Pivotal Failure in Cameron’s Proposals on Smith

David Cameron Scotland speech January 22By Jim and Margaret Cuthbert

On Wednesday 21st January, the current Westminster Government published its detailed proposals on the implementation of Smith. The intention of Smith was to give more powers, greater flexibility, and more responsibility to the Scottish Parliament. Among the recommendations made by the Smith Commission were the transfer of tax powers, and in particular income tax powers.

In our Bella article of 4th December (Smith Fatally Flawed by Inadequate Attention to Feasibility’), we pointed out that for successful implementation of the income tax proposals, the principle embodied in Clause 95(4)(b) of the Smith report was critical: this clause specifies that changes to taxes in the rest of the UK, (rUK), for which responsibility in Scotland has been devolved, should only affect public spending in rUK. So, if there was an increase in income tax rates in rUK, this should not affect the level of public expenditure in Scotland. We also argued in our Bella article that it would be impossible to implement this principle satisfactorily under any system other than a full federal model.

When Westminster came to publish its proposals on how it would implement Smith, there were always going to be three possibilities as regards the vital Clause 95(4)(b):

a) Westminster ignored the principle entirely

b) Westminster accepted the principle, and took on board the full federal implications

c) Westminster accepted the principle, without federalism

In the case of (c), what we would then expect is that some very unsatisfactory implications would result.

It was therefore with great interest that we opened last Wednesday’s proposals to find which of these three approaches was going to be adopted – and the answer is, (c). What we do here is look at exactly how Westminster proposes to implement Clause 95(4)(b): and then explain how the particular approach they have adopted does indeed have profoundly adverse, and unacceptable, implications for Scotland.

What we had argued in our original paper in Bella was that implementing Clause 95(4)(b) satisfactorily, would involve ring fencing rUK income tax receipts so that they could only be spent on devolved services in the rest of the UK. Essentially, there would need to be a Block Grant for the rest of the UK similar to the Block Grant we already have in Scotland, with spending on “devolved” services in rUK being funded solely from the rUK Block Grant and rUK income tax receipts.

Westminster, not surprisingly perhaps, were unwilling to go down the federal route implied by this approach: so they proposed something quite different. What they propose is that it is up to the Westminster Parliament to decide whether it wants to use a change in rUK income tax rates to fund devolved services in rUK or reserved services for the whole of the UK. And if they choose to use an increase in rUK income tax for reserved functions, then the following mechanism would apply – as explained in paragraph 2.4.14(ii): “… similarly, if the UK government spends this extra funding on reserved areas (such as pensions, benefits, defence, debt interest, etc.) then this would be spent UK wide, including Scotland, despite the “rest of UK” income tax not applying in Scotland. The tax deduction element of the funding model therefore needs to work alongside the
Barnett Formula to ensure that increases in “rest of UK” tax do not fund higher spending in Scotland.”

What this means is as follows. Suppose a UK government decided it was going to fund extra expenditure on say, Trident, by raising rUK income tax rates. Since defence is a reserved function, public expenditure on Trident is regarded as “benefiting” the whole of the UK. So public expenditure in Scotland will rise by Scotland’s population share of the extra spend on Trident. Since aggregate public expenditure in Scotland has now risen by this amount, the principle of Clause 95(4)(b) is in danger of being breached, so to avoid this happening, Westminster will reduce Scotland’s Block Grant correspondingly.

The implications of this are stark: if Westminster decides to use an increase of rUK income tax to fund a reserve service like Trident, (as it is perfectly entitled to do under Cameron’s interpretation of Smith), then Scotland has the choice of either:

* Accepting a cut in Scotland’s devolved services equal to our population share of the increase in reserved expenditure: or
* Raising our own income tax rates so as to recover an amount equal to our population share of the extra income tax revenue being raised in the rest of the UK.

This is profoundly unsatisfactory.

Letting Westminster spend rest of UK income tax on reserved services means that Westminster can force on Scotland cuts in devolved services or changes in Scottish tax rates. This is absolutely counter to what the Scottish people were led to believe they were going to get from the extra powers promised under Smith. We thought we were getting control of income tax: well, it now turns out that this is only true to the extent that Westminster does not decide to use rest of UK income tax to fund reserved services.

