Tax changes put more power, and responsibility, in Scottish hands

Having spent much of last week in Scotland, I saw how different the political and economic debate there is from that in London. Yet what was really noticeable was how much the discussion had altered in response to the devolution of wide-ranging powers to make tax policy. Real change is in the air.

The Holyrood government has always had control over much of public spending in Scotland. From next spring, it will have control over taxes, including most of income tax, which raises 40 per cent of the revenues required to cover devolved spending. From 2019, half of the VAT raised there will also be assigned. Half of Scottish spending will then be paid for by taxes devolved or assigned to Scotland. That is a remarkable change. Scotland will have far more control than now over its tax affairs and over the size of its budget.

Obviously, that means some serious discussion of tax policy. What is striking, though, is the focus on the performance of the Scottish economy itself, for with devolution of tax-raising powers comes devolution of risk. If the Scottish economy performs worse than that in the rest of the UK, such that income tax and VAT revenues per person are depressed, then Scotland will have less to spend. Conversely, it will benefit from faster growth.

The Scottish budget will now enjoy the upside and suffer the downside of economic performance that differs from that in the rest of the UK. The incentive on the Scottish government to focus on growth is much sharper than ever before. Even small differences will compound over time into big differences in the money available.

One worry is that in the short term the economics don’t look to be working in Scotland’s favour. In part as a result of a declining oil industry, economic growth in the past year has been significantly less than that in the UK as a whole and it is expected to do less well again next year. The direct effect of falling oil prices, the collapse in revenues from taxes on North Sea oil and gas production, won’t affect the Scottish budget. These taxes are not devolved. The effects of their loss are shared across the UK. But the Scottish budget will suffer to the extent that the earnings and spending of those working in the industry, or in related industries, suffer.

In the longer term, the Scottish government hopes to be able to influence growth. It also will have to deal with plenty of other uncertainties over which it has less control: the consequences of Brexit, for example, on both growth and on grants received from the European Union.

One risk not faced by Scotland will be the consequences of tax revenues growing more slowly as a result of differential population growth. The Westminster government lost that argument in agreeing the new fiscal framework. That matters because, for decades, the Scottish population has grown less quickly than that in England. That’s essentially why the Barnett formula remains so generous to Scotland. Originally it was supposed to lead to a gradual equalisation in spending per head, but the consistently lower rate of population growth in Scotland has left public spending per person there much higher than it is in the rest of the UK. The new devolution settlement will entrench that advantage, at least for now.

That extra spending is substantial, despite incomes per person being almost identical. Public service spending per person in Scotland today is still quite a bit higher than it was in England before the present period of austerity began. Of course, what is felt is that spending is being cut, even if less quickly and from a higher base than elsewhere in the UK. What is not felt is how much higher it was and how much higher it remains.

In fact, the Scottish government is looking to use some of its new tax powers to increase taxes relative to those south of the border to cushion the budget from further cuts. That, of course is precisely the point of devolution. It allows the Scottish people to make a different set of choices. The first really significant divergence will come from the Scottish government’s decision not to increase by more than inflation the higher rate threshold, the point at which the 40 per cent rate of income tax starts to bite. Given the Conservative government’s manifesto commitment to raise that threshold to £50,000 by the end of this parliament, this could open up a range of income between about £46,000 and £50,000 on which Scots will pay income tax at a rate of 40 per cent rather than the 20 per cent faced by taxpayers elsewhere in the UK.

The trouble is that in making this choice the Scots are immediately coming up against the limits of the devolution settlement. National insurance contributions are not devolved, but a key threshold in the system, the upper earnings limit, is linked at the moment to the higher rate threshold for income tax. It is set in Westminster. That means, on existing expected policies, Scots earning between about £46,000 and £50,000 will face an overall marginal tax rate on their earnings of 52 per cent. That compares with the combined income tax and NICs rate of 32 per cent for English taxpayers on the same incomes, and 42 per cent for those earning more than £50,000.

That’s only one of the many messy outcomes that greater fiscal devolution will throw up. There are great opportunities from this devolution. Grabbing them will require navigating a careful route around the risks and the constraints.

This article was first published by The Times and is reproduced here with permission. Paul Johnson is director of the Institute for Fiscal Studies. Follow him on @PJTheEconomist