The Smith commission appointed in the aftermath of the Scottish independence referendum presented its report last week, which amounted to an agreement of sorts between the leading political parties in Scotland.
Public expenditure in the country is about £65bn, of which the Scottish government itself spends about £37bn, mostly on health and education. Welfare, defence and debt interest are the largest expenditure items that remain the responsibility of the UK government. At present the Edinburgh government is almost entirely funded through a block grant from London. Under the Smith recommendations, nearly half of its expenditure would be raised by transferring control of Scotland’s income tax receipts and half of the value added tax revenues attributable to Scotland. Even though Edinburgh will have no power to vary the rate of VAT, the revenue from both sources will depend on the performance of the Scottish economy. Unless this outstrips the rest of the UK, the outcome will be a gradual reduction in the effective subsidy to Scotland, which at present receives about £5bn more in grants than its population share could justify.
At present there are three rates of income tax in Britain: the basic rate, payable on income above the personal allowance of £10,000; the higher rate, which applies to income above £40,000 or so; and the additional rate on income over £150,000. About 2.1m Scottish taxpayers pay the basic rate; 370,000 are liable at the higher rate; and 18,000 suffer the additional rate. The Edinburgh government will have the power to vary the rates and bands but not the overall structure or the personal allowance. It has had some such power since the Scottish parliament was established in 1999; the basic rate of tax can be varied by up to 3 percentage points, though the use of this power has never been seriously considered.
But now the pressure to do something will be hard to resist. You cannot have a long campaign for more devolution and then maintain policies identical to those of the rest of the country. You must do something – but what? Lower tax rates in Scotland than in the UK would call into question Scotland’s generous funding formula. Meanwhile, almost every discussion of policy changes in the country refers to social justice and involves more spending. The objective for its policy makers must be to obtain a bit more revenue and create at least the appearance of greater progressivity.
That puts the spotlight on the 18,000 people who pay additional rate tax at 45 per cent. But, although for most people it is not difficult to identify if they live and work in Scotland, there is ambiguity for some – and they are heavily represented among the 18,000. If only 1,000 of these individuals were to succeed in establishing that they are resident outside Scotland for tax purposes, the erosion of the tax base would offset any gain from a 5 per cent higher additional tax rate; if 2,000 did so, the move would actually cost revenue.
Raising the 40 per cent higher rate is more rewarding. An increase to 45 per cent might bring in £500m or so – enough to cover the promised reduction in air passenger duty (welcomed by the 18,000, many of whom are found daily in the business lounge at Edinburgh Airport) and the end of the “bedroom tax” (the cut in housing benefits for those deemed to have more accommodation than they need). But even a single point reduction in the basic rate would cost the full £500m and the agreement precludes any increase in the personal allowance for the low paid.
There is only one way in which the Scottish government’s new freedom to vary income tax can be exercised, and that is to raise it. That was not what the supporters of more devolution had in mind when they asked for additional powers.
This article was first published in the Financial Times on December 3rd, 2014.