Tax policy – and more specifically the scope for cutting tax rates – has been dominating the Conservative leadership campaign.
Many of these debates relate to taxes that are reserved to Westminster, including VAT, Corporation Tax and National Insurance Contributions. As such, tax policy changes would apply across the UK as a whole.
The obvious tax for which this is not the case is income tax. Changes to income tax rates or bands introduced by the UK government will not apply to taxpayers in Scotland[i]. Instead, it will be for the Scottish government to decide whether and how to respond to income tax policy changes introduced by the UK government.
The key policy proposal on the table in this regard is a proposed cut in the basic rate of income tax in the UK from 20p to 19p. This is already confirmed policy of the UK government, planned for implementation in April 2024. In campaigning, Sunak has now also announced an intention to cut the basic rate substantially further, to 16p, by 2030.
The purpose of this blog is not to discuss the merits or not of these policies, but to consider their implications for the Scottish budget.
Re-capping existing income tax policy differences
By way of recap, the table below shows the structure of income tax (for non-savings, non-dividend income) in Scotland and the UK as a whole in 2022/23.
Table 1: Income tax schedules in Scotland and the rest of the UK, 2022/23
|UK tax schedule||Scottish tax schedule|
|Basic rate||20%||£12,571-£50,270||Starter rate||19%||£12,571 – £14,731|
|Higher rate||40%||£50,271-£150,000||Basic rate||20%||£14,732 – £25,668|
|Additional rate||45%||Over £150,000||Intermediate rate||21%||£25,669 – £43,662|
|Higher rate||41%||£43,663 – £150,000|
|Top rate||46%||Over £150,000|
The implications of these differences can be described in broad terms as follows:
- The narrow band of income that is taxed at the 19p ‘starter rate’ in Scotland, but at the 20p basic rate in rUK, means that Scottish taxpayers with incomes below £27,800 – approximately half (54%) of all income taxpayers in Scotland – face slightly lower tax liabilities than equivalent income taxpayers in rUK. However, the difference in tax liability is relatively small – Scottish taxpayers with incomes below the median pay a maximum of £22 per annum less in tax than they would if they lived in other parts of the UK.
- At incomes above £27,800, Scottish taxpayers begin facing higher income tax liabilities than equivalent taxpayers in rUK, as a result of Scotland’s 21p intermediate tax rate.
- The much lower threshold for the higher rate in Scotland, combined with a higher rate of 41p rather than the 40p that applies in rUK, means that the gap in liabilities faced by a Scottish taxpayer compared to an equivalent taxpayer in rUK widens substantially above an income of £43,600. For a taxpayer with an income of £50,000, the Scottish taxpayer faces liabilities around £1,500 higher than the equivalent taxpayer in other parts of the UK.
Implications for the Scottish budget of a 1p cut in UK basic rate, but no change to Scottish income tax rates
Lets assume the UK government goes ahead with its plan to reduce the UK basic rate from 20p to 19p in 2024/25. What are the implications for the Scottish budget?
First lets think about what happens if the Scottish government choses not to respond, and to retain its 19p starter rate, 20p basic rate and 21p intermediate rate (and with increases to the basic and intermediate thresholds in line with inflation).
This decision not to respond to the UK government’s tax cut strengthens the Scottish government’s budget position.
How so? Under Scotland’s fiscal framework, UK tax policy acts as a counterfactual against which the deduction to the Scottish government’s block grant is made. The more that UK income tax rates are cut, the less revenue that the UK government has implicitly ‘foregone’ as a result of having transferred income tax revenues to Scotland, and hence the less that is deducted from the block grant.
So a cut in the UK basic rate in itself strengthens the Scottish budget position because it reduces the amount that is deducted from the Barnett formula[ii].
However, the flipside of a Scottish government decision not to change its tax rates in response to the UK change is that the Scottish government would no longer be able to say that Scottish taxpayers with incomes below the median face lower tax liabilities than they would if they lived in other parts of the UK. The 19p UK basic rate would apply to income between the Personal Allowance and the Higher Rate Threshold of £50,270, whereas in Scotland the 19p rate would apply only to the narrow ‘starter’ tax band.
