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Why income tax powers will leave Holyrood short-changed

Lord SmithLord Smith will make history on Thursday when he recommends that Holyrood gets full control of income tax. This is not just a further appendix to be added to the Scottish parliament’s guidebook to government; it represents a re-writing of the rules and it comes with a health warning.

The first of the Smith Commission reports goes further than had been expected because Labour has effectively been forced to join the other parties and change its position on income tax. Until now, it supported only an increase from 10%, contained in the 2012 Scotland Act, to 15%.

Thus, Smith will present a fait accompli, further devolution and maybe another step on the road to independence.

That is for the politicos to cogitate and deliberate over. For those at the sharp end, the new powers over the biggest of all taxes will have potentially profound implications. What does full control over income tax actually mean?

We will have to await the details, but the hope among the more cautious is that it is restricted to the rate of tax, not the base, nor the structure. The rules over taxation are immensely complicated and companies do not want to complicate them further by having another set north of the border. The experience of 2009 when 22 companies left the UK because of changes to the tax rules, including the taxation of overseas profits, still lingers. They returned only when the chancellor changed his mind. The message is clear: play with the rates, but do not mess with the rules.

But even varying income tax rates also comes with some complications. It does not only affect everyone’s take-home pay, it also impacts on pensions, dividends, some benefits and trusts. The tax experts will be rubbing their hands in anticipation of all the new business coming their way.

The rate determines the return to the exchequer, or the amount the government will receive from income tax. It is a progressive tax, in other words it is variable according to income.

But the total tax returns for a government include regressive taxes such as VAT which are fixed and therefore hit the lower paid disproportionately. Business taxes – corporation tax, rates and petroleum revenue tax – make up the third strand of income.

Recent evidence has shown that the UK has become more regressive since the financial crisis in 2007/08 but is likely to revert to a progressive tax system by 2017. Nicola Sturgeon, who wants to redistribute wealth, will be keen to follow suit. But she has a problem.

Handing over income tax to Scotland, but not VAT or corporation tax, means the Scottish government will continue to have an imbalanced source of revenue and an in-built difficulty trying to achieve its redistributive goals.

Under the changes being introduced in April any change to income tax must affect all rates proportionately. If one goes up or down the others must do likewise.

Unless Lord Smith is proposing greater flexibility in the income tax regime this will a major frustration for Holyrood, particularly as it cannot cut VAT to compensate the poorer in society for any rise in income taxes.






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