ࡱ> OQNq` xgbjbjqPqP *::R_%8TR4-24"VVVVVVx-z-z-z-z-z-z-$+/h1-"VV""-VV-)))"dVVx-)"x-))V,@-V pzO#, d--0-, {2#{2-{2-dV4 )@ VVV--%:VVV-"""" Open Letter to the Calman Commission: Technical Failings in the Calman Proposals on Income Tax. Jim Cuthbert Margaret Cuthbert 15th July 2009 1. Introduction. It is clear from recent poll evidence that the general thrust of the Calman Commission proposals, to extend the powers exercised by the Scottish Government, is in line with the current of popular opinion. The precise income tax mechanism is, however, flawed. Using a purely technical argument, we show that for an income tax sharing mechanism to work well, it is necessary for the following conditions to be satisfied: that the change in the revenues going to the Scottish Government from exercising its tax varying powers should be in the same direction as the change in total income tax revenues collected in Scotland. That the Scottish Government should secure the same proportion of the revenues raised from each different income tax band. In this note we will examine the consequences if these two conditions are not met. We will demonstrate that there are circumstances, which we will argue are very possible, where the Calman mechanism fails to achieve (a): and that the Calman mechanism always fails to achieve (b). We will suggest amended proposals which satisfy both of the conditions but which would require that the UK and devolved governments move towards a more federal type of joint working. This note has been drafted as a purely technical comment on the Calman income tax proposals, and does not seek to question Calmans basic axioms about the desirability of maintaining the political, economic and social unity of the UK. The fact that we have not questioned these axioms here should not be taken as any indication that the authors agree with these axioms. 2. Consequences if the two conditions are not met. We consider first of all the implications if the first condition, (a) above, is not met: in other words, if the change in the revenues going to the Scottish Government from exercising its tax varying powers is in a different direction from the change in total income tax revenues collected in Scotland. Suppose, for example, that the effect of the Scottish Government increasing the rate of income tax it levied was to increase the revenues coming specifically to the Scottish Government, but to decrease the overall, (that is, Scottish government plus UK government) income tax take in Scotland, and vice versa. In these circumstances, if a Scottish Government needed to raise more revenue, then it could do so successfully by raising the Scottish rate of income tax. But this increase in revenue would be accompanied by an overall decline in the income tax revenues raised in Scotland as a whole: which, since this corresponds to a declining overall tax revenue from an increased rate of tax, must correspond to a decline in overall Scottish income that is, a decrease in overall economic activity. Conversely, if a Scottish Government in a similar position wanted to stimulate the Scottish economy by reducing the Scottish rate of income tax, then the price of doing this would be a reduction in the tax revenues coming to the Scottish Government itself even though overall Scottish income tax revenues, (and the revenues going to the Treasury), were increasing. In other words, a devolved Scottish Government operating under the Calman income tax proposal could find itself in a deflationary trap; where it was forced, by its need to raise revenue, to increase the Scottish rate of income tax but at the expense of deflating the Scottish economy. Note that an independent government, faced with an overall tax yield curve with similar characteristics, would not be in this trap. Such a government could cut its tax rate, increasing both its revenues, and overall economic activity. Section (3) of this note identifies the circumstances under which condition (a) would not be met, if the Calman proposals were implemented. We will argue that this set of circumstances is far from unlikely. Turning now to condition (b), what happens if that condition is not met: that is, if the Scottish Government does not get the same proportion of the revenues raised in the different income tax bands. This situation would lead to the following two problems:- First of all, because of the effects of fiscal drag, there is likely to be a consistent shift through time in the proportions of overall income tax revenues raised from the different tax rates. If condition (b) is not met, this will then lead to an increasing or decreasing trend in the tax revenues going to the Scottish Government, over and above any trend in overall tax revenues. The effect of fiscal drag is usually to increase the proportion of tax raised at the higher tax rates: thus, if the Scottish Government received a lower proportion of high rate tax revenues than basic rate tax revenues, the overall effect would be to reduce the share of tax revenues going to the Scottish Government. Secondly, whenever the UK government, which is in charge of the UK income tax system, changed the tax thresholds or the structure of the system, there would be a shift in the relative amounts of tax collected in the different bands and hence, a change in the amount of tax allocated to the Scottish government. At the very least, this would open the Scottish government to the danger of unpredictable and unplanned changes in its tax revenues. At its worst, this situation could be manipulated deliberately by a UK government, if it wished to trim the resources going to the Scottish government. Either way, the Scottish government would be placed in an unsupportable position. It can be seen immediately that condition (b) would not be met if the current Calman proposals were implemented. For example, at the base 10p Scottish rate, the Scottish government would get 50% of basic rate tax collected in Scotland, but 25% of 40% rate tax, and only 20% of the new 50% rate tax. 3. The circumstances under which the Calman