The role of income tax in Scotland's budget
A discussion paper that aims to provide useful background to help inform the debate on future use of the income tax powers devolved to the Scottish Parliament.
4 Tax and spending policy choices
This chapter highlights what our taxes pay for and the choices that our Parliament faces in agreeing a budget. In doing so, it sets out the benefits of government spending for the economy as a whole, for public services and for individuals.
In discussing income tax policy we also have to consider the policy tests against which any changes should be assessed. This chapter therefore sets out the policy tests which the Scottish Government believes should be applied before any decision is made to change income tax.
4.1 What do taxes pay for?
The international comparisons in the previous chapter highlight that we cannot consider income tax policy in isolation from public spending choices.
The Scottish Government’s tax and spending decisions support our pledge to build a more sustainable economy, protect the quality of our public services and promote an inclusive vision for Scotland’s communities. Our spending plans for 2017-18 are shown in Chart 4. It is important to note that spending on, for example, health and education also supports our economy through improving the health, education and skills of the workforce.
Chart 4: Scottish Government Portfolio Expenditure, 2017-18
With the Scottish budget facing unprecedented cuts and demand for public services continuing to rise, some of the alternatives to changing tax policy would be:
- to reduce or charge for some universal services
- to reduce mitigation of UK welfare reforms
- to reduce the provision of public services.
It is our view that it is in the context of these alternative options, which the Scottish Government does not favour, that a discussion about changes to income tax is essential.
Support for the economy, public services and individuals
In key areas this Government has chosen to invest more than elsewhere in the UK to secure better results. For example in the following areas:
Economic development: Public sector spending per person on economic development in Scotland is nearly double the level than that of the rest of the UK. This has allowed us to secure more Foreign Direct Investment in the last 5 years than any other part of the UK outside London and to reduce the productivity gap between Scotland and the UK.
Transport and Housing: Infrastructure investment is key to economic development. We have invested over £7.7 billion in rail since 2007 – spending twice as much on rail per person than in England. We have also delivered major road projects, such as the M8 improvements and the new Queensferry Crossing. This infrastructure investment supports Scotland’s economy. For example, the Borders region has seen a 27% rise in hotel and bed and breakfast stays and an 8% rise in tourism-related employment since the Borders railway opened. In addition, since 2007 we have built more homes per head of population than England and Wales - delivering 48,000 more homes than would have been delivered had we matched England’s lower per capita rate.
Health: Health spending will increase by £2 billion by the end of this parliament to support rising demand as our population ages. We are increasing the share of the frontline NHS budget dedicated to mental health and to primary, community and social care. Health spending per person in Scotland is 7.2% higher than in England. That means health spending in Scotland is £800 million higher than it would be at England’s per head spending levels.
The Scottish Government has chosen to mitigate UK Government’s cuts to social security spending in order to limit the number of people being pushed into poverty. For example:
- Since 2013-14 we have invested over £350 million to mitigate UK Government welfare reforms and to support low income families. This has included full mitigation of the Bedroom Tax
- We have helped 241,000 individual households - a third of which include children - through the Scottish Welfare Fund
- We have also invested over £1 billion in the Council Tax Reduction Scheme since 2013- 14, assisting almost half a million households each year to meet their Council Tax and preventing people from falling into debt and rent arrears.
The Social Contract
The spending choices that the Scottish Government has made over the last ten years have also helped to deliver a social contract that underpins our society and economy. The social contract ensures that all those who pay into our public finances have the opportunity to benefit from their contribution. The social contract reduces costs for individuals by providing for services collectively.
In considering proposals to change income tax, it is appropriate to consider the value of the social contract against any change in tax policy and the impact that might have on individuals.
With our current income tax policy, we opted to freeze the HRT last year rather than following the UK Government in giving a £400 tax cut to the highest earning 10% of Scottish adults, as was done in the rest of the UK. The income forgone by Higher Rate taxpayers equates to £7.70 per week. This money contributes to Scotland’s social contract.
The services provided under the social contract and their value to individuals and households are set out in Box C.
Box C: Value of Scotland’s Social Contract
Tuition Fees: The abolition of tuition fees saves undergraduate students living in Scotland up to £27,000 as compared with the cost of studying in England. As a result, Scottish domiciled students graduate with less debt and are able to begin their working lives in a stronger position.
Care for older people: Around 77,000 older people benefit from free personal care in Scotland saving self-funders in residential care, or their families, £8,892 per year.
Childcare: Our current entitlement of 600 hours free childcare for all three and four year olds saves families up to a total of £2,500 per child per year, and our expansion to 1,140 hours over the course of this Parliament will save families over £4,500 per child per year.
School meals for all Primary 1 to 3 children: The provision of a nutritious school meal saves families around £380 per child per year and supports learning and development by ensuring young people are not hungry or stigmatised in school.
Prescription charges: Scottish patients who need a prescription save £8.60 per item as compared to England. This saves those with long term medical conditions hundreds of pounds a year and reduces administration costs when compared to providing free prescriptions only to those with specific conditions.
NHS eye exams: Patients are entitled to a primary eye examination every two years, or annually for some groups.  Nearly 2.1 million eye examinations took place in 2016-17 at an average cost of £36 per test.
Concessionary travel for older and disabled persons: Around 1.3 million cardholders benefit by an average of around £250 each year.
