The Smith Commission report had a mixed reception in Scotland and in the rest of the UK (rUK). There is a widespread view in Scotland that the proposals are far from enough: a view with which we concur. Meanwhile, in England, there is a concentration on Cameron’s response of ‘English votes for English laws’.
However, one fundamental flaw in the Smith report is its lack of attention to detail: this is despite Smith saying that the proposals were agreed on the basis of top expert advice. This failure to deal adequately with detail is in itself a result of the unsatisfactory and undemocratic nature of the process, in which a small group of politicians were given an inadequate timescale to come up with proposals. The result has been that some significant technical issues have either been glossed over, or entirely ignored. We argue this is likely to prove fatal.
Some of the issues which the Commission has skated over were pointed out in submissions made by the public or interested groups. Examples are the problems of exactly how to index the reduction to the Barnetted Block Grant if the Scottish Government is given extended tax raising powers of its own: the problem of likely fluctuations in the tax base if income tax is used as a major source of funding for the Scottish Parliament: and the problems that would arise if the tax base for which the Scottish Parliament was given responsibility intrinsically grew less fast than the corresponding tax base in the rest of the UK.
Particularly disappointing, and of major importance, is the failure to give the Scottish Parliament adequate economic powers to grow the tax base on which it will have to rely: Smith signally fails to address the difficulties posed by giving the Scottish Parliament responsibility (for a given tax base), without power (to grow that tax base).
All of the above issues were identified, for example, in the submission which we made to the Smith Commission on behalf of the Jimmy Reid Foundation: and no doubt other submissions among the 407 from civic institutions and 18,381 from members of the public raised similar points.
The specific problem we want address here, which we call the ’gearing problem’, seems to have escaped general notice. It has the capability of blowing the Smith proposals, and indeed the union itself, apart – particularly in the light of Cameron’s typically opportunistic response to restrict decisions on income tax rates in the rUK to rUK MPs.
So what is the ‘gearing problem’? Suppose that the Scottish Government was given responsibility for funding devolved spending out of the income tax it raises itself (as well as out of other smaller taxes for which it has responsibility) and out of the reduced Block Grant determined by an adjusted Barnett formula.
Income tax is going to be a major component of the Scottish government’s funding: according to Government Expenditure and Revenues, it amounted to nearly £11bn in 2012-2013. Approximately 7.2% of this is income tax levied on savings and dividends. So the total expected income tax receipts from non-savings, non-dividend income tax in Scotland is around £10bn. Total expenditure within the control of the Scottish government and local authorities is nearly £39bn. Thus, if the Scottish Government set income tax rates at the current UK levels, then income tax is going to fund about 26% of that public expenditure in Scotland within the control of the Scottish Government
For the rUK, income tax is one of the revenue streams which contribute to the funding of general public expenditure: that is, not only those services for the rUK like health and education which are devolved in Scotland, but reserved services for the whole of the UK like welfare, defence, and foreign affairs. Rest of UK income tax funds about 19% of all of this expenditure.
Also suppose that, under Cameron’s law, it is only rUK MPs that are responsible for setting rUK income tax rates. Suppose, as is very plausible, that a right wing majority of those MPs decide to implement a significant cut in income tax rates, and have a corresponding reduction in public expenditure.
Suppose, for example, there is a 5% reduction in rUK income tax receipts as a result, and further suppose that the corresponding reduction in public expenditure is spread evenly over not just domestic ‘devolved’ services in rUK but also over ‘reserved’ services like defence, social security etc.
Since, as we have seen, income tax funds 19% of this expenditure, the result would be a 0.05 x 19% cut in this expenditure, that is a fall of 0.95% in expenditure, and hence, specifically in expenditure in devolved services in the rUK.
Now consider Scotland’s position. If the Scottish government does not match the cut in income tax rates by the rUK, then the Scottish economy is likely to be at a chronic disadvantage: ultimately, any Scottish Government would have to follow suit if the rUK was pursuing an aggressive policy of cutting income tax rates.
But if the Scottish Government does adopt the same cut in tax rates as the rUK, and if that reduces Scottish income tax receipts by the same 5% as in the rUK, then since income tax accounts, as we have seen, for 26% of the funding of the public expenditure under the control of the Scottish Government, then the cut in Scottish Government public expenditure will be 1.3% – namely, a 37% larger cut than in similar expenditure in the rUK. This is what we mean by the gearing effect.
This kind of arrangement would put Scotland in an intolerable situation. The gearing effect would mean that an income tax cutting policy in the rUK would force upon Scotland either disproportionately higher tax rates or disproportionately greater cuts in public expenditure.
And in the situation where, English may wish to voters want to punish Scotland for the referendum result, the potential for doing precisely this through the gearing effect of income tax cuts, would not be lost on right wing English MPs.
