FINANCE COMMITTEE INQUIRY INTO THE DEVOLUTION OF FURTHER FISCAL POWERS SUBMISSION FROM DR JR CUTHBERT AND MRS M CUTHBERT ON BEHALF OF JIMMY REID FOUNDATION The issues surrounding the devolution of further financial powers to the Scottish Parliament were considered at some length in our Jimmy Reid submission to the Smith Commission. This submission is attached at Annex A to this note. This note addresses the particular points of interest to the Committee by drawing the Committee’s attention to the main parts of the JRF submission which are relevant to the specific questions raised in the Committee’s call for evidence. 1 What general principles should apply to the devolution of further financial powers to the Scottish parliament? Section 1 of the JRF submission establishes 5 criteria against which, we argue, any set of proposals regarding devolution of further fiscal powers should be judged. These criteria are: Is there an appropriate balance between incentives to grow the tax base, and the operation of fiscal transfers within a monetary union? Tax responsibility must relate to a suitable choice of tax: and must be accompanied by appropriate powers for growing that tax base. Is a suitable balance being struck? Are there technical/ feasibility problems with what is proposed: and if such problems are being assumed away by an implicit model of how the economy works, then are the assumptions involved in such a model being made overt? Does the proposed solution have a reasonable chance of agreement: and is there sufficient clarity about the proposal, on those aspects which are critical for agreement? Does the proposal measure up to the promises made in the run up to the referendum? 2. What further financial powers should be devolved to the Scottish Parliament and why? The JRF submission argues it would be appropriate to devolve responsibility for National Insurance and taxes on land: paragraphs 6.3 to 6.5 of the JRF submission below sets out our reasons for suggesting these as the prime candidates for fiscal devolution. It is important, however, to stress that the question of devolving responsibility for particular taxes is intrinsically bound up with the question of whether sufficient economic powers are also being transferred to give the Scottish government a reasonable chance of growing the economy, and hence the tax base. Transferring fiscal responsibility without adequate powers could well be a recipe for disaster, with the danger of Scotland becoming locked in a cycle of a shrinking tax base, increasing tax rates, and relative economic decline. Paragraphs 6.6 to 6.9 of the JRF submission deal with the question of what powers should be transferred to accompany increased fiscal responsibility. It 1 is argued there that, in the context of the union, certain reserved powers which are currently not being operated satisfactorily in Scotland’s interests, are nevertheless not suitable for outright devolution within the union. What is suggested is that some quasi-federal solution needs to be developed in such cases. 3. What further financial powers should not be devolved to the Scottish Parliament and why? The JRF submission argues that, even though income tax is central to the proposals put forward by the Conservative and Labour parties, there are very significant drawbacks to the use of income tax. In particular, as demonstrated in paragraph 2.3 of the JRF submission, the distribution of taxable income in Scotland is very different from the distribution in the UK as a whole. Importantly, the UK has a much bigger proportion of taxpayers at the high end of the earnings scale, (due to the unbalanced nature of the UK economy, and the dominance of the City of London’s financial sector). As argued in paragraph 3.4 of the JRF submission, this is likely to mean that the Scottish income tax base will be intrinsically less buoyant than the tax base of the UK as a whole, if there is a further period of finance-based expansion in the UK economy. Combined with the indexation method proposed for the abatement of the Barnett formula Block Grant, (which we take it will be based on Holtham indexation – i.e., in line with the overall growth in the UK income tax base), this could well put the finances of a Scottish government at a chronic disadvantage. Further, income tax is a relatively volatile tax, and this volatility will itself cause problems. 