In the course of this Parliament we are also committed to expanding free personal care to include care for those under 65 who need it, including ensuring that those diagnosed with a terminal illness receive the personal care they require. We are also consulting on the extension of concessionary travel to modern apprentices and are committed to increasing the provision of nursery education by doubling the number of hours available. We will also extend superfast broadband to 100% of business and residential premises and increase investment in business research and development. We will further support business by establishing a new National Manufacturing Institute and a Scottish Investment Bank. And we are determined to ensure fair and affordable pay rises for our public sector workers.
This Government believes that our investment in the economy, public services and the social contract – which goes significantly beyond what is provided in other parts of the UK – delivers benefits for all taxpayers and makes a significant contribution to making Scotland the best place in which to live, work, study and invest. The value of Scotland’s social contract, and our investment in public services and support for the economy outweighs that of the any possible tax changes set out in Chapter 7.
4.2 Our Policy Tests
If, in order to protect and support our economy and our public services, we choose to change tax rates or bands, it is important to consider the policy tests against which the Scottish Government believes any tax change should be judged. There is unlikely to be unanimity on the relative importance of these tests but they are an important guide to our discussions and decisions.
We do not underestimate the impact that changes to taxation can have on individuals, public services and the economy and will always take decisions in a careful, considered and responsible way. Any changes to income tax, therefore, need to be rigorously assessed to ensure that they are informed and evidence based.
In light of current economic conditions, and the pressure that the UK Government’s austerity programme places on Scottish public services, the Scottish Government believes that any income tax change in 2018-19 must be assessed against the following four tests. Tax changes must:
- Mitigate UK Government spending cuts and maintain and promote the level of public services: Income tax policy should help maintain the provision of, and promote the level of, public services which people in Scotland expect
- Make the tax system more progressive: Any tax changes should make the tax system more progressive and reduce inequality
- Protect lower earners: The lowest earning taxpayers should not see their taxes increase
- Support economic growth: Income tax changes, and the accompanying change in public spending, should support the economy.
Recent analysis from the Fraser of Allander Institute  shows that the Scottish budget has faced unprecedented cuts over recent years. In real terms, the Scottish budget will be cut by £2.9 billion over the decade to 2020. These cuts have put significant pressure on Scotland’s public services and have constrained the Scottish Government’s ability to invest in our infrastructure and public services.
We believe that any income tax changes in 2018-19 should raise additional revenue, over and above the current policy, to help protect public services in Scotland and support the social contract.
A progressive tax regime taxes people according to their ability to pay, with higher earners paying proportionately more in tax than those on lower incomes. The income tax system in Scotland is already progressive. For example, based on continuing rates and bands, someone earning £24,000 would pay £2,430 in income tax in 2018-19 (10% of their gross income), whilst someone earning £90,000 would pay around £24,800 in 2018-19 (28% of their gross income).
We are able to measure the progressivity of income tax policies and their impact on inequality by reporting the change in the Gini co-efficient, an internationally recognised measure of how equally income is distributed across the population. A reduction in the Gini co-efficient would reduce income inequality and would therefore mean that the income tax policy is more progressive. 
We believe that any changes to the income tax system should increase the progressivity of the tax system and reduce income inequality.
Protecting Lower Earners Test
Many families have already seen their incomes squeezed over recent years as a result of the UK Government’s reforms to the social security and tax credit system. Rising inflation is also now putting pressure on living standards.
In 2017-18, the Scottish Government took the decision to protect lower paid income taxpayers, whilst asking those highest earners to forgo the tax cut made by the UK Government, and with the additional revenue support public services.
The median income for all income taxpayers in Scotland is estimated to be approximately £24,000 in 2018-19. This means that half of all taxpayers in Scotland earn below this level.
We believe that at a time when living costs are also rising, taxpayers in lower income brackets should not pay more tax.
Economic Growth Test
A recent report from the IMF suggests that there is no strong evidence that increasing the progressivity of the tax system will reduce economic growth.  The economic implications of a change in income tax, and an accompanying change in public spending, will depend on a number of factors including:
- The scale of the tax change
- The response of individuals and businesses to the change
- Where the change in public spending is directed.
In the short term, an increase in income tax can affect the economy through two channels as summarised below. A reduction in income tax would have the opposite effect.
- An increase in income tax could reduce consumer spending and/or lower households’ savings. This would have the effect of lowering consumption. Tax rises which impact on lower income households are more likely to reduce consumption in the short term, as such households generally spend a larger proportion of their income, rather than save it
- The corresponding increase in Government spending provided by a tax rise can support employment, higher wages and economic activity in the economy and can therefore counteract any fall in consumer spending.
In the longer term, the implications of a tax change will depend on the response of individuals and businesses and the extent to which the corresponding change in Government spending impacts on the economy. The impact of a tax rise is discussed below. A tax cut would have broadly the opposite effect.
- If the additional spending is used to boost the country’s long term productivity, for example by investing in education or infrastructure, or increasing public sector pay, this could increase growth in the long term, benefitting the economy and boosting revenues in the futureï If, on the other hand, businesses believe that these improvements are not sufficient to offset the direct increase in costs the tax changes impose on them, they may reduce investment in Scotland
- For individuals, tax rises may change their perceptions and their behaviours, including the amount of hours they are willing to work. Tax can also be a factor individuals consider when deciding where to live and work, alongside other factors including public service provision, access to universal services and the cost of housing.
While this test can only fully be assessed once both taxation and spending decisions have been made at the completion of the budget process, it is important to consider the scale and the response in terms of changing perceptions and behaviours in order to assess the potential economic impact of any proposed changes. We believe that changes in income tax policy, and the accompanying change in public spending, must support the economy.
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