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Scottish Budget, Scottish Economy

Scotland’s Budget Report Preview #2: Potential reforms to income tax in Scotland

Tax rates and thresholds in Scotland and the rUK

The Scotland Act 2016 enabled the Scottish Government to set its own tax policy on non-savings, non-dividend income – i.e., on earnings from employment.

Income tax is considered partly devolved in Scotland. Although the Scottish Government has the power to set tax rates and thresholds that apply to earnings in Scotland, it does not have the power to change allowances – such as the personal allowance – or adjust tax policy surrounding earnings from interest and dividends.

Since 2017-18, income tax policy in Scotland has diverged from that of the rest of the UK (rUK). Today, there are two new bands that exist in Scotland (the ‘starter’ and ‘intermediate tax’ band), as well as changes to the basic and higher rate of tax.

Table 1: Scottish Tax Rates and Bands, 2023/24

Scottish Tax Rates Tax Bands Rate
Personal Allowance Up to £12,570 0%
Starter Rate £12,571 – £14,732 19%
Scottish Basic Rate £14,733 – £25,688 20%
Intermediate Rate £25,689 – £43,662 21%
Higher Rate £43,663 – £125,140 42%
Top Rate Over £125,140 47%

Source: Scottish Government, 2023

Table 2: rUK Tax Rates and Bands, 2023/24

rUK Tax Rates Tax Bands Rate
Personal Allowance Up to £12,570 0%
Basic rate £12,571 to £50,270 20%
Higher rate £50,271 to £125,140 40%
Additional rate Over £125,140 45%

Source: UK Government, 2023

The devolution of income tax policy has enabled the Scottish parliament to raise additional funds for the Scottish budget. The Scottish Fiscal Commission (SFC) estimated that Scotland’s devolved income tax policies raised an additional £750 million in tax revenue between 2017-18 and 2021-22, when compared with income tax policy in the rUK. However, owing to Scotland’s comparatively weaker economic performance and a different income distribution, the overall increase in the Scottish budget from income tax devolution was £85 million in 2021-22.

When comparing Scotland with the rUK, those earning up to £27,800 tend to pay a little less income tax than they would in the rUK, and those with earnings above this level tend to pay significantly more.

In addition to income tax, earners below State Pension age must also pay National Insurance Contributions (NICs) on their income. National insurance is not devolved and therefore the same rates and thresholds apply in Scotland as they do in the rUK.

Following changes to NICs that the Chancellor announced in November, the following rates and thresholds of NICs apply in Scotland and rUK from January 2024 onwards for employees. [1]

Table 3: National Insurance Rates and Thresholds, Scotland and rUK from 6 January 2024

National Insurance Thresholds and Rates Bands Rate
Lower Earnings Limit Up to £12,570 0%
Primary Threshold £12,571 – £50,270 10%
Upper Earnings Limit Above £50,271 2%

Source: UK Government, 2023

Marginal Tax Rates

Marginal tax rates are a term used to describe the rate of tax an earner pays on each additional unit of income they earn. They are calculated as the total rate of income tax plus NICs for each unit of income earned, considered alongside personal allowances and any taper rates that may apply.

Generally, marginal tax rates are designed in a progressive way, where the marginal tax rate increases in steps as a worker earns more. In the rUK, this tends to be the case, except for earnings between £100,001 and £125,000, where the marginal tax rate increases to 62%, before falling to 42% for all earnings beyond £125,000. This increase in the marginal tax rate for earnings between £100,001 and £125,000 is due to the taper rate, where for each £2 earned above £100,000, there is a £1 reduction in the £12,500 tax free personal allowance.

Like employees in rUK, earners in Scotland experience a sharp increase in their marginal tax rate for earnings between £100,001 and £125,000, rising to 65%. However, earners in Scotland also face a significant increase in their marginal tax rate to 52% for earnings between £43,663 – £50,270, which earners in the rUK do not.

Chart 1: Marginal Tax Rate, Scotland and the Rest of the UK, 2024/25

Source: FAI Calculations, 2023

You may ask what is driving this increase in the marginal tax rate in Scotland?

This sharp increase in the marginal tax rate is driven by deviations in Scottish income tax policy from the rUK. In the rUK, rates of NICs fall from 10% to 2% at the same level of earnings (£50,270) that income tax increases from 20% to 40%. However, because earners in Scotland move up to the higher rate band at a lower threshold of £43,662, they start paying a higher rate of tax of 42% without any immediate reduction in their NICs rate.

Some argue that this sharp rise in the marginal tax rate may disincentives earnings at the margin. By this, we mean that if a worker is earning £43,662 each year, they may be disincentivised to earn more because they would have to pay 52p of each additional pound they earn (up to £50,270).

Although this distortion in the Scottish marginal tax rate may impact workers incentive, it does bring in an additional £600 million of tax revenue each year. [2]

In the following section, we explore two potential reforms to Scottish income tax policy that could smooth out this distortion in marginal tax rates, whilst importantly, ensuring there is no significant reduction in the revenues from income tax that the Scottish Government currently collects.

Potential revenue-neutral reforms to Scottish Income Tax

There are two reforms to Scottish income tax policy that this analysis focuses on.

To be clear, this report does not advocate for any particular reform. Instead, it models the impact on Scottish Income Tax revenue from two reforms that are available to the Scottish Government.

