Why tax rises can mean less revenue
Some documents in Scottish economic life we hope we never have to read. And there are those we need to read if we are to have sensible tax and spending policies. The latest one from the Scottish Fiscal Commission (SFC) is both.
Its 35-page paper – Behavioural Responses and Income Tax Policy – fills in many of the gaps in assessing our responses to changes in tax levels and rates.
It is a formidable piece of work, well-informed both in methodology and in references to similar work undertaken both across the UK and overseas. Modelling taxpayer behaviour is critical if budgets are not to end up as misleading guides to revenue outcomes – and a shortfall in the real amount of money available to spend.
As such, it is required reading for anyone engaged in Scottish economic policy.
How much do tax changes cause us to change behaviour? Just how much tax does the Scottish Government really collect – as opposed to the confident predictions when new tax rates and levels are announced?
The behavioural impact is not much, you might think, after the modest tax rises announced in the Scottish budget. But the SFC puts the cumulative cost to Holyrood over the next five years at more than £300 million.
This is because so much of Scotland’s income tax derives from a small segment of the population: just 0.7 per cent of total taxpayers – those at the top end – account for 13.7 per cent of income tax revenues. Cause these people to look at ways of mitigating their tax liability and Holyrood would have a problem. This could become pronounced even without a tax change if top-rate taxpayers act on the perception that not only is the direction of travel upwards, but that the gradient is steepening.
Now taxpayer behavioural change is uncertain, its different manifestations difficult to quantify and responses variable across different tax bands – no less than five of these in Scotland.
We can respond by forestalling – shifting the timing of income around tax policy changes to capture a lower rate of tax – or resort to greater use of tax planning and tax avoidance schemes. We might opt to take income in the form of dividends or profit-share schemes, thereby attracting the lower rate of UK capital gains tax. We could vary the amount of hours worked to avoid a higher marginal rate, or choose to migrate – moving our tax domicile outside of Scotland. And the more that UK and Scottish tax systems diverge, the greater the incentive to artificially shift income.
There are 332,000 in the 41 per cent higher rate band (£43,431 to £150,000) and 18,900 liable for the 46 per cent tax rate (above £150,000), where the likelihood of behavioural response is greater.
The paper estimates that, over the five years to 2023, behavioural change could result in a cumulative loss of tax revenue totalling £316m, equivalent to almost 21 per cent of the revenue from the Budget tax changes. Taking 2018-19 as an example, it is estimated that the administration’s tax changes would raise an additional £276m. The SFC estimates that £56m of this will be lost due to behaviour change – £42m due to behavioural response to changes in the marginal rate of tax and £14m from changes in the average effective tax rate.
However, take care. All the available research here and overseas suggests a broad range of behavioural change outcomes across different countries, income levels, and type of policy change and over time. And while behavioural responses can be highly uncertain, they can also be significant and are therefore considered as part of any tax forecast.
Economist David Bell of Stirling University told Holyrood’s finance and constitution committee that “the worldwide evidence on behavioural responses to tax changes tends to agree only on the belief that higher income tax rates will lead to behaviours that have a negative effect on tax revenues.”
He continued: “These include reducing labour supply, tax avoidance and migration. There is some evidence for each of these kinds of response, but their applicability to Scotland is difficult to judge. Particularly important are the responses of high income earners who generate a disproportionate share of Scotland’s income tax revenues.”
And as HMRC admitted on the introduction of the 50p additional rate of tax: “There was a considerable behavioural response to the rate change … the modelling suggests that underlying behavioural response was greater than estimated previously … decreasing the pre-behavioural yield by at least 83 per cent”.
And as if that wasn’t enough, the sainted Institute for Fiscal Studies published studies last year on the responsiveness of top incomes to tax.
It showed a wide range of elasticity estimates ranging from either a loss or gain of tax revenues following an increase in the top rate of tax.
At one end, a five percentagepoint increase in the additional rate of tax in the UK could raise an estimated £2.8 billion, or at the other end lead to a loss of revenues of £4.4bn.
How might Scotland respond? Here the SFC sounds a warning. “The opportunities for migration from Scotland, particularly to the rest of the UK, are greater than opportunities for migration from the UK to other countries.” And because the Scottish Government is unable to make good the resulting loss, for example through taxes on dividends, corporate taxes and capital gains tax, the shifts from non-savings and non-dividend income (NSND) to another form will mean a total loss of tax revenue in Scotland.
“On balance, the Commission’s judgment is that the opportunity for migration, particularly for the highest income taxpayers, and the risk of income shifting leading to a total loss of revenues in Scotland, outweighs the impact of the policy applying to NSND income only.”
This means the potential for loss from behavioural change among those with the very highest incomes is “greater in Scotland than in the rest of the UK”.
Finally, throughout all this a paradox remains: ever-rising estimates of Scottish tax revenue climbing from £15.4bn in 201718 to £18.8bn in 2022-23, a rise of more than 20 per cent, while its estimate of economic growth is dire: less than half its long-term trend rate out to 2023.
The Office for Budget Responsibility’s next forecast stab is likely to come in May. Without an uplift, the administration may find the last straw of “modest tax hikes” could break the camel’s back.
Wealthy people tend take steps to avoid paying higher rates of tax – like emigrating, writes Bill
Jamieson