In response to the article by Jim and Margaret Cuthbert in the last issue, Jim Gallacher argues that Scotland should be looking at the Scotland Bill in terms of its major powers, not its minor flaws

The Scotland Bill, which will give the Scottish Parliament new tax powers, now has the support of all the big political parties in Holyrood and Westminster. So there is a good chance that the Parliament will in future take major tax decisions. What might this mean?

Today the only devolved taxes are local taxes. Ministers set business rates and have found ways to freeze the Council Tax, but these taxes hardly make them accountable to the electorate, and add up to less than 15 per cent of devolved spending. So it is hard for a Scottish Government to be held accountable for taking a different view from the rest of the UK on the levels of taxation and spending.
That will change. Once the Scotland Bill is in force the Parliament will have tax powers, including income tax, covering nearly one third of devolved spending. It can decide to tax more or less and spend accordingly. Income tax is a very visible tax and taxpayers will be able to connect what they pay to the services they get. If Scotland prefers higher public spending, then the Scottish Parliament will be able to levy the taxes to support it. If public opinion favours low taxes to stimulate growth, then that option is open too. No longer will the Scottish Parliament simply be a spending machine: it’ll be a taxing one too.

Of course there is not a simple one-to-one relationship between devolved tax and spending, as there will still be a Westminster grant as well and taxes, including some income tax, will still be paid to Westminster. So every one per cent of tax change does not yield one per cent of spending change. This is like virtually every other Parliament in a federal state: there are transfers of resources between different levels of government and different parts of the country, often justified by different needs. Some argue there should be no sharing of resources and risks across the UK: that is simply the fiscal expression of the idea of independence. It makes sense if (and only if) you are committed to independence for other reasons.

Taxation is mainly about raising money to pay for public services, usually in the least painful way possible. But taxes are also policy instruments: they can encourage some behaviours and discourage others. The bundle of taxes to be devolved along with income tax allows some scope for this, and so does the power to create new taxes in the Bill.

One obvious example is Stamp Duty Land Tax. It will now be devolved. Together with non-domestic rates and council tax, that means that all taxation on real property in Scotland will be decided in Scotland. The Parliament will have the option of changing property taxation radically – whether to tax the value of sites, rather than buildings, or to encourage the productive rather than unproductive use of land. New taxes also offer opportunities – though maybe harder to realise – to use tax instruments to address social problems, for example excessive alcohol consumption, or access new streams of revenues such as tourist taxes. The challenge will be creative imagination.

A lot of criticisms were made of the Scotland Bill, usually from the point of view of those who favoured something much more adventurous. In the end, however, these were not strong enough to stop the Scottish Parliament supporting it by an overwhelming majority – 121-to-three. Perhaps many were persuaded by the argument that, just as devolution itself is a continuing process, the Bill’s provisions are unlikely to be the final world on fiscal decentralisation. In fact they are a very significant first step – certainly by UK standards: the first time the UK Treasury has given up tax powers since it discovered the leverage to be gained by centralising taxation during the Napoleonic wars.

This article does not deal with all the criticisms of the Bill, nor the various improvements proposed to it. These are discussed in the Report of the Scotland Bill Committee. One however was give prominence in the last edition of this journal in an article by Jim and Margaret Cuthbert. It is quite technical in nature, but merits proper discussion.

It’s a bit of a surprise to see the “Laffer curve” popping up in a Left Review. It’s more usually in the discourse of American economic libertarians, and was of course a building block of Reaganomics. Nevertheless one should not dismiss the points made by the Cuthberts simply because they rely an idea from one of Ronald Reagan’s favourite economists. The Scotland Bill Committee extended them the courtesy that it gave to all its witnesses of thinking properly about what they had written to see whether this was indeed a “flaw” in the proposals. This is set out in the Committee’s report (paragraphs 558 to 568).

Laffer’s curve is a theoretical beast. It starts from the insight that, beyond a certain point, increasing the rate of taxation won’t necessarily produce any increase in tax yield, since the tax base erodes faster than the tax rate goes up. Taxpayers’ incentives change, so when tax rates get too high they may do less of the tax generating activity, like work, or devote more effort to sheltering their income from tax. Since at a 100 per cent tax rate the taxpayer has no incentive at all to generate taxable income you might expect tax yield be zero – as it would be if the tax rate was zero per cent. Hence the idea of a Laffer curve – an inverse U-shaped relationship between tax rate and tax revenue.

