Scottish income tax: the time has come

Since its creation, the Scottish Parliament has had its moments of decisive policymaking. 

Commitments to free, universal personal care, prescriptions, university tuition fees and elderly bus travel have all been heralded as defining moments, as have public health initiatives like the smoking ban and minimum unit alcohol pricing.

But on the subject of tax, the parliament has been conservative and reticent to use the powers it has.

That is, until now.

During a period described by Finance Secretary Derek Mackay as “the most challenging circumstances we have faced since devolution”, he has taken Scotland’s first steps as a tax-varying administration.

“We do not take tax decisions lightly,” he said in his budget statement. He wasn’t kidding.

In 1997, all areas of Scotland apart from Dumfries & Galloway and Orkney voted to give Holyrood tax-varying powers. This meant it could adjust the basic rate by up to 3p.

In reality, however, successive governments found the prospect too bitter a political pill to swallow, and proposals to raise income tax have rarely proved a vote winner in elections.

The 2012 Scotland Act gave the parliament the ability to raise or lower income tax by 10p in the pound, in accordance with the recommendations of the Calman Commission, but again, the prospect was never seriously raised by Alex Salmond.

Then, following the independence referendum in 2014, the parliament was granted full control over income tax rates and thresholds on all non-savings and non-dividend income.

Despite this new-found power, the 2017/18 budget contained only a minor tweak: that the higher rate would continue from £43,430 while in the rest of the UK, it would lift to £45,000.

It was a tweak that was a product of the new political layout of the parliament, as the Scottish Greens forced Mackay’s hand as a price for their backing of the budget.

At the time, Liz Cameron of the Scottish Chambers of Commerce called the move “a dangerous precedent” because it would be the first time in devolutionary history that tax bands would be differentiated north and south of the border.

Whether it was dangerous or not remains to be seen, but Cameron was right to call it a precedent, as the 2018/19 budget has shown.

Driven by the need for opposition support in the wake of losing its overall majority, the government took the opportunity to open the discussion on tax the Scottish Parliament had always avoided.

A discussion paper was published in November which read like a multiple choice for opposition parties. Four options were offered, representing models with three, four, five or six tax bands, but all of which proposed higher taxes for those earning more than £44,290.

The country, said First Minister Nicola Sturgeon, “must consider if the time has come for those who earn the most to pay a modest amount more”.

The sentiment was echoed by economist Professor Sir Anton Muscatelli, one of Sturgeon’s top economic advisers, who wrote on the Policy Scotland website ahead of the budget statement that he hoped parliament would deliver.

“True, there has always been the power to vary the basic rate of income tax, but for the first time since the delivery of devolution, the Scottish Government is now able to give serious thought to the raising of additional revenue,” he said.

“In my view, this represents a significant milestone. Holyrood should not just champion landmark social legislation or seek to manage public infrastructure better, but it should, and now can, take real and meaningful steps to reshape Scottish society for the better.”

Muscatelli argued “competitive advantages”, like innovative growth driven by sectors such as precision medicine and the digital industries, or a fairer society which protects public services  “won’t simply fall into our laps. We will need to pay for them”.

He concluded: “After almost two decades of devolution, the time to decide on what we are prepared to pay for the services we value and our ambition for the future of our economy and society is now.”

Further economic advice to Mackay, ahead of his statement, was not unanimous. Scotland’s chief economist Gary Gillespie had warned against setting income tax bands at a “substantially” different rate than the rest of the UK.

Strathclyde University’s Fraser of Allander Institute advised Mackay to focus on growth amid Brexit uncertainty. 

IPPR Scotland warned that without tax rises there would be cuts of £1.3bn to non-protected departments per year, which would only be mitigated by a 4p increase in the basic rate.

Reform Scotland, meanwhile, argued Scotland should not alter its income tax rates from UK levels until other taxes such as VAT and business tax are also devolved.

Mackay had also faced calls from Scottish Labour, the Greens and Liberal Democrats to increase the tax take, with new Scottish Labour leader Richard Leonard calling for “a radical change of direction”.

The Scottish Conservatives, meanwhile, were isolated as the only party to reject tax rises, pointing out many business groups have warned against any rise in income tax, including the independence-supporting Business for Scotland.

When it came to the big reveal, however, Mackay said 70 per cent of taxpayers – those who earn £33,000 or less – in Scotland would pay no more, with a majority actually paying less in income tax than the rest of the UK.

“I’ve decided to reform Scotland’s income tax system to make it fairer,” he said.

While the 20p basic rate will remain frozen for those earning over £13,850, Mackay introduced new rates on either side of it.

A new ‘starter rate’ of 19p will apply to earnings under that, while a 21p ‘intermediate rate’ will kick in at £24,000.

He also added a penny to the higher and top rates of tax, to 41p and 46p respectively.

Any more on the top rate, he said, and modelling showed it might lead to “behavioural factors”. In other words, rich Scots would move abroad.

Based on the advice of the Scottish Fiscal Commission and the Council of Economic Advisers, he said, a penny on the top rate “was the optimum point to raise the most money for Scotland’s public services”.

The reforms, Mackay said, would increase Scotland’s budget by £164m, mitigating cuts to Scotland’s block cash grant from Westminster.

He said: “In line with the four tests set out in our discussion paper, our reforms will ensure that the vast majority of taxpayers are protected, that income tax becomes more progressive, that revenues are generated for investment in public services and that coupled with our spending choices, there will be a positive impact on the economy.”

But as last year showed, the SNP will need the backing of the Scottish Greens or another party to get the plans through. 

With Scottish Labour pushing for a bigger increase in the top rate of tax, the expectation is that Mackay will seek the support of Patrick Harvie to get the budget through when it goes to a vote next year.

However, the Scottish Greens were not impressed by his plan to “protect the local government resource budget in cash terms”.

Harvie described it as a real-terms cut and “unacceptable”.

“The Scottish Government still has work to do to present a budget that we can support when it reaches the Stage-1 vote at the end of January,” he said.

Liberal Democrat leader Willie Rennie also called it a “savage” cut.

It could be that like last year, Mackay will find some extra cash for councils and has kept it back as a bargaining chip this time. 

But questions will remain over whether the changes proposed by Mackay will raise the money needed to meet the ambitions.

As Gillespie’s analysis points out: “The Scottish context is more complex as differential tax policy in Scotland and the rest of the UK creates new opportunities for behaviour change. 

“For example, high income taxpayers could have more than one UK address and therefore change their residency on paper if income taxes are lower in the rest of the UK. 

“Alternatively, some high income earners could decide to incorporate to benefit from lower corporation tax rates relative to income tax rates, with detrimental impacts on Scottish income-tax receipts.”

The gamble Mackay has made is this: will they do that for 1p in the pound?