Editor BILL JAMIESON thinks Scots politicians relying on a hike in taxes to fund benefits and reduce inequality are heading for a nasty surprise.
Don’t blame Revenue Scotland, Finance Minister John Swinney or HMRC.
Look instead to the taxpayer – and to that most dangerous of all consequences in tax planning: behavioural response.
Holyrood’s new tax raising powers, specifically the Scottish Rate of Income Tax (SRIT) – make its debut in April 2016.
Don’t assume that Scotland’s 2.5 million taxpayers are well up to speed on the changes.
An HMRC survey this year on public knowledge of SRIT found that only one in 85 individuals knew about it. Most expressed surprise over the major changes ahead.
More troubling is the persistent belief that raising income tax rates is an easy solution to Scotland’s budget problems and that higher rates translate into a straight arithmetic increase in tax revenues.
Income tax will be the Scottish Government’s main future revenue source, already bringing in £11.4 billion a year.
But that revenue is highly dependent on a very small number of taxpayers.
Only last month Scottish Labour leader Kezia Dugdale breezily announced a “double whammy” at her party conference – not raising the threshold for the 40p income tax band and introducing a 50p rate on incomes above £150,000.
Hit the rich – and fiscal problems sorted?
Let’s note how vulnerable that taxpayer base is.
The richest 10 per cent of taxpayers in Scotland pay more than 50 per cent of income tax revenues. The top five per cent of tax payers – comprising just 130,000 people — contribute 40 per cent of that revenue.
There are around 11,000 additional rate taxpayers in Scotland, comprising less than 0.5 per cent of Scottish taxpayers – but accounting for around 10 per cent of income tax.
That makes Scotland’s tax structure like a shaky tall building – one that, in inclement tax weather, is vulnerable to corrosion and loose masonry at the top.
The notion that ever higher tax rates on the well-off bring in commensurately higher tax revenue thus needs critical scrutiny in view of the potential damage. Growing attention is now being paid in Scotland to the behavioural effects of tax changes.
A new paper on income tax in Scotland has recently been posted by Anouk Berthier on the Scottish Parliament (SPICe) website. This carries valuable facts and figures on Scotland’s tax structure and discusses how taxpayers might respond to changes in tax rates and levels.
A more detailed analysis of behavioural response – and the best available so far in this field – has been compiled by Professor David Bell of the Stirling Management School and Centre on Constitutional Change (‘Behavioural Responses to Changes in Income Tax Rates; What Will Happen in Scotland?’).
The paper discusses possible responses to changes. For example, an increase in tax on earnings could see workers reducing their hours of work, or seek a more attractive job offer to maintain their real wage.
In assessing this “elasticity of labour supply” it is generally assumed that tax increases have a negative effect on labour input.
Withdrawing from the labour market altogether might cause an increase in payments of state benefits. Therefore, since most benefits will continue to be paid by DWP, withdrawal from the labour market could have implications for Scotland under the second “no detriment” principle as defined in the Smith Commission report.
An important consequential could be migration to a jurisdiction with lower tax rates.
Such migration, writes Bell, tends to be concentrated among the young who can offset the costs because they can realise the gains from migration over the remainder of their working life.
“Migration”, he adds, “is also focused on high earners, for whom the fixed costs of moving are less significant. Increased emigration and/or reduced immigration will reduce economic activity in Scotland below what it would otherwise have been. Therefore there will also be a reduction in receipts from other taxes in Scotland, which would affect UK revenues”.
Arguably the most likely response would be a switch in the way in which income is accounted for – particularly in the Scottish context as tax on income from savings and dividend income remains with HMRC and will not be devolved to Scotland.
What an escape route from the tottering skyscraper this may prove.
This avenue may encourage people to take income as profits rather than earnings by changing their status to sole proprietor or partner of an incorporated business. Workers could opt to be taxed on profits rather than earnings and thus take advantage of whichever rate of tax was lower.
There are around 300,000 self-employed workers in Scotland and 330,000 small and medium-sized enterprises in Scotland with less than 50 employees.
Finally, reductions in income may cause individuals to cut back on spending, which in turn may have adverse consequences for the economy, such as lowering aggregate income and increasing unemployment.
Judging behavioural response is complex and technical. US economist Charles Manski urged caution in making bold claims based on studies that have been undertaken to determine the tax elasticity of labour supply. However, he did argue that the evidence did clearly point to one conclusion, namely that “increasing tax rates usually reduces work effort.”
For Scotland, Bell notes, “this would imply that the tax revenue likely to be raised from increased income tax rates would be less than a simple arithmetic projection would suggest”.
Overall, the worldwide evidence on behavioural responses to tax changes tends to agree only on the belief that higher income tax rates will lead to behaviours that have a negative effect on tax revenues.
Particularly important in Scotland would be the responses of high income earners who generate a disproportionate share of Scotland’s tax revenues. “There is certainly evidence of avoidance behaviour occurring”, says Bell, “as the additional rate was introduced and then changed”.
Moral for policymakers: look carefully before you leap on income tax changes.