income tax proposals would violate the first condition (a) above. When would a change in the Scottish rate of income tax result in overall tax revenues and those revenues going to the Scottish government moving in opposite directions. Recall that the Calman proposal is that the UK government would reduce all rates of income tax in Scotland by 10p, while making a corresponding reduction in the Scottish exchequer grant equal to the total resulting loss of revenue: and that the Scottish government would then levy its own additional income tax rate in Scotland, on top of the reduced UK rate. So if the Scottish government chose to levy a rate of 10p, it would in principle get back to where it started, (at least initially). To understand the implications of this proposal, it is necessary to distinguish between tax paid at the basic rate, and tax paid at higher rates. Annex 1 sets out the required, algebra and identifies the conditions under which condition (a) will be violated, if the Calman proposals are in operation. These conditions, which differ for the basic rate and higher rates tax bands, are as follows: For the basic rate: if the effect of a unit increase in tax rates in Scotland is to reduce total basic rate revenues, but by less than 5%, then it still pays the Scottish government to increase its tax rate in these circumstances. Conversely, if the Scottish Government were to reduce its tax rate, its overall revenues would reduce, even though the total tax revenue from the basic rate would increase. For the higher rates: if the effect of a unit increase in tax rates in Scotland is to reduce total revenues, but by less than 7.5% for the 40% band, or 8% for the 50% band, then it still pays the Scottish government to increase its tax rate in these circumstances. Conversely, if the Scottish government were to reduce its tax rate, its overall revenues would reduce, even though the total tax revenue from the basic rate would increase. The question then arises: how likely is it that these conditions will be encountered in practice? In looking at this, it is necessary to distinguish between the short and the long term. In the short term, overall tax revenues are likely to move in the same direction as the tax rate, so the perverse effect will not arise in the short term. But the position in the longer term is potentially quite different. Remember that what is of concern is what happens to total basic and total higher tax revenues in Scotland as rates vary, while at the same time, rates in the rest of the UK remain fixed. In these circumstances, it is very likely that lower rates in Scotland could make Scotland a relatively more attractive place to live and work, and vice versa with higher rates. Further, any Scottish government would typically be trying to implement a package of measures to boost the economy perhaps involving a cut in income tax, together with other incentives, like reductions in non-domestic rates or utility charges. Such a package could well grow the economy in the longer term, and increase overall tax revenues: but if the growth in tax revenues was less than 5% for the basic rate, and less than 7.5% or 8% for the higher rates, (for each 1p reduction in the rate of income tax), then condition (a) would be violated. It thus appears quite likely that in the long term condition (a) will not be met. In this case, it would be a disaster for a Scottish government operating under the Calman rules. An independent government, operating with the same overall tax revenue curves, would cut taxes, suffering the pain of a short term reduction in revenues, confident in the long term that revenues would grow, along with the economy. But, a devolved government operating under the Calman rules, facing exactly the same tax revenue curves, would face a permanent hit in its revenues if it cut taxes: overall tax revenues would ultimately grow but the beneficiary would be the UK Treasury. Conversely, if the Scottish government really needed extra revenues, and so had to increase taxes, this would be at the long term expense of the Scottish economy, (and, perhaps less importantly, of the UK Treasury.) This note has dealt only with the first order effects of a change in the Scottish tax rate under the Calman rules. There are likely, in addition, to be further effects, which could make the anomaly worse. Suppose, for example, that, in the circumstances where condition (a) is not met, a Scottish Government operating under the Calman rules reduces its income tax rate, being willing to tolerate the long term reduction in its tax revenues, for the sake of a long term improvement in the Scottish economy. However, the reduced spending on public services in Scotland, resulting from the reduction in Scottish government revenues, and the increased leakage of Scottish income tax receipts to the Treasury, will have multiplier effects, which will reduce the long term beneficial effects on the Scottish economy. 4. A tax sharing system which would avoid the anomalies This section looks at the question of how a tax sharing system could be designed which would avoid the above anomalies; that is, what sort of system would always satisfy (a) and (b). The final part of Annex 1 derives the circumstances under which a tax sharing system would always meet condition (a) above. In words, the key requirement is that, in any tax band, if overall tax revenues drop as the Scottish tax rate increases, then the percentage increase in the share of tax revenues going to the Scottish government should be smaller than the percentage decrease in overall tax revenues. But since the potential decrease in tax revenues (if any) resulting from an increase in the Scottish tax rate is unknown, the only way that it can be guaranteed that condition (a) will always be met is if the percentage increase in the share of tax revenues going to the Scottish government is zero: that is, within each tax band, if the tax sharing system gives the Scottish government a fixed share of the tax revenues raised in Scotland in that band. The circumstances