David Bell: Powers are a taxing issue

The Yes and No campaigns are now underway. For the next two years we will have to endure claim and counterclaim about the effects of independence on the Scottish economy. For many of the questions there will be no definitive answer. However, one thing we do know is that the Scotland Bill, which represents a significant increase in Scotland’s fiscal sovereignty, has been enacted and preparations for its implementation are necessary, irrespective of the direction of the constitutional debate.

The most important power that the Scotland Act 2012, as it now should be called, confers on the Scottish Parliament is partial control over income tax. Starting in 2016-17, the Scottish Parliament will have to set a “Scottish rate” of income tax. The resulting revenues will contribute to funding the Scottish Government’s budget.

To implement the Scottish rate, the UK Treasury will reduce all income tax rates in Scotland by 10p. The Treasury will also cut Scotland’s block grant by an amount equivalent to the revenue lost by these rate reductions. The Scottish Parliament will then have to decide whether to set the “Scottish rate” at 10p and so offset the reduction in funding from the Treasury. This should mean the Scottish Budget can be kept at its existing level. But the Parliament could set the Scottish rate below 10p, meaning that income tax in Scotland would be below those in the rest of the UK, or it could set a higher rate,.

One key issue is how accurately the reduction in Scotland’s block grant equates to the money raised by setting the Scottish rate at 10p. If the Scottish Government succeeds in maximising sustainable economic growth, the revenues generated by a 10p Scottish rate could exceed the loss in the block grant. Conversely, poorer economic performance in Scotland would lead to reduced revenues, forcing cuts to spending plans.

Income tax would be the most important source of revenue to an independent Scotland. In 2009-10, it accounted for 22 per cent of total revenues including those from North Sea oil. National insurance and VAT comprise 16.6 per cent and 15.3 per cent of total revenues respectively, while North Sea oil revenue is some way behind at 8.4 per cent. The Scotland Act effectively means that there is “tax sharing” between the UK and Scottish governments, a practice common in other jurisdictions, such as Germany.

Until recently, the received wisdom was that income tax rates had little impact on the willingness of males to supply labour, but higher tax rates deterred married women from seeking work. Evidence has suggested that high tax can be counter-productive for high income individuals, particularly those who have opportunities for tax avoidance. The recent case of comedian Jimmy Carr is a case in point. Increases in income tax rates may have significant effects on the extent to which these high earners indulge in socially inefficient practices to reduce their tax burden.

This matters because of the very unequal distribution of income tax liabilities. In 2010-11, the bottom 50 per cent of income earners in the UK provided 23.8 per cent of total income tax revenue. This only just exceeded the 23.5 per cent provided by just the top 5 per cent of earners. Top earners provide a massively disproportionate share of total income tax revenues. While one might argue that this is a socially just distribution of the tax burden, the responsiveness of this group to changing tax rates is an issue that the Scottish Parliament cannot afford to ignore.

In the short-run, small variations in tax rates are unlikely to have much effect on the willingness to work and the effects of tax-rate changes can be modelled with reasonable accuracy. This is done by using a household survey and calculating the tax liabilities of the members of each household, given their incomes, ages and family situations. I have set up such a model at the University of Stirling using survey responses from more than 4,000 Scottish households. For each household, the model calculates liabilities for income tax and national insurance as well as tax credits and a variety of benefits.

So how much revenue would different values of the “Scottish rate” generate? Estimates using the model for the year 2010-11 are shown in the graph, below left. These show total income tax revenue in Scotland for different values of the Scottish rate of income tax and indicates how this revenue is divided between the basic rate, the higher rate and what is termed the additional rate, which was 50p in 2010-11, and was payable only on incomes above £150,000. As the Scottish rate increases in steps of 2p (from left to right in the figure), the same increases are applied to the higher rate and the additional rate, in line with the rule set out in the Scotland Act.

When the Scottish rate is zero, the basic rate of income tax in Scotland will be 10p, the Treasury having subtracted 10p from the current basic rate of 20p. As the Scottish rate increases, as shown in the figure, revenues to the Scottish Government will also rise. When the Scottish rate is set at 10p, there should be sufficient revenue to offset the reduction by the Treasury to Scotland’s block grant. If it increases the Scottish rate beyond 10p, the government will have more cash to spend on its priorities, but runs the risk of increasing tax evasion and reducing labour market participation.

The difference between the zero and 10p Scottish rates is around £4.7bn. This would be the value of the reduction on the Scottish Government’s budget if it chose to set the Scottish rate at zero.

The Scottish Government might choose to set a Scottish rate above 10p, depending on its priorities and the state of its finances. The graph shows the Scottish rate rising up to 20p. With the first 10p payable to the UK government, this would imply a basic rate of 30p, a higher rate of 50p and an additional rate of 55p. At these rates, Scottish income tax revenue is likely to fall below the model’s predictions, because some workers will leave the labour market and tax avoidance/evasion will increase.

One of the features emerging from the model results is that the design of the Scottish rate means that the Scottish Parliament has negligible control over the progression of income tax in Scotland. This means that the shares of Scottish income tax revenue from the basic rate, the higher rate, and the additional rate hardly change as the Scottish tax rate increases.

The design thus reflects the UK government view that control over tax progression should not be ceded to Scotland, but instead should be retained by central government. The Scottish Parliament can raise the overall level of income tax, but it cannot focus particularly on, say, high income earners. This would only be possible if it were able to control income tax allowances and vary tax rates independently of each other.

Though the independence debate may be taking the headlines, the Scottish Parliament will have to agree a budget in 2015 to be implemented in 2016-17. Time for debate is relatively short. The issue of the choice of the Scottish rate needs to be given more attention by politicians and the press as well as by my colleagues in Scottish universities.

• David Bell is Professor of Economics at Sitrling University