Will the (Scottish) Budget raise income tax rates?

Published on Tax and Welfare

With the UK Budget imminent, it’s important not to forget proposals released in Scotland earlier this month. These could lead to increases in income tax rates as soon as April, intended to protect public services and benefits in Scotland. This would be a departure from the usual direction of travel in the UK: there has not been an increase in the basic rate of income tax since 1975, and no change in the higher rate since 1988 aside from the introduction of the additional rate (though National Insurance rates have often been raised instead). It’s an important development for Scotland, an important test of devolution, and an important precedent for the rest of the UK.

Firstly, the process itself is notable. In contrast to the ritual of UK tax policies being revealed as faits accomplis by the Chancellor in Budgets, Scotland has a draft budget (next month) and – even before that – open policy discussions. Although the motivation is of course partly political (the SNP does not have a majority and has previously been cold on raising rates), the Scottish government has released an impressive report, outlining in plain language the principles it thinks should drive this decision, the positions of each party and a range of options.

In a nutshell, the options involve moving from the current (UK-aligned) income tax bands of 20 per cent, 40 per cent and 45 per cent to rates of up to 21 per cent, 42 per cent and 50 per cent. And all are designed to avoid raising taxes on anyone earning less than £24,000: the expected median income of income taxpayers (and more than the median individual, including non-taxpayers). In more detail, the report sets out the following five alternative approaches designed to move beyond party-specific proposals and “facilitate a debate”:

Estimated income tax bands in 2018-19 under the different approaches
(differences from the current system highlighted in bold)

All tax rises can be controversial but raising income tax rates is generally a sensible, neutral way to raise money if additional revenue is demonstrably needed, and all the proposals are extremely progressive. As the report notes, 44 per cent of Scottish adults don’t pay any income tax – and so could not be affected – while only 8 per cent (366,000 individuals) are in the higher or additional rate bands. All the options would reduce inequality in Scotland (even before considering how the money is spent). At present Scotland’s Gini coefficient is 34.1 per cent – putting it consistently in the more unequal half of the UK’s 12 regions and nations. According to the document, the Gini coefficient would fall by between 0.1 per cent and 0.25 per cent depending on the chosen tax rise.

And all the approaches raise significant though not vast sums: between around £100 million and £300 million (i.e. a population-wide average of around £100 per household).

Now, some of these plans would also raise the complexity of the Scottish tax system (on top of the inherent complexity of having tax variation across the UK). This potential complexity is especially true when we include the National Insurance that most taxpayers pay, as well as the withdrawal of the Personal Tax Allowance (PTA) above £100,000 – not to mention the withdrawal of child benefit above £50,000 or other benefits means-testing. The figure below shows what the marginal rate schedule would look like in the most complex option (Approach 4) and under existing policy.

It’s true that most people don’t need to know their marginal tax rates: software can simply spit out their tax bill. But there is value in avoiding unnecessary complexity.

One way to reduce potential complexity – and one not covered much in the report – is the option of introducing a zero rate band (effectively increasing the PTA). Looking at Approach 4, a 19 per cent tax band between £11,850 and £15,000 means a net tax cut for those on incomes up to £27,000, despite an increased rate of 21 per cent above £24,000. But the same outcomes could be achieved with fewer tax rates by slightly raising the starting point for tax. In Approach 4 – the impacts of which are shown in blue below – you must earn at least £15,000 to get the full, £32 a year gain from the 19 per cent band. Raising the PTA instead – as in the green line below – would be identical except that those between £12,000 and £15,000 would receive the full tax cut too.

Raising the PTA or introducing a zero rate band is not as progressive as protecting benefits, but it is certainly more progressive and sensible than cutting the basic rate for some (which has been suggested by the Scottish Greens, Labour in 2015 and elsewhere). The case for a new 19 per cent band rather than the alternative above is a political one rather than economic or distributional.

However, given that this policy package is intended to be a tax increase, it may be that there will be no tax cuts in any case. Instead, the main question facing Scotland may be whether or not to slightly raise the basic rate for those above £24,000 – and what difference to services people can expect in return.

At the high end of the income spectrum, increasing the top rate to 48 per cent or 50 per cent may well affect behaviour. There is little evidence to suggest that higher tax rates lead high earners to do less productive work, but it does increase the incentive for avoidance. One short-term risk – borne out in 2010-11 – is that income may be brought forwards to beat the rate rise. But if Scottish rates rise as soon as April then the potential for this will be reduced. There is also the risk of high earners deciding to move elsewhere, which seems more likely on a sub-UK level than internationally, though any loss to Scotland could be a fiscal gain to the rest of the UK (something not explored in the report). The greatest risk is of more income being transformed into dividends and capital gains – as the taxation of these is not devolved and so will be unchanged. So any increase in top income tax rates in Scotland only increases the need for the Chancellor to change the tax differences and laws that make avoidance (and evasion) so easy. Just how high the additional rate should go is a crucial decision for the Scottish government and parliament.

One bonus of any Scottish reform will be to improve the evidence base for UK tax changes. Given recent policies from Labour, Lib Dems, Greens, SNP and Plaid Cymru, there’s a significant chance that the rest of the UK will at some point move in the same direction as Scotland.