4. To what extent could the Scottish Government be constrained in how it uses new tax powers given the interaction with fiscal decisions at a UK level? As we argue in paragraph 4.8 of the JRF submission, we see a specific restriction in the Labour party tax proposal as being potentially dangerous: the restriction involved is that the Scottish government would be able to raise higher band tax rates above the tax rates in the rest of the UK, but would not be able to lower them below the rest of the UK rates. We argue that this might build in an upward ratchet effect on Scottish tax rates. More generally, we would see the question of imposing specific restrictions on the Scottish government as being better addressed by mechanism for quasi- federal working (as advocated in paragraph 6.9 of the JRF submission), rather than devolving power and then restricting it. 5. What are the implications of further fiscal devolution for the block grant? As already noted, if income tax is the central mechanism for delivering increased fiscal responsibility, and if the abatement to the Barnett Block Grant is subject to Holtham indexation, then we see the likelihood of there being a chronic squeeze on the finances of the Scottish parliament. In the specific case where what is being delivered is a modification of the Calman tax arrangements, (as for example in the current Labour party proposals), then paragraph 4.6 of the JRF submission sets out a specific technical suggestion which might ameliorate this: namely, that the Barnett abatement should be 2 indexed by the growth in a UK 15p tax rate: rather than by the growth in the UK overall income tax base. (Since the same problem is likely to arise under the arrangements currently being implemented through the Scotland Act, we mention as an aside that there may be advantages in implementing this change even if no further fiscal powers are devolved). Another issue which will arise, particularly if income tax is the primary vehicle, is the question of the increased volatility this will imply for the Scottish government’s funding. It is disappointing that none of the submissions to the Smith Commission by the main parties appears to address this issue: but as paragraph 3.8 of the JRF submission argues, there will certainly be a need for some increased shock absorber mechanism in the arrangements for financing the Scottish government. An important issue which would arise in the specific circumstance of the implementation of the Labour party proposal of an increase in the Scottish rate of tax under Calman from 10p to 15p, relates to the effects of fiscal drag. As paragraph 4.7 of the JRF submission notes, this would have the effect of increasing by 50% the known adverse effects of fiscal drag on the Scottish government’s finances under Calman type arrangements. Further points, not specifically addressed in the Finance Committee’s questions. In addition, we think the following specific points are worth drawing to the Committee’s attention, although they do not fall under the specific questions in the call for evidence. a) as regards income tax, there is a technical issue as to whether the Scottish government’s income tax revenue should be net or gross of those tax credits which are regarded as negative tax: As paragraph 3.7 of the JRF submission argues, there appear to be strong arguments that Scotland’s tax receipts should not be reduced by this negative tax element of tax credits. b) The current Labour party proposal recommends extending the use of Tax Incremental Funding, (TIF). As paragraph 5.1 of the JRF submission argues, there are potential problems with the use of TIF. 3 Annex A Submission to the Smith Commission regarding increased powers for the Scottish Parliament from the Jimmy Reid Foundation 28 October 2014 About the authors. Dr Jim Cuthbert worked in the Scottish Office and the Treasury, and was latterly Scottish Office Chief Statistician. His research interests are in topics like utility pricing, international purchasing power comparisons, and various aspects of Scotland’s economy and public finances. Margaret Cuthbert lectured in economics before running an economics consultancy firm, gaining experience both in the UK and abroad in the role of governments in supporting economic development. She has written widely on various aspects of the Scottish economy. Copies of the Cuthberts’ papers may be accessed on their website at www.cuthbert1.pwp.blueyonder.co.uk. 4 Executive Summary 1. This is a submission by the Jimmy Reid Foundation in response to the public invitation by the Smith Commission to submit views on the powers to be offered to Scotland in the aftermath of the Scottish referendum. 2. The submission deals almost exclusively with fiscal and economic issues. It develops five criteria against which proposals for increased fiscal responsibility for the Scottish Parliament should be judged: these are Is there an appropriate balance between incentives to grow the tax base, and the operation of fiscal transfers within a monetary union? Tax responsibility must relate to a suitable choice of tax: and must be accompanied by appropriate powers for growing that tax base. Is a suitable balance being struck? Are there technical/ feasibility problems with what is proposed: and if such problems are being assumed away by an implicit model of how the economy works, then are the assumptions involved in such a model being made overt? Does the proposed solution have a reasonable chance of agreement: and is there sufficient clarity about the proposal, on those aspects which are critical for agreement? Does the proposal measure up to the promises made in the run up to the referendum? Since it is clear that issues relating to income tax are going to be at the core of the reform discussions, we have devoted a lot of time to income tax.