Budget Preview #1: What might income tax changes by the UK Government mean for Scotland?

We are less than a month away from the UK Budget, and speculation is running rampant about what the OBR will say on productivity growth and how much that might force Rachel Reeves’ hands.

The Chancellor started with a historically limited buffer for meeting the fiscal rules were there to be bad news on the next set of forecasts. With the OBR reviewing its productivity assumption to bring it more – though not yet fully – in line with the dismal post-Financial Crisis outturn, that bad news has materialised and then some.

Not ruling it out anymore

The Labour Manifesto for the 2024 General Election had a promise to “not increase National Insurance, the basic, higher, or additional rates of Income Tax, or VAT.” Of course, eagle-eyed readers will note that there has already been an increase in the rate of National Insurance Contributions paid by employers, but even if we were to concede that the spirit of this promise was on employee NICs, any change to income tax would seem to collide with it.

Which is why the Prime Minister not ruling it out in the Commons earlier this week felt so significant. The difference between current plans and ones that meet the fiscal rules are so vast that it may be infeasible to close that gap without touching the big revenue-raisers. So income tax might well be back in play.

Devolved doesn’t mean insulated

Income tax is (mostly) devolved in Scotland. It is nearly fully for non-savings, non-dividends income, which is over 90% of all income in Scotland. The Personal Allowance is set by the UK Government, as is the definition of income, but rates and thresholds are decided in Holyrood.

All revenue raised by Scottish Income Tax goes directly into the Scottish Budget. But there’s a further complication: there is a Block Grant Adjustment (BGA), a deduction that attempts to capture what would have happened in the absence of devolution.

The rationale is relatively straightforward and logical: the Scottish Government gets to keep income tax revenues and decide on rates, but spending decisions at UK level – which flow into the Block Grant – are based on UK Government decisions about tax rates.

So it makes sense that there would be some sort of compensatory mechanism. It can also be seen an incentive for the Scottish Government to find ways to raise more revenue, be it by increasing rates or growing the tax base.

The latter is actually pretty difficult to do in the short run – it depends on many factors, and governments can only affect it so much year-to-year – but the Scottish Government has raised rates on net. This has meant that the Scottish Budget is about £0.6 billion larger in 2025-26 after accounting for higher tax rates in Scotland (which increase revenues) and for faster growth in the counterfactual revenues in the rest of the UK (which increase the BGA, and therefore reduce revenues).

As we have pointed out before, the devolution of income tax makes decisions on Budgets in Westminster and Holyrood more interlinked, not less. And that certainly will be true if the UK Government changes rates.

Figure 1: How the Scottish Budget is determined

Source: FAI analysis

An additional 2p on the UK basic rate would cost the Scottish Government £1 billion next year

While Scottish taxpayers’ tax bills would not be directly affected by any change in UK income tax rates, the effect on the Scottish Budget is automatic through the BGA.

Remember that the BGA is a proxy for how much revenue would be raised in the absence of devolution of the tax. If the UK Government raises rates, then a non-devolved system would have raised more money – and so the deduction is larger.

How much larger? We can use the HMRC Ready Reckoner and the OBR’s latest forecast to calculate how much different options would raise for the UK Government, and consequently how this affects the BGA. The table below summarises the net effect on the Scottish Budget – all of them come directly through an increase in the BGA – so a larger deduction from the Scottish Budget.

 Table 1: Effects of UK income tax measures on the Scottish Budget (£m)

Measure	2026-27	2027-28	2028-29
UK basic rate increased by 1p	-486	-580	-575
UK basic rate increased by 2p	-972	-1,160	-1,150
UK higher rate increased by 1p	-113	-151	-147
UK higher rate increased by 2p	-225	-302	-295

Source: HMRC, OBR, FAI calculations

This would be a pretty significant cut to funding, and it would then be for the Scottish Government to determine how to react to this. It could decide to adjust spending plans, or to raise taxes to return revenues to where it expected to be. The Scottish Government ready reckoners suggest that increasing the starter, Scottish basic and intermediate rates all by 1p would be roughly in line with the cut from the BGA for a 1p change by the UK Government on their basic rate. The same is true for increasing both the Scottish higher and advanced rates in relation to an increase in the UK higher rate.

Either way, there’s no free lunch here. If UK income tax rates are raised, either the Scottish Government will have to spend less or Scottish taxpayers will also have to pay more tax – it’s just arithmetic.

What about an income tax/NICs switch?

One of the floated measures over the past few days would be to increase income tax by 2p on the basic rate, but to cut the primary rate of employee NICs by 2p.

This could be an attractive option for the UK Government. Employee NICs are due on employment income only, whereas income tax is also due on pensions, the self-employed, savers, investors, landlords and other types of non-employment income. This would raise about £6 billion from 2027-28 onwards, on top of reducing the wedge between employee and self-employment tax – which would be a good thing for the efficiency of the tax system. And if one wanted to argue that workers were being protected, it would be much closer to achieving that.

Income tax is devolved, but NICs are not. So if this came to pass, Scottish employees would pay the same income tax, but less NICs – therefore, benefiting more than employees in the rest of the UK – while those not paying employee NICs would not be directly affected at all.

The Scottish Government, however, would continue to face the same BGA issue. That deduction would increase, while NICs changes do not directly affect the size of its budget. So it would have to decide whether to make any changes to its own income tax rates or to cut expenditure in response.