Careful What you Wish for? Risk and Reward with Scottish Tax Devolution

September 2022 marked twenty-five years since the referendum on the creation of the Scottish Parliament. From the early days of devolution, debates over Holyrood's tax powers have been a recurring theme. Recent reforms to the Parliament's tax powers have been driven by the Scottish National Party and the Scottish Conservatives, a confluence of arguments from two unlikely political allies, with both embracing arguments for greater autonomy and fiscal responsibility.

Debates on fiscal devolution typically focus upon the rewards, but as the case of Scottish tax devolution shows, the risks are real and require careful management. Politicians on all sides need to be careful what they wish for.

Scotland's new tax powers

In 1999, the new Scottish Parliament was granted responsibility for many aspects of day-to-day public spending, including health, education and justice. But its tax powers were limited to local taxes (including council tax) and modest flexibilities on income tax (the ‘tartan tax’). Since then, a series of reforms has increased Holyrood's tax powers significantly.

The pivotal moment was the election of the SNP in 2007, followed by the 2008 Calman Commission, which led to greater flexibilities over income tax, and the devolution of stamp duty on property transactions and landfill tax.

The 2014 Smith Commission extended these powers. It recommended that all non-savings non-dividend (NSND) income tax revenues should be transferred, more than doubling the scale of income tax devolution.

As a result, from 2016, Holyrood became responsible not just for the marginal changes in revenues from tax decisions, but for the relative performance of the entire base of devolved taxes in Scotland.

Should Scotland's tax base grow more quickly than the equivalent tax base in the UK, the Scottish Parliament's spending capacity would be better off than it would have been before tax devolution, and vice versa.

For the SNP, the key prize from tax devolution was increased autonomy. The aim has been to collect around an additional £1,000 million largely from taxing higher earners more than in England.

They point out that, as a result of these decisions, the majority of Scottish income taxpayers pay less than if they lived in England.

But critics have argued that whilst individual tax policies have been more ‘progressive’ at the margin, this does not necessarily mean the establishment of a fair tax system. For example, the SNP has not replaced the council tax, despite a 2007 manifesto commitment to do so.

So, is the Scottish budget better or worse off following further tax devolution?

Budget outcomes

A useful indicator of the rewards of devolution is the ‘net tax’ position. This is the difference between Scottish income tax revenues and the income tax block grant adjustment.

The former is straightforward to understand, although it is important to note that it is initially forecasted and then updated as income tax receipts are collated.

The latter is more complicated. It is an estimate of the tax revenues foregone by HMRC because of tax devolution (in simple terms an estimate of the tax revenues HMRC would have collected if UK income tax policies applied in Scotland and the tax base had grown at the same rate as the rest of the UK).

Evidence from HMRC on the impact of higher taxes in Scotland suggests that tax policy choices since 2016 have had little impact on declared income, and hence have raised revenues.

But the uplift in resources available to the Scottish Government has been much less than the increase in the tax burden would suggest. This year, instead of raising an additional £1,000m from income tax as the SNP intend, the net gain is only around £300m.

This is because the Scottish tax base has been growing more slowly than the UK as a whole.

The Scottish Parliament, having accumulated new competencies and used these new tax powers to do things differently, is now facing the fiscal reality of taking on responsibility for its tax base.

Risk and reward

The new fiscal arrangements in place in Scotland represent a devolution of both risk and reward. In doing so they deliver something for each part of this coalition of disparate interests.

To date, most of the attention has been focussed on the ‘reward’ from gaining these powers and being able to exercise them, but the risk element is an integral part of the new fiscal powers and requires much greater attention than it is currently receiving.

The transfer of powers has enabled Holyrood to set different tax policies. This has been the reward of devolution.

But the cost is weaker tax revenues as a result of the underperformance of the tax base. Coupled with a series of costly policy commitments on social security, the Scottish budget for day-to-day devolved services is being squeezed relative to what it would otherwise have been, despite that effort to raise the tax burden on higher earners.

This may turn around in the next couple of years, but the Scottish budget is now exposed to structural risks in the Scottish economy that have been years in the making and which will have an impact upon relative tax performance.

Demands for greater devolution can empower policy makers to do things differently. But this needs to be set alongside an appreciation of what is an acceptable level of fiscal risk to transfer, the tools to manage such risk, and who should ultimately bear the burden of that risk.