There must be something in this. It is clear that very high rates of tax – like the 90+ per cent marginal rates of income tax the UK once had – cause serious distortions and may indeed be counterproductive. But it suits anyone who dislikes taxes to argue that, whatever rate there is, cutting it will increase revenues. Hence Reaganomics, and huge US budget deficits: cut the tax rates and surprise, surprise, tax revenue goes down.

No-one exactly knows where the UK is on this theoretical curve, but it is pretty clear that cutting rates of income tax will not increase the amount of revenue. If that were the case we’d see an orgy of tax cutting by governments desperate to pay off debt. Nor is it remotely plausible to argue that we are near that level: again if it were, there would be an army of right-wing tax cutters alleging it was so. Nevertheless it is reasonable to assume that if the government raises income tax there will be some disincentive effect causing the tax base to fall, and vice versa, though not necessarily by the same amount. It is difficult to be precise about the magnitudes of the effects, but they are likely to be small, or the Treasury’s sums would be even wronger than they have been.

Why is this relevant to the new Scottish Income tax – and how can it disclose a flaw in it, as Jim and Margaret have for some time argued? Under the plans in the Bill, Income tax will become a shared tax. That is to say both the UK and Scottish Governments will levy a rate of income tax on Scottish taxpayers. (The UK rate will be reduced by 10p in Scotland to allow for this.) If a changing the tax rate affects the tax base, then rates set by one government will affect the income of the other – through the shared tax base. So if the UK Government were to cut its income tax, then the Scottish Government might get a bonus; conversely if Edinburgh cuts its rate, then UK income tax revenue might go up. In economics jargon these are ‘vertical fiscal externalities’ – vertical because they relate to different levels of government, and externalities because they are effects of decisions on those who did not take them.

The Cuthberts have argued that this is a problem. Initially their concern was that if the Scottish Government cut its rate of income tax, the total amount of income tax paid by Scottish taxpayers could go up while tax revenue accruing to the Scottish Government fell. More recently they have defined the issue more precisely: when a Scottish Government cuts income tax it bears the full revenue cost of the lower tax rate but does not get all the revenue benefits (such as they may be) from the stimulus to the tax base – some of this goes to the UK Government. Equally when they put their tax rate up they get all the fiscal benefits of the higher rates but only a fraction of the disbenefits of the consequent shrinkage in the tax base: some of this is carried by the UK. Put differently, the Laffer curve is steeper if the tax base is shared than if it is not. This leads to their conclusion – put by them in these terms in your pages for the first time – that for a shared tax there is a somewhat greater incentive to increase rather than decrease taxes.

So is this a flaw in the plans or mildly interesting curiosity? The latter. The Cuthberts have done well to gnaw away at this issue until they formulated more precisely their nagging doubt. But in doing so they have demonstrated just how theoretical the problem is. First of all there is no evidence for UK income tax today of the size of any Laffer effect. Certainly it is not so big that growth in the tax base would offset a rate cut. Secondly, even accepting their analysis of the nature of shared tax bases, their conclusion does not follow. There are many factors that determine tax rates: the fact that slope of the Laffer curve is steeper under a shared tax than if the Scottish Government set all of income tax is unlikely to be uppermost in the mind of governments. They face the incentives they face, not some theoretical alternatives, and will have to make and justify the choices on the tax they actually have to the electorate. There are much bigger real incentives acting on governments when they make these decisions – the unpopularity of tax rises and service reductions alike. Those are what will drive tax decisions – and quite right too.

There is a great deal still to be done to put the Scotland Bill into practice, and the Bill itself would benefit from some improvements. The most important issue however is not these rather abstruse bits of economic theory but the challenge of calculating the offsetting reduction in grant from London to Edinburgh to take account of the new stream of tax income. Get that wrong and Scotland could be disadvantaged, or alternatively quids in. Neither would be right. The Scotland Bill Committee’s report suggests a way to do this which is intended to ensure that the spending power of the parliament will depend on its tax choices and the success of the Scottish economy. That should offer Holyrood both opportunity and accountability, and represents the next phase in Scottish home rule.