Indeed, as Chart 1 shows, if the Scottish government kept its tax plans unchanged in response to a cut in the UK basic rate, no Scottish income taxpayers would pay less income tax then their rUK counterparts (those with incomes below £15,000 would be liable to the same tax revenue as those in rUK, since both sets of taxpayers would pay tax at a 19% rate above the personal allowance, but all other taxpayers in Scotland would pay more tax than they would in rUK).
Chart 1: Differences in income tax liability between Scotland and rUK, under three scenarios for 2024/25
Implications for the Scottish budget of a 1p cut in UK basic rate, mirrored by equivalent tax cuts in Scotland
The Scottish government may decide that it wanted to retain the same difference in tax liabilities between Scotland and rUK for individual taxpayers that exists now. The simplest way of doing this would be to reduce the starter, basic and intermediate rates of tax in Scotland by 1p each, so that they became 18p, 19p and 20p respectively.
This would enable the Scottish government to maintain its aspiration that Scottish taxpayers with below-median incomes faced lower tax liabilities than they would in rUK. But it would come with substantial revenue implications. The Scottish budget would be around £420 million lower in 2024/25 than it would be relative to the ‘no policy change’ scenario set out above. This comparison is important because the Scottish government’s spending plans for 2024/25 as set out in its Spending Review in May are predicated on the assumption that the UK government does reduce the basic rate to 19p, but Scottish tax rates remain unchanged.
So on one level, the decision facing the Scottish government in 2024/25 is whether a reduction in starter, basic and intermediate rates of income tax in Scotland – which would maintain the existing reduced tax liabilities for below-median income taxpayers in Scotland relative to those in rUK – can be justified by the £420 million price tag, when that £420m is already baked into its spending plans.
Of course the Scottish government has other options in response to a cut in the UK basic rate. It could for example reduce the starter and basic rates in Scotland by 1p each, but leave the intermediate rate at 21p. This would not be as costly in revenue terms (it would cost around £280m in reduced revenues, compared to leaving tax rates unchanged). But it would also increase the tax liabilities – relative to those faced by taxpayers in rUK – of Scottish taxpayers with incomes above £29,500 (see chart 1).
The big picture
The key point to remember is that a cut to the basic rate of income tax in April 2024 by the UK government will not apply in Scotland.
Despite the complexity of the fiscal framework, the trade-off facing the Scottish government is intuitive. The more closely that it tries to match, or even surpass, tax cuts made by the UK government, the less revenue it will have to fund public services in Scotland.
Current Scottish government spending plans for 2024/25 are based on forecasts which assume that the UK government’s planned cut in the basic rate is not matched by any changes to Scottish rates. If the reality differs from this assumption, the Scottish government may end up with less resources available to it.
It will be interesting how the politics of this play out as the decision looms towards the end of 2023. Public services are feeling severe strain north and south of the border. The cost-of-living crisis is also biting UK-wide (and the point that a cut in the basic rate is not a great way to help the lowest income households also applies as much in Scotland as in rUK). The Scottish government has tended to make the case for greater investment in public services than that proposed by the UK government. But it also likes to reiterate the advantages of its ‘fairer and more progressive’ tax system which results in over half of Scottish taxpayers paying less income tax than they would if they lived in the rest of the UK.
A reduction to the basic rate of income tax in rUK may force the Scottish government to prioritise between these two pillars of its tax strategy. Will it worry less about a widening of the tax gap between Scotland and rUK, and emphasise the merits of a relatively higher tax burden for public services? Or will it tack more closely to UK government policy, mirroring tax cuts in order to maintain a policy narrative about fairness in relation to the tax liabilities of the lowest half of income taxpayers?
[i] The Scottish government sets the income tax rates and bands that apply to Scottish taxpayers’ income from employment, self-employment, pensions and property. However, the savings and dividend income of Scottish taxpayers is subject to UK government tax policy.
[ii] Note however that we are implicitly assuming in this analysis that the cut in the UK basic rate does not affect UK government departmental spending plans, and hence the size of the Barnett formula itself. This is a reasonable assumption as far as the cut to 19p in 2024 is concerned, but may not be a reasonable assumption to extend to subsequent cuts in the UK basic rate.