But in fact, the actual situation is even worse than this, as we will now see. This is because an important principle, which used to hold prior to the current attempt to implement Smith, has now been breached. Previously, if Westminster chose to use a change in income tax to fund a reserved matter like Trident, what each part of the UK would contribute would be the sum yielded by the relevant change in income tax applied to that part of the UK. Now, when Westminster decides to increase rUK income tax to fund a reserved service, what Scotland will have to contribute(by cutting services or raising income tax) is Scotland’s pro rata population share of the change in rUK tax yield. And since the income tax base in Scotland is very different from the income tax base in rUK, (with Scotland having many fewer of the very high taxable incomes associated with London’s financial sector), then the implications are serious. Since income tax yields per head are significantly lower in Scotland, (with Scotland having 7.4% of total UK income tax receipts, compared with 8.3% of UK population), then raising an equivalent sum per head in Scotland would mean a bigger increase in Scottish income tax rates than the original increase in rest of UK rates.

Westminster’s failure to grasp the federal implications of the important Clause 95(4)(b) principle is therefore, as we predicted, very harmful for Scotland. The way that Westminster is currently proposing to implement Smith means that one of the basic principles of Smith, that we are completely in charge of our income tax rates, is breached: in the sense that, if Westminster decides to spend an increase in rUK income tax on reserved services, we are then faced with a stark choice of either cutting our devolved services, or raising the Scottish rate of income tax. And not merely is this important principle breached: but the changes in income tax rate forced on Scotland will be disproportionately large.

The overall conclusion is inescapable. Westminster needs to do a fundamental rethink of the proposals it put forward last Wednesday – and that is without, as yet, looking at the other proposals they have made for implementing Smith.



Categories: Economics

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6 replies

  1. I always expected Westminster to in effect screw us, it is what they do, and what they are attempting now.
    The implications, should this go unchallenged, has indeed dire consequences as explained in the article for Scotland. We simply cannot trust Westminster in anything, and we need to approach all dealings with them with that in mind.

  2. I’ve spent the day scribbling notes and concur with your conclusions. The present low oil price scenario highlights a further problem at 2.4.22 we’re told in a Scotland-specific recession “the Scottish Government will not therefore be isolated from all risks….the funding model would not provide the Scottish Government with additional funding to offset its lower tax receipts or higher spending pressures…..Borrowing could be undertaken to respond to a shock, but a clear plan will be needed to repay the debt incurred in order to ensure a sustainable fiscal position.”
    This means a collapse in income tax receipts from Aberdeen City and Shire due to low oil prices could only be plugged by imposing an austerity programme. Welcome to Greece!

  3. Dear Jim and Margaret,

    As a non-economist, I think I can follow the general logic of your analysis. However,I have a question about the specific example that you offer: the UK government raising income tax to pay for Trident. My understanding is they the government does not generally make links between specific tax increases and specific spending projects. Instead, all of the money goes into a general tax fund, that is then allocated in the annual budget. Does this make any difference to the points you make in your paper?

    • Thanks. Yes, that is how things work at present, a single revenue pot: but they have got to change fundamentally in light of Smith. If we just keep on with the old approach, then we have the gearing problem described in our 4th December Bella article: which is totally unacceptable from Scotland’s viewpoint.
      Paragraph 2.4.14(ii) of last Wednesday’s proposals for implementing Smith represents Westminster’s recognition that there is a problem, and that they will in future no longer be able to treat all government revenues as a single pot. But the specific approach they propose is again totally unacceptable for Scotland, for the reasons we have set out in our current piece.
      The only satisfactory solution is that, post Smith, rUK “devolved” services are funded from an rUK Block Grant plus rUK income tax revenues. Which, if it is going to work right, implies a full federal approach.

      • Or full fiscal autonomy?

        The problem with federalism, so obvious that even Gordon Brown can see it, is that whilst the US federal government is neutral and independent of its largest federal state, California, at 13% of population, the Federal German government of North Rhine-Westphalia, its largest component at 20%, a federal UK government will be to a very close approximation just its largest component, England, at 84%. So federalism in the UK context is just rule of Scotland by England (no change there then). The only way, it seems to me, you can even have a stab at having a nation at 8.3% of a state with a great big cuckoo like England in it functioning as a nation not a province of the larger entity is FFA (though of course that will require a just deal on debt etc if we are not also to come off very badly).

        As far as I can see, FFA pretty cleanly allows an rUK pot to be separated off. True if the Uk decides to spend more on e.g. defence or foreign embassies, then Scotland will have to send a larger cheque down to Westminster, and fund this by raising taxes, borrowing more or cutting public expenditure (or using reserves). The only way out of that is independence (so perhaps it would be a good thing if that happened and hasten the day!) But there would be no disproportionately higher cost to Scotland versus rUK of ‘central’ spending decisions of the type you outline re the current income tax proposals, would there?

  4. The very idea of (part) devolving one tax was always a nonsense and a sham: as practical as supping soup with a fork, but that was the plan of course…

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