This is a guest post by Gerald Holtham, who chaired the Welsh Government’s Independent Commission on Funding and Finance in Wales and is adviser on finance to the Welsh Government. The question he addresses – of how to manage a reduction in the block grant to allow for tax devolution while maintaining the Barnett formula – is a highly timely one, given the ongoing discussions about the ‘fiscal framework’ for Scotland (for which this is the key issue) as well as corporation tax devolution for Northern Ireland and moves on income tax devolution for Wales announced in the Spending Review. (My own comment on this post can be found here.)
In all the discussions about tax devolution for all parts of the UK, a key issue has not been clarified. That issue is how to reduce block grants when a tax is devolved. Indeed there still appears to be no general agreement between the devolved governments and the UK Government about how to proceed. It is a particularly knotty question in discussions about income tax but also VAT and it has the capacity to delay devolution to Scotland and to stall it altogether for Wales.
There is little problem in the first year of devolution. An estimate can be made of the revenue foregone by the Westminster government, given prevailing tax rates, and that can be deducted from the block grant. Subsequently the deduction can be revised when actual revenues differ from the estimate. The difficulty comes for subsequent years when the deduction must be expected to grow with the economy and its tax base but must not be affected by changes in tax rates by the devolved administration – otherwise devolution of tax powers is not real.
The Independent Commission on Finance and Funding for Wales, which I chaired, first proposed that the deduction should be indexed in some way to the growth of the tax receipts base in the rest of the UK, at least for income tax. The idea was that such receipts a base would be affected by the policies of the UK Government while the policies of the devolved government would not influence the deduction. The proposal was made when income-tax devolution was to be partial; Westminster and Scotland (and Wales) would share the tax base each taking a certain number of income tax points. That sharing meant devolved territories would still pay their share if income tax were raised for expenditures on reserved policy areas like defence. With complete devolution of income tax, the link between the tax and reserved spending can be preserved only if the grant deduction is indexed to receipts in the rest of the UK, rather than the tax base. Changes in income tax rates in Westminster would thereby affect the block grant when income tax was wholly devolved.
The general approach of indexing the deduction to rest-of-UK income tax in some form has gained fairly broad acceptance but leaves a number of detailed questions to be resolved. Unfortunately these details are crucial because different methods of carrying out the indexation have very different effects.
A recent paper by David Bell and David Eiser of Stirling University and David Phillips of the Institute for Fiscal Studies, (henceforth Bell et al for short) entitled Adjusting Scotland’s Block Grant for new Tax and Welfare Powers: Assessing the Options (available here) is the first look at this in detail since our commission’s report. It makes a valuable contribution by looking in detail at three methods of doing the indexation and tracing their effects. It names the three methods the Indexed Deduction (ID), Per Capita Indexed Deduction (PCID) and the Levels Deduction (LD).
The ID method indexes the deduction to the percentage change in tax revenues in the rest of the UK. If UK income tax receipts were to grow by 1.5 per cent from year to year, the reduction in the block grant would be increased by 1.5 per cent too. PCID adjusts for possible differences in population growth by multiplying the deduction by relative population growths. The LD approach does not take the percentage change in rUK income tax; instead it takes the actual change in pounds per head and alters the deduction by that amount multiplied by the population of the devolved area. In effect it treats the block grant deduction much as the Barnett formula treats expenditure – it changes by the same per capita amount as income tax in England. The description by Bell et al. of the methods and their different effects is impeccable. When it comes to assessing which is the best method on which to proceed, however, the paper hits a snag.
It makes the assessment in the light of the ‘no detriment’ principles adumbrated by the Smith Commission. The first of these is that no government should suffer simply because of devolution; the second is that there should be no detriment to one government as a result of policy decisions of the other government post-devolution. The principles are unobjectionable but their interpretation and implementation is not straightforward. The Smith Commission thought the second principle implied:
Changes to devolved tax rates in Scotland should only affect public spending in Scotland. Changes to tax rates in the rest of the UK, for which responsibility in Scotland has been devolved, should only affect public spending in the rest of the UK. This is the principle of taxpayer fairness.
Bell et al. interpret that to mean that a balanced budget increase in income tax and public spending on devolved matters in the rest of the UK should not affect the Scottish block grant.
The inference that the Smith Commission makes from its second principle, as set out above, turns out to be incompatible with its first principle on closer inspection. It is not surprising therefore that, as Bell et al. conclude, no one approach could satisfy both.
The nub of the problem Smith Commission’s ‘taxpayer fairness’ principle in effect rules out any further redistribution from rich to poor in the UK so far as that redistribution might have a geographical dimension. No political party in England has embraced such an idea, although the SNP’s preference for ‘fiscal autonomy’ could be interpreted as a rejection of any potential further redistribution, whether from England to Scotland or vice versa. Yet almost all federations have some scheme of redistribution or revenue equalisation. The UK does this in practice, to an extent, by the Barnett formula – but the formula is not designed for that purpose and does not do it very well. If the UK wishes to maintain such a scheme then invariance of a block grant with respect to the level of tax and spend in England is not a reasonable principle.
Consider the case where the UK Government raises income tax in order to finance expenditure in a devolved area like health or education. The Barnett formula implies that a devolved authority would receive the same absolute increase in pounds of spending per head as in England. The PCID approach would increase the deduction from the block grant by the same percentage change as per capita tax revenues in England. If tax per head is lower in the devolved territory (because the devolved territory has lower income per head) that means the same percentage increase in income tax per head would yield a smaller absolute amount than income tax in England. There would therefore be an increase in the net transfer to the devolved territory as the increase in spending exceeds the increase in the block grant deduction. Symmetrically a cut in tax and services would reduce the transfer. Bell et al. argue that Smith Commission principles require that balanced increases in spending and taxation in England should not affect the block grant.
