If the Scottish Parliament uses its tax powers successfully, it loses money. If it doesn’t use its tax powers successfully, it loses money. Given that Jim and Margaret Cuthbert already pointed out this serious flaw, why is it still there?

The Scotland Bill, which is intended to implement many of the proposals stemming from the Calman Commission, was published by the Westminster government on St Andrews Day. In many ways, the central plank of the Bill is the proposal relating to the Scottish rate of income tax. In this paper, we will show:

• how these income tax proposals suffer from grave technical flaws:
• how this threatens serious damage to the Scottish economy:
• and why, in political terms, the Bill constitutes a minefield for Labour in particular.

We should start by making our own position clear. In principle, we very much support meaningful new powers for the Scottish Parliament: and we support the objective of increasing accountability. But as regards tax powers, it is essential that they are well formulated and not technically flawed: otherwise they could constitute a trap for the wellbeing of the Scottish economy.

The original Calman proposals were published in June 2009. In July 2009, we published an open letter to the Calman Commission pointing out that its proposals on income tax were technically flawed. There were, in fact, two main flaws. It is worth describing these at this point in the paper, because the same problems are still there in the income tax proposals in the Scotland Bill.

Under the Calman proposals, the Scottish Parliament would be responsible for setting a Scottish rate of income tax every tax year. More specifically, all of the rates of income tax levied on the non-savings income of Scottish taxpayers would be reduced by 10 pence: and the new Scottish rate of income tax would be levied on top of this reduced level. Correspondingly, the block grant from the UK Government would be reduced to reflect the loss to the UK exchequer from the reduction in the UK tax rate charged to Scottish taxpayers.

So if the Scottish government were to set its tax rate at ten pence, it would, at least initially, get back by way of income tax the same amount as had been deducted from its block grant. Now consider what happens if the Scottish government reduced the Scottish rate of income tax to below 10 pence: the most obvious reason being as part of an overall package of measures designed to make Scotland a more competitive place to do business and to stimulate the Scottish economy. Suppose total income tax receipts collected in Scotland, (from the combined UK and Scottish tax rates), rose as a result of this stimulus package. Would the income tax receipts coming to the Scottish government rise too? In fact, because the Scottish government would be getting a decreasing share of the increased total income tax take, the receipts coming to the Scottish government could well fall.

A hypothetical example makes it clearer how this could happen. Suppose that the Scottish government reduced its tax rate by one pence, from an initial starting value of 10 pence: then the Scottish government would in future receive 9/19 of the basic rate income tax collected in Scotland. Suppose also that, as a result of an overall stimulus package to the economy (of which the tax cut would be an important part) total basic rate income tax receipts in Scotland rose from 100 to 103. Before the change, the Scottish government would have received 10/20 of the 100 total basic rate receipts: that is, it would have received 50 from the basic rate. After the change, it receives 9/19 of the increased total of 103, which amounts to 48.8. So the effect of the successful stimulus package is that the Scottish government in fact receives 1.2 less than it did before. The other side of this coin, of course, is that the Whitehall exchequer would be better off, to the tune of 4.2. So while overall basic tax receipts have gone up by three per cent, what the Scottish government gets goes down by 2.4 per cent, and what the UK exchequer gets goes up by 8.4 per cent.

We analysed the conditions under which this effect would happen in detail in our open letter. It turns out that, if the effect of a one pence reduction in the Scottish rate of income tax is to increase overall basic rate revenues in Scotland, but by less than five per cent, then the revenues coming to the Scottish government from the basic tax rate would always fall. The corresponding percentages for the intermediate and highest rate bands are 7.5 per cent and eight per cent respectively. Since a one pence reduction in the Scottish rate of tax is very unlikely to stimulate overall tax revenues by more than these percentages, the implication is that a Scottish government operating under the Calman tax proposals would be unable to use its tax powers to stimulate the economy, without suffering a drop in its own revenues, and a consequent drop in the services it could supply. And while the Scottish government’s revenues would suffer, the beneficiary of a successful stimulus package would actually be the Whitehall exchequer, which would receive increasing income tax revenues from Scotland. This perverse package of effects was the first technical flaw we identified with the Calman proposals.

The second technical problem we identified with Calman relates to the differing proportions of tax revenues coming to the Scottish Government from the different income tax bands: at a 10p Scottish tax rate, the Scottish government would receive 50 per cent of basic rate tax revenues, 25 per cent of middle rate revenues, and 20 per cent of highest rate revenues. However, the phenomenon known as fiscal drag means that the proportion of tax revenues generated by the higher rate tax bands tends to increase through time. But since the Scottish Government receives a lower proportion of the revenues generated by the higher rate bands, this would lead to a decreasing trend in the average proportion of income tax revenues going to the Scottish government. The mathematics underlying these effects are given in a paper we published in the Fraser of Allander Economic Commentary in February 2010.

What the first technical flaw means is that a Scottish government would be unable to increase its revenues by decreasing the Scottish rate of income tax: its only option, if it has to increase revenue, is to increase the Scottish tax rate.