This modelling uses a 5-year forecasting window, where if a change to income tax resulted in less than a £15m change to tax receipts on average each year, then it is considered broadly revenue-neutral. In addition, this report also assumes income tax thresholds in Scotland and the personal allowance are mostly frozen between 2024-25 and 2028-29, using the Scottish Fiscal Commission’s (SFC) assumptions on indexation as set out in their May 2023 forecast.

All reforms are assumed to be implemented from 2024-25 onwards unless otherwise specified.

Reforms have been costed using our model which is based on the SFC’s published methodology, and which we first used when looking at the revenue-raising potential of proposed measures for an additional rate between the higher and top rates.

Potential reform 1

The first reform could be to make the following changes to Scottish income tax rates and thresholds –

  • Increase the intermediate rate upper threshold to £50,270;
  • Increase the basic rate by 1%;
  • Increase the intermediate rate by 2%;
  • Increase the higher rate by 1%.

This would result in the following thresholds and rates of income tax across Scotland –

Table 4: Tax Rates and Thresholds for Reform 1

Tax Thresholds 2024-25 Rate 2025-26 Rate 2026-27 Rate 2027-28 Rate 2028-29 Rate
Up to £12,570 0% 0% 0% 0% 0%
£12,571 – £14,732 19% 19% 19% 19% 19%
£14,733 – £25,688 21% 21% 21% 21% 21%
£25,689 – £50,270 23% 23% 23% 23% 23%
£50,270 – £125,140 43% 43% 43% 43% 43%
Over £125,140 47% 47% 47% 47% 47%

Source: FAI Calculations, 2023

This reform would smooth out the distortion in marginal tax rates for earnings between £43,663 – £50,270 and bring in, on average, an additional £15 million of tax revenue for the Scottish government each year and £77 million over the 5-year forecasting window.

In 2024/25 and 2025/26, this reform would raise an additional £56 million and £38 million, respectively. However, the value of tax receipts collected from this policy would gradually decrease, going negative from 2027/28 onwards.

Chart 2: Change to Scottish Income Tax Receipts from Reform 1, £m millions

Source: FAI Calculations, 2023

Potential reform 2

The second reform includes raising the intermediate rate threshold from 2024-25 onwards, and incrementally increasing the basic rate, intermediate rate and higher rate. Specifically, this reform refers to –

  • Increasing the intermediate rate upper threshold to £50,270;
  • Increasing the basic rate to 21% between 2024-25 and 2026-27 and to 22% from 2027-28 onwards;
  • Increasing the intermediate rate to 22% between 2024-25 and 2026-27 and to 23% from 2027-28;
  • Increasing the higher rate to 43% between 2024/25 and 2027-28 and to 44% in 2028-29.

This would result in the following thresholds and rates of income tax across Scotland –

Table 5: Tax Rates and Thresholds for Reform 2

Tax Thresholds 2024-25 Rate 2025-26 Rate 2026-27 Rate 2027-28 Rate 2028-29 Rate
Up to £12,570 0% 0% 0% 0% 0%
£12,571 – £14,732 19% 19% 19% 19% 19%
£14,733 – £25,688 21% 21% 21% 22% 22%
£25,689 – £50,270 22% 22% 22% 23% 23%
£50,270 – £125,140 43% 43% 43% 43% 44%
Over £125,140 47% 47% 47% 47% 47%

Source: FAI Calculations, 2023

Like the first reform we modelled, this reform would also smooth out the marginal tax rate for earnings between £43,663 – £50,270 and increase the income tax revenue collected in Scotland. Notably, this reform would increase the average revenue from income tax collected each year by £13 million and increase the total revenue of income tax collected by £67 million over the 5-year forecasting window.

However, it is important to note that this reform would cost an average of £159 million between 2024-25 and 2026-27, before raising an additional £240 million and £302 million in 2027-28 and 2028-29, respectively.

Chart 3: Change to Scottish Income Tax Receipts from Reform 2, £m millions

Source: FAI Calculations, 2023

What next for income tax in Scotland?

On the 19th of December, the Scottish Government will announce its proposed spending and tax plans for the year ahead. Although this is expected to be a particularly challenging budget for the new Finance Secretary and Deputy First Minister Shona Robinson, it could present an opportunity for the Scottish Government to think about its Income Tax policy more broadly.

In this article, we have explored the distortion in Scotland’s marginal tax rate, and touched upon how it could be reduce labour market incentives for employees around the £43,662 – £50,270 income range. Through this analysis, we hope to highlight the potential reforms within the Scottish Government’s gift  to smooth out Scotland’s marginal tax rate, whilst importantly, ensuring they are revenue-neutral, and therefore do not significantly affect the Scottish Government’s spending power over the medium-term.

Footnotes

[1] Different rates apply to self-employed persons – in this blog we have focused on employees as they make up the largest proportion of the workforce.

[2] In 2024-25, changing the upper threshold of Scottish intermediate rate from £43,662 to £50,270 would reduce income tax revenue collected in Scotland by £602 million.

Authors

Calum is an Associate Economist at the Fraser of Allander Institute (FAI) and a Researcher at the Centre for Inclusive Trade Policy (CITP). He specialises in economic modelling and trade, and holds an MSc in Economics from the University of Edinburgh.

João is Deputy Director and Senior Knowledge Exchange Fellow at the Fraser of Allander Institute. Previously, he was a Senior Fiscal Analyst at the Office for Budget Responsibility, where he led on analysis of long-term sustainability of the UK's public finances and on the effect of economic developments and fiscal policy on the UK's medium-term outlook.