Calman panel member warns of 'disastrous' tax changes

Published on Saturday 20 June 2009 20:00

A MEMBER of the expert group which recommended tax reforms to the Calman Commission has broken cover to warn that the planned changes are "a disaster waiting to happen" which would cripple the Scottish economy.

Professor Andrew Hughes Hallet, writing with fellow economist Professor Drew Scott, has slammed plans to create a new Scottish income tax rate as "unworkable" and "illiterate".

They warn that, if adopted, the plans would lead to a vicious circle of tax rises and spending cuts.

Hughes Hallet, who also sits on the Scottish Government's Council of Economic Advisers, was a member of the independent expert group which advised the commission on tax policy.

Last week, Calman backed plans to create a Scottish income tax rate. Holyrood would be given powers to set the first 10p of income tax. Its block grant would be docked to compensate for the extra powers.

Backers say it will make the Scottish Government more accountable. But writing today, Hughes Hallett, who supports a system of full tax autonomy in Scotland, warns that the "halfway house" measure would be disastrous.

He also reveals he, like other members of the expert group, were told they were banned from speaking out until Friday. Calman's report itself was published on Monday last week.

The two economists say: "However attractive the Calman proposals might be in the political context, they are seriously flawed – if not illiterate – for simple economic reasons."

Hughes Hallett warns that, as the Scottish Government's ability to borrow would be restricted, greater spending cuts or tax rises would be inevitable.

They write: "In the UK as a whole, the crisis has caused a drop of 5-6 per cent in income levels and the government has had to borrow 11 per cent of national income to counter it. Translating that to Scottish conditions, since noncapital borrowing is ruled out, public spending on services (schools, health) would have to be cut by 11 per cent immediately."

Full text

In some political circles, the response to the fiscal policy reforms put forward by the Calman Commission have a certain superficial appeal because they increase the accountability of the Scottish Parliament for a small (15%, up from 5%) part of its spending decisions. The proposals may appear doubly attractive in the same circles because they seem to deliver a counter-punch to the current SNP Government which, since May 2007, has dominated the debate about Scotland's constitutional options and, as a part of that, the economic powers a Scottish government should command if it is to be able to tackle Scotland's underlying economic problems and the economic challenges that lie ahead. These points are true as far as they go (15%), but only in so far as they work. They cannot. However attractive the Calman proposals might be in the political context, they are seriously flawed (if not illiterate) for simple economic reasons. And that will affect the politics. The superficiality of Calman's proposals should not blind us to the dangers for Scotland's economic prospects.

The big idea in the Calman Report is "tax devolution". Under this a future Scottish Parliament will be responsible for setting a Scottish element of the UK rate of income tax (one-half on the UK basic tax rate). The revenues from this would be assigned to the Scottish budget as "own resources". An amount equivalent to the revenues that would have been expected from the application of the UK rate of income tax in Scotland, will be docked from the block grant (which, in the meantime, will continue to be set by the Barnett formula]. Notionally this will create a situation where, if the Scottish Parliament should decide not to alter the Scottish segment of income taxation from the UK-wide rate, there will be no impact on Scotland's budgetary revenues or public spending. If, however, the Scottish Parliament were to change Scotland's income tax component, overall revenues and spending would be reduced (increased) by the amount that income taxes were lower (higher) than those that would have been generated had Scotland's tax rate been set at the UK rate. This poses a problem. If one takes the view that the provision of a certain level of services is necessary, then reducing the Scottish tax rate is scarcely an option. Or, as Henry Ford would have put it "you can have any form of devolution you like as long as you don't use it". (He actually told his customers "you have any colour they like as long as it is black"). In addition, the Scottish Parliament is forbidden to alter the differences between upper and lower tax brackets, or to interfere with taxes on savings, investments, dividends or profits. So Scotland is forbidden to try to create a fairer society; or, more crucially, a more competitive economy should she wish to do so.

The fundamental objection we have to the Calman proposal is that it inevitably and unavoidably leads to a situation in which the revenues flowing to the Scottish budget will be subject to unanticipated variations which either requires a perverse – that is to say pro-cyclical – policy response on the part of Scotland's government (but not its Parliament) to offset these fluctuations; or automatic and immediate access to net additional funds. The latter is ruled out by denying Scotland the ability to borrow (except for immediate cash flow problems, capped at bn), although a last-minute ad hoc bail out by the Treasury might be possible. Maybe that is the point: control.

