The fiscal trap

11 Mar 10
Plans to give Scotland additional tax powers contain a fatal flaw. A built-in perverse incentive means that the Holyrood government would be less inclined to adopt a fiscal stimulus and could, instead, be forced to raise its income tax rate. Jim Cuthbert and Margaret Cuthbert explain
By Jim Cuthbert and Margaret Cuthbert

11 March 2010

Plans to give Scotland additional tax powers contain a fatal flaw. A built-in perverse incentive means that the Holyrood government would be less inclined to adopt a fiscal stimulus and could, instead, be forced to raise its income tax rate. Jim Cuthbert and Margaret Cuthbert explain

The UK government is pushing on with plans to reform the income tax system in Scotland, following the recommendations of Sir Kenneth Calman’s Commission on Scottish Devolution. In most circumstances, this rush to reform would be welcome, but there are serious flaws in the Calman proposals, which have been ­exacerbated in Westminster’s subsequent white paper.

The commission, set up in April 2008 to review the arrangements of devolution, published its final report in June last year. The proposals on income tax were among its most important recommendations. They were intended to remedy the acknowledged weakness of the current system – that the Scottish Government has significant powers to spend but limited control over the size of its budget. Calman proposed giving Scotland the power to set its own tax rate as part of the income tax collected in Scotland. Forcing the Scottish Government to make an explicit decision on the Scottish rate of income tax would make it accountable for the determination of a significant part of its revenue.

Another weakness Calman recognised with the present system is that the Scottish Government has a limited fiscal stake in the success or otherwise of the Scottish economy: and it is reasonable to assume that the commission’s proposals are ­intended to remedy this problem too.

To get the new system up and running, Calman proposed reducing all income tax rates in Scotland by 10 pence. Westminster would balance its loss of income through a one-off equivalent cut in Scotland’s block grant. As a result, if the Scottish Government set its extra income tax rate at 10p, Scotland would still receive the same overall income.

There are, however, two significant technical problems with this. First, the more the Scottish Government increases the Scottish rate of income tax, the larger the proportion it will receive of the total income tax revenue raised in Scotland, and vice versa. But a situation could arise where a reduction in the Scottish tax rate stimulates the economy north of the border and actually increases overall income tax levels. Under this scenario, Scotland would receive a smaller proportion of this tax revenue cake. If the growth in the tax cake was not large enough to outweigh the reduction in the Scottish Government’s share, its tax revenues could go down while total income tax revenues increased.

We published a detailed explanation of how this might happen in the February edition of the University of Strathclyde’s Fraser of Allander quarterly economic commentary. Briefly, the problem arises if the effect of a 1p reduction in the Scottish rate of income tax increased overall basic rate tax revenues collected in Scotland, but by less than 5% (the corresponding percentages for the intermediate and higher rate tax bands are 7.5% and 8% respectively).

If these conditions were to apply, then Scotland would find itself in a fiscal trap. If it reduced the Scottish rate to stimulate the economy, its own finances would suffer – even though the Whitehall Exchequer would benefit. Much more likely is that a Scottish government would be forced to raise the Scottish rate – so increasing its own revenues, but with the perverse effects of deflating the Scottish economy and reducing the revenues going to the Whitehall Exchequer.

How likely is it that the conditions for this anomaly would actually apply?
No-one can know, as this is a completely new situation. However, if the Scottish Government were trying to stimulate the Scottish economy, it would probably implement a package of measures, such as reductions in business rates and water prices, not just a cut in income tax. In these circumstances, the outcome could well be a modest increase in economic activity and in total income tax revenues  – in which case the conditions for the ­fiscal trap might apply.

The second technical problem relates to the effect of fiscal drag. If the Scottish government set a tax rate of around 10p, then it would receive 50% of the basic rate tax revenues collected in Scotland, 25% of the intermediate rate revenues, and 20% of the revenues from the highest rate band. The effect of fiscal drag, however, is typically to increase through time the proportion of the overall tax take that comes from the higher bands. Since the Scottish Government receives a lower proportion of the higher rate tax collected, fiscal drag would over time reduce the overall proportion of income tax ­revenues it would receive.
Last November, the government published its white paper response to Calman. It proposed implementing the commission’s income tax proposals virtually unaltered, with the exception of transitional arrangements, which would operate for an unspecified period until economic and fiscal circumstances permitted. Under the transitional arrangements, instead of making a one-off initial cut in the Scottish block grant, the adjustment would be calculated afresh for each public spending planning round.

The effect of these transitional arrangements would be significant and would worsen the first of the technical problems identified. Whatever income tax rate the Scottish Government set, it would always increase its revenues by raising the tax rate and decrease them by cutting it. This would happen even if the reduction in the Scottish rate were accompanied by an increase in both economic activity and overall income tax revenues collected in Scotland. The algebra demonstrating this is in our Fraser of Allander paper.

The transitional arrangements would increase the disincentive for the Scottish Government to introduce a fiscal stimulus package, including a cut in the Scottish rate of income tax. Instead, if it needed to increase its revenues, it would be forced to increase the tax rate – at the expense of deflating the Scottish economy. Far from having a stake in the success of that economy, the Scottish Government would have, in effect, the opposite.

The 2009 UK Budget stated: ‘Governments should manage their public finances so as to support economic growth, as this ensures a robust economy and improvements in living standards. This is important to provide future revenues to finance public services and spending, thereby ensuring that future obligations can be met.’

It is most unfortunate that the income tax proposals in Calman and the subsequent white paper run counter to this principle. There is also a more general conclusion to be drawn: namely, that the consideration of the technical aspects of the proposed changes to income tax has been inadequate in both papers.

Any attempt to reform the tax powers of the Scottish government should ­proceed on the basis of a much more thorough analysis of the technical ­implications of any changes proposed.

Jim Cuthbert and Margaret Cuthbert are members of the Public Interest Research Network at the University of Strathclyde. The Fraser of Allander commentaries are available at:

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