The key numbers in Scottish Budget’s income tax choices

Article by our chair Professor Graeme Roy, first published in the Herald on 8 January 2024.

Professor Graeme Roy

Last month’s Budget prompted debate about income tax in Scotland and its impact upon the economy and public finances.

Much of this discussion was shaped by pre-Budget speculation around an apparent “funding gap” in spending plans. It is unsurprising, therefore, that early commentary was framed around how much new tax policy choices might raise and the likelihood of taxpayer behavioural effects limiting any such gains. At the Scottish Fiscal Commission, we forecast how much we think the Scottish Government will raise both from its new tax policy choices and in total from income tax revenues over the next five years.

For 2024/25, we estimate that the introduction of the new “advanced rate”, for earnings above £75,000, will raise £74 million, whilst increasing the top rate – on earnings above £125,140 – will raise a further £8m.

These estimates include our assessment of some taxpayers changing their behaviour. For example, a taxpayer impacted by these policies may choose to pay more money into a pension scheme or alter the hours they work. We estimate the behavioural responses to these two specific policy changes to be worth £118m next year.

It is helpful, however, to put this into context. Next year, we forecast income tax revenues of £18,844m. Many times larger than figures mentioned so far.

This is not to suggest that such policies are insignificant, or that there shouldn’t be a debate about whether behavioural effects will be larger or smaller than forecast. Instead, it hopefully highlights how examining individual tax changes in isolation is only one – albeit important – part of a complex picture of how taxation supports the economy and public finances. The crucial driver of income tax is what is happening to earnings and their interaction with the underlying tax system that has evolved over many years.

For several years, Scottish earnings growth had been lagging behind the rest of the UK. But recent data points to a more positive picture, with Scottish earnings outpacing those elsewhere in the UK. Why does this matter? We estimate that for each 0.1 percentage point of additional earnings growth in Scotland relative to the UK, this will deliver an additional £25m of tax revenue. Very small changes in our relative economic performance can have hugely significant implications for the amount of revenues collected.

On top of this, how much of any growth in earnings is captured by tax is influenced, in part, by “fiscal drag”. This happens when earnings increase faster than tax thresholds and taxpayers find themselves moving into higher tax bands. Due to high inflation, this can happen without an increase in real pay.

Since 2017/18, the Scottish Government has sought to raise revenues by making the tax system more progressive. For example, in 2024/25, taxpayers in Scotland will start paying the higher rate of 42% at earnings of £43,662, compared to in England where the higher rate will be 40% for earnings above £50,271.

The effects of fiscal drag can be observed in various ways. For example, in 2016/17, just over 300,000 taxpayers (around 12% of all Scottish taxpayers) were paying at least the higher rate of income tax. In 2024/25, this will rise to nearly 650,000 (around 22% of taxpayers).

We estimate that due to fiscal drag, each one percentage point of earnings growth in Scotland delivers around £25m more revenue than would be generated by the equivalent UK tax policy. With earnings growth over the last two years topping 10%, the boost to income tax revenues from this drag effect is increasingly significant.

However, today’s high inflation environment will subside. At some point too, policymakers may take the view that some taxpayers paying higher rates of tax – now or in the future – are not the workers they view as “high earners”.

They may also be cautious in widening the tax differential with the rest of the UK much further without evidence that doing so will not impact long-term growth prospects.

Ultimately, securing robust real-terms growth in the economy is the crucial mechanism to delivering the earnings that – with a progressive tax system – can lead to sustainable growth in tax revenues. How to achieve that is one part of the Budget that hopefully will spark constructive debate and ideas as the Budget Bill makes its way through Parliament.

Graeme Roy is professor of economics at the University of Glasgow’s Adam Smith Business School and chairs the Scottish Fiscal Commission.