David Eiser, Fraser of Allander Institute
The slowdown in Scotland’s rate of economic growth relative to the UK has been well documented. Whilst growth in UK GDP per head has been weak, growing at just 2.3% between Q1 2015 and Q2 2017, Scottish growth has been weaker still, with per capita GDP growing just 0.57%, over the same period (Chart 1).
Revenues from non-savings, non-dividend (NSND) income tax now form part of the Scottish budget. Under the Fiscal Framework, the Scottish budget will be better off than it would have been without tax devolution, if revenues per capita grow more quickly in Scotland than they do in the rest of the UK (rUK). Conversely, slower growth will translate into a smaller Scottish budget.
A critical question therefore is what slower growth in GDP per capita – in Scotland relative to rUK – might mean for the growth of income tax revenues per capita in Scotland relative to rUK. Does slower growth in GDP per capita necessarily mean slower growth in income tax revenues? How strong is the relationship and what factors might influence it?
This blog considers the relationship between GDP growth and income tax revenues. It summarises a longer article in December’s FAI Economic Commentary.
Chart 1: GDP per capita (Q1 2015 = 100)
Long run relationship between GDP per capita and the income tax base
It is important to note initially that income tax revenues are a function of the tax base (the amount of taxable income), and income tax policy (allowances, rates and bands). So the first question to consider is the relationship between GDP and the tax base.
Clearly, increases in population will tend to increase both the size of economy (GDP) and the tax base (taxable income). To abstract from this relationship, let us assume that population is constant. How then might changes in GDP (i.e. GDP per capita) effect the tax base?
In the long-run there must be a reasonably strong relationship between GDP per capita and the income tax base.
- GDP per capita will grow if there is an increase in employment (or hours worked) or an increase in productivity (i.e. the amount produced per hour worked).
- The income tax base will grow if hours worked or hourly wages increase.
Productivity and average wages are inextricably linked. In the long-run, the only way in which average real wages can grow is through increases in productivity: productivity improvements are what enable firms to pay higher wages without increasing prices.
This link between productivity and real wages means that the two things that underpin increasing GDP per capita – hours worked and/or higher productivity – are the same two factors that can increase the size of the income tax base – hours worked and wages.
But even in the long-run, the relationship between growth in GDP per capita and growth in the income tax base is unlikely to be absolutely fixed nor be constant over time. This is partly because the composition of GDP growth can effect average incomes and the way in which they are distributed. For example:
- There might be changes over time in the share of labour as opposed to capital in GDP growth. In most OECD countries, the share of labour (wages and incomes) relative to capital (profits and dividends) in GDP has tended to fall in recent decades. The reasons for a falling labour share are debated, but is thought to be at least in part due to technological change, and perhaps also because of a weakening of labour’s bargaining power.
- Similarly, changes in the composition of employment between self-employment and employees might influence the relationship between economic activity and the tax base, if self-employment is taxed differently from employment.
- The relationship between productivity and wages might also weaken over time if non-wage benefits become more important relative to wage benefits. For example, increased employer contributions to pensions or to healthcare plans or perks such as company cars might weaken the link between productivity and wage growth.
Short run relationship between GDP per capita and the income tax base
In the short run, the relationship between GDP per capita and the income tax base is likely to be weaker, for several reasons:
- There can be lags between changes in output (GDP) on the one hand and changes in employment and/or wages on the other. Firms might ‘hoard’ labour for example during an economic downturn and allow profits to fall instead. During an upswing, firms might be able to return hoarded labour to more productive uses, expanding output without needing proportionate increases in labour.
- Some factors determining the income tax base are not really affected by GDP in the short run. For example, pension income is not correlated with GDP in the short run (but in the long run of course, pension income is in large part a function of earnings during working life).
Inconsistency of geographical scales
A further complication that may weaken the relationship between growth in GDP per capita and growth of the income tax base is that the geographical level at which these things is measured is not consistent.
This is particularly the case in the Scottish context. When we talk about Scottish GDP we are usually talking about ‘onshore GDP’, i.e. we exclude activity generated by the offshore oil and gas sector in the North Sea etc. But it is quite possible that individuals’ working ‘offshore’ count as Scottish taxpayers for the purposes of determining Scottish income tax revenues.
More significantly, people whose main residence is in Scotland but who work partly or wholly in another part of the UK don’t directly contribute to Scottish economic output, but the income generated from this activity will form part of the Scottish income tax base (and vice versa).
Tax policy and the distribution of income
When considering the relationship between growth in GDP per capita and income tax revenues there is a further complication which may muddy the picture: the role of tax policy.
With a progressive tax system such as the UK’s, a given rate of average income growth should lead to a proportionately greater increase in revenues.
But the way in which a given level of income growth is distributed can also have a material impact. With a progressive tax system like the UK’s, wage growth that is disproportionately concentrated on those with higher incomes might strengthen the link between wages and the income tax base, whereas wage growth that is disproportionately focussed on the poor might weaken this relationship.
There must in principle be a reasonably strong correlation between growth of GDP per capita and growth of income tax revenues per capita.
But a large variety of factors mean that this relationship is likely to be much weaker in the short term. The tax base is determined not only by the wages and income of those in work, but also by income from pensions and other factors that are only weakly linked to contemporaneous economic activity. The way in which growth is shared between labour and capital, and the way in which labour income gains are distributed across the labour force also matters. Changes in tax policy can influence the size of the tax base for a given level of activity. And short term variations in economic activity might not show up immediately in wages or employment.
From this point of view, slower growth in Scottish GDP per capita without materially slower growth in income tax revenues per capita is not inconceivable as an outcome at least temporarily.
On the 14 December 2017 the Scottish Fiscal Commission will publish its first ever forecasts for Scottish GDP growth and Scottish income tax revenues over the next five years. It will be interesting to see what judgement the Commission has come to about the evolution of both.
The Fraser of Allander Institute (FAI) is a leading economy research institute based in the Department of Economics at the University of Strathclyde, Glasgow.