The UK Government is considering how to fund a major increase in social care spending in England. The costs of ‘fixing the crisis’ in England are estimated at up to £10bn annually.
Briefings indicate that the UK Government is minded to fund an increase in social care spending in England through increases in National Insurance Contributions (NICs) rather than through income tax (IT). Many commentators argue that IT would be a more appropriate way to raise revenue. Unlike NICs, IT applies to the over 65s, and to those receiving income from sources other than pay and self-employment income.
One reason why the UK Government is apparently reticent to fund an increase in social care spending in England via increases in income tax is that income tax is devolved in Scotland. At first glance this argument feels odd. If IT is devolved in Scotland, doesn’t that strengthen the case for using it, rather than NICs, to fund a spending increase on a devolved service in England?
However, on closer inspection, raising income tax in rUK to pay for social care spending in England could create a number of potential territorial funding iniquities and administrative challenges. This blog outlines those challenges, and considers how material they are likely to be in influencing the UK Government’s policy decision.
Funding the social care spending increase via NICs
If the UK Government funded its social care plans by increasing NICs, the funding implications are quite straightforward. The tax increase (whether to employee or employer contributions, or to the self-employed) would apply in Scotland. The Scottish budget would benefit from a Barnett consequential as a result of the increased spending in England. A £10bn increase to spending on social care in England would result in approximately a £1bn increase to the Scottish block grant.
(As is the case with income tax, the NICs raised in Scotland from an increase in NICs may not fully cover the sum of the additional Barnett consequential that flows to Scotland. This is seen as ‘fair’ in the context of a tax that is ‘pooled and shared’ across the UK. As we will see, the arguments around income tax, which is devolved, are viewed differently.)
Funding the social are spending increase via income tax – fine in principle?
If the rise in social care spending in England is funded through an increase in income tax rates, this tax increase would not apply in Scotland. But Scotland would still get the same Barnett consequential as a result of the increase in English spending. If the story stopped here, the outcome would obviously be very unfair, with the Scots benefiting from an increase in spending funded by a tax rise in rUK that does not apply in Scotland.
But of course the story doesn’t stop there. A core principle of the Smith Commission – subsequently implemented in the Scottish Fiscal Framework – is that Scots should not benefit from English spending increases that have been funded by a tax policy change that does not apply in Scotland (and vice versa).
This principle is operationalised through the income tax block grant adjustment (BGA). The BGA is basically an estimate of the revenues that UKG would have raised from IT in Scotland, assuming: a) IT had not been devolved, b) the same IT policy applied in Scotland as rUK, and c) the tax base had grown at the same rate in Scotland as rUK. So a rise in rUK income tax revenues (all else being equal) automatically leads to a larger BGA being deducted from the Scottish block grant.
In principle, the rise in the BGA deduction should offset the Barnett consequential flowing from increased English spending on social care. The Scottish budget is left unaffected in net terms by the UK Government’s policy changes, and the Scottish Government can decide whether or not it wants to adopt similar measures in Scotland.
Complication 1 – an infringement of the taxpayer fairness principle
That’s how it would ideally work in principle, but in practice things get a bit messy.
Specifically, there is a techy reason why the increase in BGA might not completely offset the Barnett consequential. This relates to the different way in which the Barnett consequential and the BGA are derived.
- The Barnett consequential allocates the Scottish budget a per capita share of the English spending increase.
- But the increase in BGA is calculated on the basis of the percentage increase in per capita income tax revenues seen in rUK, applied to Scottish revenues per capita.
Since Scotland raises less in income tax per capita than rUK, the rise in its BGA is likely to be less than the rise in its consequential.
To illustrate this, consider this example:
- The UK Government increases social care spending in England by £10bn, generating a £1bn consequential for Scotland
- To fund this, the UK Government introduces income tax increase in England which cause income tax revenues per capita in rUK to increase by 6%
- The BGA calculation applies this 6% increase in rUK per capita revenues to Scottish income tax revenues. This results in the BGA increasing by £900m.
- So the Scottish budget has received an additional £1bn in Barnett consequentials, but its block grant adjustment has increased by only £900m. Despite the fact that the rUK income tax policy does not apply in Scotland, the Scottish budget has received a £100m windfall.
These numbers are hypothetical and broad brush, but plausibly indicative of the sort of magnitudes we could be talking about. The UK Government would presumably argue that this infringes ‘taxpayer fairness’ principles.
You might wonder why the BGA is calculated in a way that yields this outcome. The fact is that there is no easy solution. An alternative approach that avoided this specific issue would be unfair to Scottish taxpayers – requiring Scottish income tax revenues to grow faster than rUK revenues to avoid the size of devolved Scottish spending relative to equivalent English spending eroding over time.
Complication 2 – what happens to reliefs?
There are other complications to. One is about what happens to income tax reliefs – particularly pensions contributions relief – if a higher rate prevails in rUK than in Scotland.
At the moment, many Scottish taxpayers face a higher marginal rate of income tax than counterparts in rUK. The two governments have previously agreed that taxpayers should get pensions relief at their respective marginal rates. So an intermediate taxpayer in Scotland can get pension relief at 21%, and a higher rate taxpayer in Scotland can get pension relief at 41%. For taxpayers on PAYE, this all happens automatically. Other Scottish taxpayers have to make a retrospective claim to HMRC, similar to the current process for higher rate taxpayers in UK, if they want to receive relief at the marginally higher rate that they are entitled to. (Scottish ‘starter rate’ taxpayers pay a marginal rate of 19% but get pension tax relief at 20% automatically and are not required to pay anything back to HMRC.)
So far therefore, differential marginal tax rates across the UK has not been a major issue of concern. But in theory at least, if we moved to a situation where tax rates were higher in rUK than Scotland, the issues here could become more problematic. Rather than the onus being on some individuals in Scotland to claim a higher relief from HMRC, the onus might shift onto HMRC to reclaim higher reliefs that have erroneously applied to Scottish taxpayers.
We are used to hearing that the devolution settlement is constraining the policy choices of the Scottish Government. The notion that the devolution settlement might potentially constrain the UK Government’s policy choices comes as something of a surprise.
Whether or not these issues are significant enough to justify a potential UK Government decision to fund an increase in social care spending increase via NICs rather than IT is debateable. And to be fair, it is clear that other considerations, beyond the thorny mechanics of the devolved fiscal framework, have influenced the UK Government’s apparent preference for relying on NICs.
But it is also clear that there are material issues here which the UK Government might be concerned about. These are likely to feature heavily in the upcoming review of the fiscal framework.