Magazine article Public Finance

The Fiscal Trap

Magazine article Public Finance

The Fiscal Trap

Article excerpt

THE UK GOVERNMENT is pushing on with plans to reform the income tax system in Scotland, following the recommendations of Sir Kenneth Caiman's Commission on Scottish Devolution. In most circumstances, this rush to reform would be welcome, but there are serious flaws in the Caiman 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. Caiman 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 Caiman 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, Caiman 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 Ip 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. …

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