under which condition (b) will be met are, trivially, the percentage share of the tax revenues from each tax band going to the Scottish Government must be the same. The implication is that, if conditions (a) and (b) both hold simultaneously, then the Scottish government will receive a fixed percentage share of the overall income tax revenues raised in Scotland. Hence a tax sharing system which would always satisfy conditions (a) and (b) would involve the Scottish government setting its own rate of tax, (as proposed by Calman), which would therefore have an effect on the total income tax revenues raised in Scotland: but the Scottish government would then always receive the same, fixed, percentage share of overall income tax revenues collected in Scotland. While this approach represents an entirely successful solution to the identified problems, there are other implications of this solution which both the UK and Scottish governments would have to be willing to accept. Principal among these is that a decision by the Scottish government to change the Scottish rate of income tax would have a direct impact on the revenues received by the UK government: and conversely, any change in tax rate by the UK government would have a direct impact on the revenues of the Scottish government. Successful operation of such a system would require that the UK and devolved governments are willing to operate in a collegiate manner being appreciative of, and respecting, the impact that their own actions will have on the revenues of the other parties. The implication is that a successful tax sharing system would have to involve a more federal way of working than is the current practice in the UK. It would be very unfortunate if the Calman Commission had been forced towards its flawed proposals on tax sharing because it was unwilling to countenance the implication that a proper system of tax sharing would inevitably involve a more federal aspect to the operation of the UK constitution. 5. Implications of the Canadian System of Tax Sharing The tax sharing system used in Canada, and also evidence from the Canadian expert Professor Vaillancourt, clearly had a substantial influence on the Calman Commission expert group, and also on the Commission itself. It is therefore of considerable interest to consider whether the tax sharing system used in Canada actually satisfies the requirements we have identified. There are essentially two elements to the Canadian system for sharing income tax revenues between the federal government and provinces. Both of these are described in the first report of the Expert Group. The most significant part of the Canadian income tax sharing system is the arrangement denoted as tax assignment. This is the element of the Canadian system which is closest in conception to the Calman proposals for Scotland, in that the provinces are making active decisions about tax rates, which affect the resources they will receive. Under the Canadian tax assignment system, the federal government is responsible for the tax base, that is, for deciding who will be subject to tax, and what constitutes taxable income. The federal government then also decides the tax rates and banding structure for the federal income tax: and the provincial governments each decide the rates and banding structures for their provincial income taxes. The revenue raised by federal income tax in a province is then split between the federal government and the province in the proportion 64.7% to 35.3%: and the revenue raised by the provincial income tax is split between the federal government and the province in the same proportion. The implication of the Canadian system of tax assignment is that, since the province will always receive 35.3% of the revenue raised under its own tax rate and 35.3% of the revenue raised under the federal rate, then the province will always receive 35.3% of the overall income tax revenues raised. But this is precisely the condition identified in the previous section which implies that conditions (a) and (b) are simultaneously satisfied. Note also that the federal government appears willing to accept the implication that its tax revenues will vary, as provinces exercise their rights to vary provincial income tax rates. There are also important tax transfer arrangements in Canada, mainly covering health and education. As well as block transfers, the federal government may agree with the province to transfer to the province part of the federal tax rate. In the case of tax transfer like this, the overall rate of tax paid by the tax payer is fixed, at the federal rate, and the element within this fixed overall rate which goes to the province is determined by mutual agreement between the federal government and the province. Tax transfer, therefore, differs from the kind of tax sharing arrangement proposed by Calman, in that the province is not setting its own tax rate. Overall, therefore, in relation to those parts of the Canadian income tax sharing system where the province is actively setting its own tax rate, the Canadian system does effectively satisfy both (a) and (b) unlike the Calman proposals for Scotland. It is unfortunate that the Calman Commission, and its Expert Group, did not appear to realise that the differences between their proposals, and the way income tax sharing operates in Canada, did not just represent minor points of detail which were of no real significance but instead represented fundamental departures which would potentially have a significant, and harmful, effect on the way their proposed system would operate. 