One can only speculate on the motives for favouring a regime that comprises such a punitive measure. But consider how it would have played out in the current crisis. In the UK as a whole, the crisis has caused a drop of 5%-6% in income levels and the government has had to borrow 11% of national income to counter it. Translating that to Scottish conditions, since noncapital borrowing is ruled out, public spending on services (schools, health) would have to be cut by 11% immediately. But those cuts in spending will drive a further decline in incomes and hence tax revenues, requiring a second round of cuts and/or tax rises. Ultimately, in order to restore spending, tax rates would have to rise to make up the short fall, provoking yet another (a third) decline in disposable incomes and hence revenues and spending.

This cycle of revenue declines, followed by spending cuts and then tax increases, is unavoidable because one cannot increase taxes immediately and to save the spending cuts. It takes two years: one year to pass the budget change through Parliament, and then one year for the changes to be implemented and bring the higher revenues in. This problem is a direct consequence of linking current government spending to current tax receipts under a regime in which the annual budget must be in balance – i.e. outgoings (expenditure) have to be matched by income (revenue).

Although the Calman report might have acknowledged this situation could arise, and would prove a nightmare from the perspective of economic management, astonishingly it offers no insight – still less any proposals – as to how it might be addressed. This is, to say the least, a disaster waiting to happen – and one that does not require a crisis anywhere close to the magnitude we are presently experiencing to trigger it. Economists are very familiar with the need for Governments to have access to a facility for "smoothing" unexpected variations in revenues, typically through borrowing powers. No country in the world (bar Denmark and Korea) tries to operate without those powers for itself or its regional governments. Yet the Calman Commission elected to ignore this issue entirely. This was not ignorance or oversight: the Commission was warned repeatedly, both in evidence to their expert group and in evidence from the council of economic advisors, of the dangers of following this path. But it appears not to have interested them. Most telling perhaps are the three scenarios on pages112-13 of the Report. They are: tax revenues in the status quo, and where Scotland reduces her tax rate, and where Scotland enjoys a boost to incomes. But there is no scenario where incomes fall in a recession. One might ask: why not? Was it because they didn't think of it; or because they thought it would never happen; or because they didn't dare admit that their proposal was fatally flawed?

There are also practical problems that make the Calman tax proposals unsuitable, if not unworkable. How is the block grant going to be cut if tax revenues are uncertain and variable? These cuts have to be made in advance (not after the revenues come in), and in an exact number of pounds. Percentages relative to the rest of the UK won't do since the UK revenues are just as uncertain. What dispute resolution procedure will be invoked when it is discovered that too much grant was cut because the UK revenues were weaker than expected? All tax revenue figures are subject to revision for up to two years later. What is to be done if revenues were expected to be higher, so the grant element is cut causing public services to be cut, and then they are revised to imply that the grant should never have been cut by so much? Then again, how are the self-employed, partnerships and trusts to be allocated a jurisdiction? The opportunities for flipping are nearly endless. And who will pay for all this, to administer and enforce the new regime? And how much will it cost? It used to be said that half of the Tartan tax would have absorbed in administration and implementation. If so, to raise 10p's worth of revenues under the new system, to restore spending power to its previous level, would require a Calman tax rate of 20p on top of the 10p UK tax rate. Although our figures might exaggerate the case, Scots would nevertheless see their tax rates rise above the rest of the UK just to stand still. Why would the Commission want that?

There is a further problem. The calculation of how much to reduce the block grant is made relative to what the UK-wide rate would have yielded in the old system. But incomes per head are about 4% lower than in the UK as a whole. This implies a loss of 4% (approx 400m) of revenues, and hence spending, compared to the old system, even if Scotland keeps her tax rates at the UK-wide rate. So it is not as if things have not changed if the Calman tax is not used. In today's money, this is equal to a loss of 16 schools each year. The reason for creating such a permanent bias is not clear.

In summary, we have to conclude that the current recommendations are worse than undesirable; they are unworkable. And while we acknowledge a preference for fiscal autonomy ourselves, it is important to recognise that if this is the level of service we can expect from official sources, then most people will demand a degree of autonomy when the advantages of this proposed system reveal themselves – including a hand in the design of the system. If there was ever proof "we" could do it better than "they", this was it.

By Andrew Hughes Hallet, Professor of Economics and Public Policy, George Mason University and Professor Drew Scott of the University of Edinburgh