Indeed, if the public expenditure cuts funding the reductions in rUK income tax rates were loaded disproportionately onto reserved functions such as defence or social security, Scotland could be penalised at little or no cost to rUK devolved services.
The Smith Commission report does not spell out this problem of gearing: but on the other hand, there is evidence to suggest that they are aware of the problem (see paragraph 95.4(b): ‘Changes to taxes in the rest of the UK, for which responsibility in Scotland has been devolved, should only affect public spending in the rest of the UK. Changes to devolved taxes in Scotland should only affect public spending in Scotland’.
The most obvious interpretation of this provision is that a change in rUK income tax rates should not be used to fund, or should not be funded by, changes in UK wide services like defence or social security. If implemented, it would mean that rUK income tax receipts, (or, more specifically, the non-savings/non-dividend element of these receipts), would be hypothecated to funding rUK only services – which effectively, are those services which are devolved to Scotland.
The result of implementing this provision would therefore be to solve the gearing problem. So although the Smith Commission did not specifically spell out the implications of the gearing problem, the circumstantial evidence of paragraph 95.4(b) suggests it was aware of it.
Given that the Smith Commission did not specifically identify the gearing problem, the critical importance of paragraph 95.4(b) is not at all then obvious, meaning there is every danger of this clause being overlooked when the Smith Commission findings are legislated upon. It is of fundamental importance for Scotland that this does not happen.
What Smith missed, however, are the difficulties of implementing the provisions of paragraph 95.4(b). It is very difficult to see how the principle underlying paragraph 95.4(b) could be implemented without putting in place a fully federal system. Let’s follow the chain of logic which points to this conclusion.
If 95.4(b) holds in any meaningful sense, then there would have to be a ring-fenced rUK budget for ‘devolved’ services in rUK, which (leaving items like council tax out of the equation for simplicity) would be funded from rUK Block Grant and rUK income tax revenues. This then raises a number of questions.
Who would make the decisions on how this budget is spent? Since one of the major sources of funding for this budget (namely rUK income tax) would be under the control of rUK MPs and since the services funded by this budget will be solely rUK devolved services, the only satisfactory answer would be that rUK MPs make the spending decisions.
Then, what would be the relationship between the rUK Block Grant and the Scottish Block Grant? One possibility that would be consistent with the vow to retain Barnett would be that changes in the Scottish Block Grant would be related to changes in the rUK Block Grant via the Barnett formula.
This, however, would operate in a significantly different way from the Barnett formula as envisaged by Smith. Since the relationship is now between rUK Block Grant, that is, (rUK public expenditure minus income tax), and the Scottish Block Grant, there would be no need for the kind of complicated abatement to Barnett envisaged by Smith.
Also who would set the rUK Block Grant? This could not be a decision that was left to rUK MPs. If this was the case, then Scotland would have no democratic influence on how the major part of its funding was delivered. So at the very minimum, decisions on the size of the rUK Block Grant would have to be made by the whole UK Parliament.
Yet this would be barely satisfactory – given the numerical preponderance of rUK in the union. Leaving this problem aside for the present, what we have as very minimum as a consequence of the paragraph 95.4(b) principle is a situation where the whole UK Parliament sets the Block Grant for rUK, (and via Barnett for Scotland), while the group of rUK MPs decides on a) the rUK rate of income tax, and b) how the rUK budget for devolved services is spent.
This is, to all intents and purposes, a federal system. It appears to be the very minimum which is consistent with the principle so glibly enunciated by Smith in paragraph 95.4(b).
In terms of feasibility, this poses major problems. This type of federalism goes far beyond anything envisaged by Smith or the UK parties, and is unlikely to be acceptable to English MPs. Yet it is also unsatisfactory for Scotland.
In a federal system, the over-arching federal body has to be sufficiently wise and impartial, or has to be constituted of sufficiently balanced competing interests, that it can be trusted to make fair judgements about the transfers of resources among members, and other key decisions (like monetary policy) for which it will be responsible. Given the numerical preponderance of English MPs, Scotland could not trust the Westminster Parliament to fulfil this role.
Overall, therefore, the gearing issue is fatal for Smith. The bland wording of paragraph 95.4(b) conceals a veritable ‘Catch 22’ situation. If a solution to the gearing issue is not found (by implementing something like 95.4(b)), then giving Scotland control of income tax would put Scotland in a disastrous situation, where hostile rUK MPs could remorselessly drive down public expenditure in Scotland.
At the same time, it is impossible to see how paragraph 95.4(b) could be implemented without putting in place a genuinely federal structure for the UK as a whole and is unlikely given the disparity in size between Scotland and rUK. On this basis alone, the central plank of the Smith recommendations relating to income tax is unworkable. So while there are many good items in the Smith report, inadequate attention to detail fatally undermines its whole foundation.
Jim and Margaret Cuthbert are independent economists