Fiscal Policy and Tax, Scottish Budget, Scottish Economy, UK Economy

Weekly update: stagflation and income tax

We’ve become used to depressing economic news in the recent past. But today’s contribution from the Bank of England is particularly pessimistic.

In its latest Quarterly Monetary Policy Report, the Bank has again revised up its expectations for inflation, which is now projected to reach 13% by the end of 2022, significantly higher than the 10% projected in its previous report in May.

The increase in projected inflation is almost entirely due to big increases in gas wholesale prices following Russia’s restriction of gas supply to Europe.

The immediate impact of the rise in inflation is to further erode real household incomes. Real post-tax household income is projected to fall by almost 4% over 2022 and 2023. This drives a sharp fall in living standards, a cutback in household consumption (spending), tips the UK into recession and results in a rise in unemployment over the medium-term.

This outlook is particularly devastating for low-income households who, as Bank Governor Andrew Bailey acknowledged, are most negatively affected by rising inflation. (This is for a variety of reasons, including: more of their spending is on essential energy and food items that are seeing the biggest price rises; they already spending all their income and hence have no buffer; they have little ability to substitute towards cheaper product lines; and they have fewer savings to fall back on to tide them over for a temporary period).

When it comes to interest rates, the Bank of England continues to walk a fine line. On the one hand, it needs to ensure that rising energy prices don’t become ‘embedded’ in domestic inflation. It does this by using interest rates to do what is known in the Bank’s jargon as ‘anchoring expectations’. On the other, it needs to be confident that its actions to do this don’t exacerbate existing economic headwinds.

Reasonable economists continue to disagree about whether the Bank is on the right side of that line. Interest rates are of limited value as a policy tool to tackle inflation that is largely driven by external energy prices. The Bank recognises this, but argues that ‘There is a risk that a longer period of externally generated price inflation will lead to more enduring domestic price and wage pressures’. Today’s half point rise in interest rates is the outcome of the Bank’s attempt to balance the different risks.

Is there any positive news in the Bank’s report today? Not much. The projection that inflation will have returned to 2% by 2024 is one straw to clutch. But this does not mean that energy prices are expected to fall, just that at some point they will stop increasing.

Further government (as opposed to Bank) action to address falling living standards will be needed once the new Prime Minister is installed. A range of policy responses are possible. Tax cuts seem likely to be heavily mooted by whichever of the two candidates prevails, but are not in themselves an ideal response to the cost-of-living challenge given their distributional effect relative to the distribution of the economic pain of inflation.

Income tax choices

The issue of UK government tax cuts gives us an opportunity to discuss the potential impacts of a UK government income tax cut on the Scottish budget. This was a question we looked at in detail earlier this week. We provide a briefer summary here.

The UK government has already committed to cut the basic rate of income tax in the UK from 20p to 19p in April 2024. In leadership campaigning, Sunak has now also announced an intention to cut the basic rate substantially further, to 16p, by 2030.

Bearing in mind that income tax is devolved, what do these announcements and aspirations mean for the Scottish budget?

The first point to note is that UK government plans to cut the UK basic rate of income tax from 20p to 19p in 2024 won’t apply in Scotland. It will be for the Scottish Government to determine income tax policy in Scotland.

The choice set that the Scottish government faces is in many ways perfectly intuitive. The more closely that the Scottish Government tries to match tax cuts made by the UKG, the less revenue it will have to fund public services in Scotland.

It might therefore decide not to implement any tax cut of its own. And there are prudent fiscal reasons for it not to do so. The Scottish government’s spending plans for 2024/25, as set out in its Spending Review in May, are predicated on the assumption that Scottish tax rates do remain unchanged from those prevailing today.

But politics will play heavily on the Scottish government’s decision. If the UK basic rate falls to 19p, but the Scottish government retains its current tax policy, almost all Scottish taxpayers will pay more income tax than they would if they lived south of the border.

The ability to say that over half of Scottish taxpayers – those with the lowest incomes – pay less tax than they would under UK policy, as is the case currently, has been a key plank of the Scottish government’s claim to having a ‘fair’ approach to taxation. It might therefore be tempted to cut rates in Scotland, in response to the UK cut, so as to be able to retain this claim.

Cutting the existing starter, basic and intermediate tax rates by 1p would maintain existing differences in tax liabilities between Scottish and rUK taxpayers (so that Scots with incomes below £29,500 in 2024/25 paid less than they would in rUK).

But this would cost the Scottish government over £400m in reduced revenue 2024/25 relative to leaving its current tax rates unchanged. And remember that the spending plans for 2024/25 implicitly incorporate this £400 million.

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 can be justified by the £400+ million price tag, when that £400+million is already baked into its spending plans.

It will be interesting how the politics and economics of this play out as the decision looms towards the end of 2023.

Beyond 2024/25, the impact of further cuts to the UK basic rate to as low as 16p (as mooted by Sunak) on the Scottish budget are more difficult to foresee.

This is because it is unclear what the impacts of those cuts would be on UKG spending, and hence the Barnett Formula, as opposed to their impact on UKG borrowing. But in reality, getting to a 16p basic rate by 2030 is an unrealistic aspiration.


David is Senior Knowledge Exchange Fellow at the Fraser of Allander Institute



Emma is Deputy Director and Senior Knowledge Exchange Fellow at the Fraser of Allander Institute

Head of Research at the Fraser of Allander Institute

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.