6. Conclusion It has been argued in this note that a tax sharing system of the kind proposed by the Calman Commission is liable to give rise to severe adverse consequences if the following two conditions are not satisfied: (a) That the change in the revenues going to the Scottish Government from exercising its tax varying powers should be in the same direction as the change in total income tax revenues collected in Scotland. (b) That the Scottish Government should secure the same proportion of the revenues raised from each different income tax band. If the first condition is not satisfied, then there is a danger of the devolved government falling into a deflationary trap in which it is forced, by revenue pressures, to raise tax rates, but at the expense of deflating the economy. An independent government operating with the same tax revenue curve would not be subject to this trap. If condition (b) is not satisfied, then the devolved government will be subject to arbitrary changes in its revenue due to the effects of fiscal drag or due to deliberate tax band manipulation by the UK government. The circumstances under which the Calman proposals would fail condition (a) have been identified: condition (a) would be failed if the effect of a 1 pence increase in the Scottish rate of tax would be to reduce overall tax revenues, by 5% or less for the basic rate, by 7.5% or less for the intermediate rate, and by 8% or less for the upper rate. It is argued that there is a real danger that condition (a) would indeed be violated in the longer term. It has been shown that the Calman proposals will always violate condition (b). It is shown that a tax sharing system which would always satisfy both conditions would involve the Scottish government receiving a constant percentage share of the income tax revenues raised in Scotland. This is indeed exactly what happens in the relevant part of the Canadian income tax sharing system. It is suggested that, if the Calman proposals on income tax sharing are indeed proceeded with, then they should be modified along the lines proposed here. Such a system would have to involve a more federal way of working than the way in which the UK currently operates, with both the UK central and devolved governments conscious of the direct impact their tax decisions would have on the revenues of the other parties. Annex 1: The Conditions under which Condition (a) is Violated. The basic rate is considered first. Let B(y) = total basic rate tax revenues in Scotland, when tax levied at rate y: let f(x) = basic rate revenue going to the Scottish government, when it sets its tax rate at x. Now when the Scottish government sets its tax rate at x, it will, to a good approximation, receive a proportion  EMBED Equation.3  of the basic rate revenues raised in Scotland when the aggregate rate is (10+x). So the fundamental relationship between f and B is that  EMBED Equation.3  . What is of particular importance is how revenues change as x varies: so, differentiating with respect to x, it follows that  EMBED Equation.3  =  EMBED Equation.3  . So  EMBED Equation.3 if and only if  EMBED Equation.3 , if and only if  EMBED Equation.3  if and only if  EMBED Equation.3  . From this last expression, it follows immediately that it is possible for  EMBED Equation.3 to be greater than zero, even when  EMBED Equation.3 is less than zero: that is, condition (a) can indeed be violated. Looking at the key starting position of x=10 in more detail, it is possible to identify more precisely the conditions under which this will occur, as follows:-  EMBED Equation.3 if and only if  EMBED Equation.3  if and only if  EMBED Equation.3  . The term on the left hand side of this last expression is approximately the percentage change in overall basic rate tax revenues in Scotland, resulting from a 1p increase in the tax rate: (this can be seen on taking the first two terms in a Taylor expansion). What this means is that, when the Scottish government increases its rate of tax by 1p, the amount of revenue it derives from the basic rate of income tax will increase if either Overall basic tax revenues increase, or Overall basic tax revenues drop, but by no more than 5%. It is in this second case that condition (a) is violated: that is:- if the effect of a unit increase in tax rates in Scotland is to reduce total basic rate revenues, but by less than 5%, then it still pays the Scottish government to increase its tax rate in these circumstances. Conversely, if the Scottish Government were to reduce its tax rate, its overall revenues would reduce, even though the total tax revenue from the basic rate would increase. The algebra for revenues coming from the higher rate tax bands is similar, but the numbers are different. Let H(y) represent total tax revenues in Scotland from the middle tax band, (currently the 40% tax band), when tax is levied at rate y: then what the Scottish government gets from this tax band, when it sets its tax rate at x, is  EMBED Equation.3 . A similar argument to the above shows that the critical threshold in this case is 7.5%. Similarly, for the highest rate tax band, (currently 50%), the critical threshold is 8%. In other words:- if the effect of a unit increase in tax rates in Scotland is to reduce total revenues in the two higher rate bands, but by less than 7.5% and 8% respectively, then it still pays the Scottish government to increase its tax rate in these circumstances. Conversely, if the Scottish government were to reduce its tax rate, its overall revenues would reduce, even though the total tax revenue from the basic rate would increase. General conditions under which condition (a) met. In general, and considering the case of the basic rate, suppose f(x) = a(x) B(10+x) + c, where a(x) is the proportion of overall basic rate tax revenues going to the Scottish government when it sets its tax rate at x, and c is a constant, (which could be zero). It is reasonable to assume  EMBED Equation.3 . Since  EMBED Equation.3 , It follows that  EMBED Equation.3 and  EMBED Equation.3  will have the same signs if either (i)  EMBED Equation.3 , or (ii)  EMBED Equation.3  , and  EMBED Equation.3  , that is, if  EMBED Equation.3  , and  EMBED Equation.3  . In words, this last condition states that condition (a) will be met if the percentage increase in the proportion of income tax revenues coming to the Scottish government is smaller than the percentage decrease in overall revenues.     PAGE  PAGE 5 $%&`abnoo E ? 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