What the second flaw means is that, under most foreseeable circumstances, a Scottish government operating under the Calman proposals would face increasing financial pressure as fiscal drag decreased the share of Scottish income tax revenues which it received.

Taken together, this means that the Scottish government would find itself under almost irresistible pressure to progressively increase the Scottish rate of tax: hence condemning the Scottish economy to increasing lack of competitiveness and ongoing decline.

This led us to the conclusion that the implementation of the original Calman income tax proposals would be a disaster for Scotland and her economy.

In November 2009, the then Westminster government published a White Paper, containing its response to the Calman proposals. It endorsed the Calman proposals on income tax, virtually unchanged, and without addressing any of the technical flaws which we, and other commentators, had identified. In fact, the White Paper actually made things worse. The White Paper transitional arrangements, which would last for an unspecified time, had the effect of aggravating the first of the above technical problems. While the transitional arrangements lasted, a decrease in the Scottish rate of tax would always decrease the revenues going to the Scottish government, no matter how much the economy was stimulated: and an increase in the Scottish rate would always yield more revenue for the Scottish government, no matter how much the Scottish economy declined. Again, the maths of this is given in our Fraser of Allander article.

So, finally, we come to the Scotland Bill. Has this addressed the technical flaws? No.

What is proposed as regards the Scottish income tax is in all essentials the same as in the last government’s White Paper: this includes the flawed transitional arrangements, (now suggested to last for three fiscal years). The current proposals are therefore subject to all of the technical problems discussed above: if implemented, the proposals will impose a chronic squeeze on the Scottish budget – and as the Scottish Government is forced to raise the Scottish rate of tax to counter this, will have a disastrous effect on the Scottish economy. There is, it is true, a promise in the Command paper published at the same time as the Scotland Bill that “The UK Government will continue reviewing the system to ensure that the relative levels of public expenditure going forward remain consistent with what the Commission described”. There is no comfort in this: if anything, it gives the Westminster government the ability to impose, by default, whatever squeeze on public expenditure in Scotland that it chooses.

When the Scotland Bill was published, some commentators suggested that, in the event, future Scottish governments would be unlikely to make active use of the income tax powers: and that, just as no use has been made of the existing tax varying powers, so future governments would probably continue to set a neutral, 10 pence, Scottish rate.

What these commentators failed to grasp was that, because of the fiscal drag squeeze which will result under the new arrangements, long term continuance of a 10 pence rate is not really an option.

One of the key objectives of the Calman Commission was to improve the financial accountability of the Scottish Parliament. But Calman also identified, as one of the main weaknesses of the current block grant arrangements, the lack of effective economic management tools for the Scottish government. The great paradox of Calman is that the income tax changes which the Commission finally recommended, far from improving the Scottish government’s powers of economic management, would virtually force the Scottish government into a series of progressive tax rises which would damage the Scottish economy. And it is a strange form of accountability that forces the organisation in question down one particular, adverse, course – and then tries to make it accountable for the results.

But in addition to the potentially disastrous economic affects, there are also huge political implications: and, as we will argue, these are primarily for the Labour Party.

Let us look at the other parties first. The Conservatives have little enough to lose in Scotland anyway when the adverse effects of the Calman tax proposals become clear: and, in fact, the curb on Scottish public expenditure which will result will play quite well with certain elements of Conservative traditional support, both in Scotland and beyond. The LibDems anyway are sleepwalking to disaster. The Nationalists, on the other hand, have a consistent and defensible stance on the Calman tax proposals. They have understood that there are basic technical flaws in Calman, and have argued that the proposals should not be implemented without radical change. They will not be able to stop Calman on their own: but they will be able to account for themselves with the electorate when things go wrong.

What about Labour? First of all, they are in the position where they can stop these tax proposals if they want. As is made clear in the Command Paper, under the Sewell convention it will be for the Scottish Parliament to indicate their approval for the measures contained within the Scotland Bill. So if Labour were to oppose, then their votes, together with the SNP’s, could block this. But for Labour to do this it would mean publicly acknowledging that that part of the Calman proposals relating to income tax was flawed. It would also mean Labour breaking the consensus between the three Unionist parties, and making common cause with the SNP on this issue in what, in effect, would be a challenge to Westminster.

On the other hand, if Labour assists in pushing the tax proposals through, then as the damaging consequences of Calman become clear, Labour is likely to reap the whirlwind of Scottish electoral disapproval.

It is not too much to say that the Calman income tax proposals could become Labour’s very own Poll Tax in Scotland.

So Labour has a difficult choice to make. In our Fraser of Allander article, when we were commenting on the Labour Government’s White Paper on Calman, we made the point that a cynic might think that the failure of that White Paper to address the technical flaws in Calman might well suggest that Labour were never serious about implementing these tax proposals anyway. That same cynic, looking at the Scotland Bill, might well suggest that David Cameron’s coalition has spotted this, and sees electoral advantage in calling Labour’s bluff.