That is tantamount to saying any increase in expenditure in Scotland or any other devolved territory must be financed entirely from that territory’s own taxes.
Now consider a unitary state in which a universal service is financed by income tax. Consumption of a service like health or education may well have some correlation with income but it will be a good deal weaker than the correlation of income with income tax payments. Everyone gets some education and anyone can get sick. An increase in income tax to provide more of the universal service will therefore surely entail an increase in the net transfer from richer to poorer. That is evident at the personal level but the transfer will also have a geographical dimension. Divide that unitary state into two arbitrary geographies A and B and suppose that income per head is lower in A but consumption of health or education per head is similar. An increase in taxation to finance higher spending on the service would inevitably increases the net transfer from B to A if anyone bothered to account for it. That would not be considered unfair.
How does devolution change that? Arguably it does not. If the UK government decides to increase income tax to fund higher education or health spending in England, the overwhelming likelihood is that net transfers from, say, the south-east to the north-east of England would increase. Should Scotland or Wales be excluded from that process? The devolved territories cannot expect a free-ride. If they enjoy an increase in public spending they are supposed to make a proportionate contribution in tax effort. But what is a proportionate effort? The obvious answer is: one that sees them suffer the same increase in the proportion of their income going on tax as other citizens or the proportion dictated by a uniform income tax system. If they happen to be poorer, their incremental contribution will be smaller than that of richer fellow citizens in absolute terms.
Insisting that the net transfer to a devolved territory be invariant to the level of public tax and spend is to cut the devolved territories off from being able to participate in changes to the level of public service provision for the same change in tax effort as the rest of the Union. It is a repudiation of the social union. It says a poorer area can only participate in extra public spending if it makes a greater tax effort than richer areas – not just a similar tax effort. Of course if the UK central government has democratic support for a low-tax, low welfare regime, devolved territories would be obliged to finance to greater public provision from their own resources in any event.
There is another case where the inappropriateness of the so-called taxpayer fairness principle is even more obvious. Suppose that the UK government were to increase income tax rates in England and use the money to pay down debt rather than spend more on services, any of the three indexation approaches would result in an increased deduction from the Scottish block grant and a smaller transfer of resources to Scotland. Scotland would be making its contribution to debt repayment. Here is a change in taxes in the rest of the UK that is affecting Scotland’s overall public spending in an entirely appropriate way. Changes in income taxes in rUK to finance non-devolved expenditure or debt repayment must affect Scotland’s grant and hence its overall public spending otherwise Scotland plays no part in financing changes in non-devolved UK spending. It follows that it is the Smith Commission principle itself that is mis-specified. Smith’s first principle is that a territory should not suffer simply because of devolution. That is incompatible with the ’principle’ that Scottish public spending should not be affected by a change in taxes elsewhere.
Bell et al. conclude that PCID is compatible with Smith’s first principle but inconsistent with the taxpayer fairness principle, while it finds the LD approach contravenes the first principle but is consistent with the ‘taxpayer fairness’ principle. LD certainly contravenes the first principle and, indeed, most intuitive notions of fairness. It implies that in the absence of any changes to tax or expenditure, the deduction from the block grant of a poorer region is bound to grow faster than its income tax revenues if their growth just matches that of the rest of the country. That implies that the resources available to it will fall over time relative to those of the rest of the country. It would introduce a new and pernicious form of Barnett squeeze, which might arguably make sense for parts of the UK that have a strong tax base and are well funded, but not for those that are not.
The argument that it conforms to the ‘taxpayer fairness’ principle becomes irrelevant if we conclude that principle is misnamed and is not a principle that should be observed – implying as it does the confining of redistribution within the separate nations of the UK and ending further UK-wide redistribution. By the same token, the fact that PCID does not conform to this ’principle’ is as irrelevant as the principle is mis-specified.
While Bell et al. recognise that the Smith Commission principles ’seem to conflict with each other’ it declines to criticise the Commission and ends its assessment on a rather relativistic note – ’that depends on ones view about what the UK’s fiscal union is for.’ That may be all the invitation the UK Treasury needs to try and impose the LD approach. Indeed they have already proposed to change the treatment of Non-domestic rates in devolution finance and to adopt LD indexation.
Why would such a thing be considered? For two reasons. First, the Treasury is currently trying to save money in any way it can to meet George Osborne’s budgetary targets. Second, Scotland is considered to be overfunded currently compared with the regions of England so a squeeze is thought to be fair enough. Short term considerations are once again trumping the need to work out a fair and sustainable fiscal framework. Adopting LD would be layering an ugly fix on top of an ugly fix. Devolved territories like Wales, which no-one thinks is overfunded, would be ’collateral damage’ as a result of this ad hoc approach.
Surely at some point even the wise monkeys in the Treasury, who see, hear and speak no evil of the Barnett formula, must wake up to common sense and fairness and accede to reform of the system. Such a reform would require taking a UK-wide perspective of the sort recommended in May’s Bingham Commission report (summarised HERE, and available as a PDF here) and altering the role and prerogatives of institutions as well as replacing the formula. Meanwhile in the twilight of the Barnett era, the PCID approach is the fairest way to manage offsets to the block grant for devolved income tax.