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Fiscal Policy and Tax, Scottish Budget

Scotland’s Budget Report Preview #4: An update to how much income tax proposals would raise

In September, we published a short briefing on how much revenue some proposals for a new income tax band would raise. We did so on the basis of our understanding of the Scottish Fiscal Commission’s current methodology – published in their May 2021 paper.

We feel this is an important consideration when looking at policy proposals in this sphere. Of course, there is uncertainty regarding how much the actual behavioural response will be to any policy measures, and especially on income tax, as parameters such as taxable income elasticities, or TIEs – essentially the extent to which people affected by the change in their tax bill will respond – is extremely difficult to estimate.

But the SFC is using the best evidence available – and as it says in the aforementioned paper, there is strong evidence of behavioural responses, even if the exact figure of how much is uncertain.

And crucially, the SFC’s approach provides the official forecast, which combines with other funding elements of the Scottish Government to set the spending envelope. So it is important to consider how much might be raised under this methodology.

Of course, it is worth making it clear that this is our own work and not an official forecast:

  1. It is our interpretation and implementation of the SFC’s approach. We have taken great care to replicate previous costings to the best of our ability, but the analysis remains our responsibility;
  2. It is the SFC’s historical approach, and they could change it if they wish and if there were compelling evidence for doing so; and
  3. It uses modelling calibrated to the SFC’s May forecast, and changes to economic forecasts by the SFC in the production of their upcoming forecasts would lead to small changes in estimates.

We have refined our methodology, especially around the Personal Allowance taper

Since then, we have made some further refinements to our modelling, the most significant of which was to our method for calculating the behavioural response to a taxpayer’s change in tax rates they face.  We still quantify two main effects:

  • The ‘intensive margin’ effect, which quantifies how much declared income changes by at the marginal rate that people face, on the assumption that they continue to have the same income streams. This is called the marginal effective tax rate (METR) effect in the literature, and is generally the largest behavioural effect.
  • And the ‘extensive margin’ effect, that is, to what extent people chose whether or not to participate altogether in an activity given their new average liabilities. For example, people may choose to not work anymore, or may no longer find it worthwhile to rent out a property. This is called the average effective tax rate (AETR) effect in the literature, and tends to be significantly smaller than the METR effect.

As part of the METR effect, we have incorporated a further interaction for people whose Personal Allowance (PA) is tapered away. For those earning between £100,000 and £125,140 a year, £1 of their PA is withdrawn for every £2 of additional income, meaning they face an effective marginal income tax rate of 63%.

Our refined methodology means that between two-fifths and a half of the potential yield of the measures is likely lost through behaviour

Including this interaction the calculation of taxpayers’ behavioural response increases the size of the METR effect. The difference between the two options is similar to before – as the SFC assumes larger behavioural responses higher up the income distribution, more of the overall yield is lost to behaviour when the threshold for the proposed band is higher.

As the table below shows, we estimate that a 44p rate on incomes between £75,000 and £125,000 would raise around £41m, and a 45p rate on incomes between £58,285 and £125,140 would raise around £136m.

Table 1: FAI estimates of revenues from income tax proposals for 2024-25 and size of behavioural effects

£ million Static costing METR effect AETR effect Post-behavioural costing Yield lost to behaviour
Option A: 44p rate between £75,000 and £125,140 84 -36 -7 41 52%
Option B: 45p rate between £58,285 and £125,140 222 -72 -14 136 39%

Source: FAI calculations. Note: Individual cells may not sum to totals due to rounding to the nearest £1m.

Modelling the income tax changes proposed by the STUC earlier in the week

We have also used our income tax model to consider how the package of income tax measures proposed by the STUC on Monday might be costed using our understanding of the SFC’s current methodology.

Our estimate for the additional revenue raised by the package under this methodology is £645m, over two-thirds of which comes from dropping the higher rate threshold to £40,000.

We get similar results published by the STUC analysis for the two rate increases. However, we get lower estimates of revenue for the changes in thresholds when applying assumptions similar to the ones we expect the SFC to use. This could mean that behavioural responses around threshold changes may not be fully accounted for.

Table 2: FAI estimates of revenues from the STUC-proposed income tax package for 2024-25 and size of behavioural effects

£ million Static costing METR effect AETR effect Post-behavioural costing Yield lost to behaviour
Reduce higher rate threshold to £40,000 504 -40 -5 459 9%
Increase higher rate (£40,000 to £125,140) by 1p 157 -35 -7 115 27%
Increase top rate (above £125,140) by 1p 24 -21 0 2 90%
Introduce 45p band between £75,000 and £125,140 84 -38 -7 39 54%
Widen 45p to incomes from £58,000 to £125,140 65 -13 -23 30 54%
Total revenue raised by the package       645  

Source: FAI calculations. Note: Individual cells may not sum to totals due to rounding to the nearest £1m.

It is worth noting that some of these measures have interactions with one another, and therefore they may raise different amounts if done separately. For example, our estimate of revenue for the increase in the higher rate from 42p to 43p is £115m if the higher rate threshold were £40,000, but only £94 million under the current threshold of £43,662.

Authors

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.

Mairi is the Director of the Fraser of Allander Institute. Previously, she was the Deputy Chief Executive of the Scottish Fiscal Commission and the Head of National Accounts at the Scottish Government and has over a decade of experience working in different areas of statistics and analysis.