while the Scottish Budget would be exposed to significant vulnerability from declining revenues in one particularly element of the tax system, it would not share in the full benefit of increased revenues when the economy grows. For example, between 2003-04 and 2007-08, public sector revenue in Scotland increased by an average of £3.4 billion a year, including a geographical share of North Sea revenues. The Commission's proposals mean that the Scottish Budget would have only received around 17% of this increase - Figure 5.
Figure 5 - Growth in Scottish Tax Receipts (2003/04 to 2007/08): Share Accruing to Scottish Government under Calman Recommendations
Source: GERS 2007/08.
- There is also a risk that the Scottish Budget could be squeezed inadvertently following a technical or administrative adjustment at the UK level.
- Unlike a system of full fiscal autonomy, the Scottish Budget would be subject to risks arising from unilateral decisions taken at Westminster which shifted the balance of the income tax system, even if the total amount of taxation collected in Scotland remained the same (or even increased).
- For example, in May 2008, the UK Government announced an immediate, and unplanned, increase in income tax personal allowances and a corresponding reduction in the upper threshold for higher tax payers. This decision led to a reduction in the amount of income liable for tax at the basic rate, and an increase in the income liable for tax at the higher rate.
- Under the Commission's proposals, the Scottish Budget would have borne the brunt of this decision. As highlighted in Figure 6, the Scottish Government would have suffered 56% of the adjustment costs despite only collecting approximately 44% of total tax revenues.
Figure 6 - Impact of UK Income Tax Changes on Scottish Tax Receipts (May 2008)
More generally, in the future the Scottish Government Budget could be exposed to budgetary cuts as a result of unilateral decisions by the UK Government to alter the balance of the overall tax system in the UK from income tax - e.g. to national insurance, 'green taxes' etc.
- In this regard, the Scottish Government and wider public sector in Scotland, may be held accountable for changes in policy which are the result not of direct policy decisions in Scotland, but changes at the UK level.
- Under the Commission's proposals, the Scottish Government would be assigned less than half of total income tax receipts raised in Scotland. On most recent estimates, approximately 80% of total tax revenue raised in Scotland would continue to accrue to the UK Government.
Figure 7 - Devolved Revenue in Scotland including Calman Commission's Recommendations
Source: GERS 2007/08. Figures include geographical share of North Sea Revenue.
Current own source revenue refers to Business Rates and Council Tax
- Under the Commission's proposals, key policy levers for enhancing Scotland's competitiveness and delivering environmental sustainability, including corporation tax, VAT, national insurance contributions, capital gains taxation and environmental taxation would remain reserved. The Commission also chose not to recommend devolving control over North Sea taxation, or the establishment of a Scottish Oil Fund 2.
- In addition, responsibility for key elements of the income tax system, such as personal allowances, tax thresholds, the tax rates on savings and dividends, the opportunity to establish tax breaks for particular groups such as pensioners and the self-employed and the integration with the wider tax and welfare system, would remain reserved. The Scottish Government would only be able to apply relatively broad brush changes to the income tax system, and even then, constraints on funding prior service commitments would limit the practical opportunities to deliver real policy autonomy.
- Targeted and potentially redistributive measures, open to the UK Government, through adjusting the structure of the income tax regime and its interaction with other taxes would not be possible.