In last week’s budget, the Chancellor announced his intention to increase the personal allowance for income tax from £11,000 in 2016-17 to £11,500 in 2017-18. He also intends to increase the higher rate threshold from £43,000 in 2016-17 to £45,000 in 2017-18. The increase in the higher rate threshold has attracted particular criticism because it will principally benefit middle to high income earners.
The Scottish Government will have the power to set tax rates and thresholds for Scotland from 2017-18 now that the Scotland Act 2016 has been passed. The Scottish Government can therefore choose to implement the increase in the higher rate allowance. The SNP, Labour and Lib-Dem parties have suggested that, if elected, they would not follow this above-inflation increase in the higher rate threshold.
At present, the SNP proposal is more detailed than those of the other parties. Its intention would be to increase the higher rate threshold by the inflation rate (the Consumer Price Index), thus holding it fixed in real terms. As a result, the threshold would only increase from £43,000 in 2016-17 to £43,387 in 2017-18. A decision not to index would increase the Scottish Government’s revenue, but would imply a real cut in higher earner’s net incomes.
The main effect for Scottish taxpayers in 2017-18 will be that the higher rate of income tax will begin when their earnings exceed £43,387 (the current threshold adjusted for inflation). For rUK taxpayers, the higher rate will not begin until their earnings reaches £45,000. Compare with rUK taxpayers, each Scottish taxpayer with earnings over £45,000 will pay an extra £323 in tax in 2017-18.
Given that median earnings for full-time workers in Scotland are around £27,000, only a relatively small proportion of Scotland’s taxpayers pay higher rate income tax. Latest HMRC estimates suggest that in 2015-16, there were 372,000 higher rate taxpayers in Scotland and 17,000 additional rate taxpayers (those paying not only the higher rate, but also the additional rate of 45p). Together these comprise 15.4 per cent of all Scottish taxpayers. The number of higher and additional rate taxpayers in Scotland has more than doubled since the beginning of the century (see Figure 1). Successive chancellors failed to index the higher rate threshold, thus increasing the proportion of taxpayers liable for the higher rate. George Osborne might argue that his proposal for an above inflation increase in the threshold seeks to undo some of the “fiscal drag” which has occurred particularly since 2009-10.
Note also that although higher rate taxpayers and additional rate taxpayers comprise a relatively small group, the makes a relatively large contribution to income tax revenues. In the UK as a whole in 2015-16 basic rate taxpayers contributed around £54 billion to income tax receipts, higher rate taxpayers £67 billion and additional rate taxpayers £49 billion. Thus, higher and additional rate taxpayers together paid 68% of revenues although they only comprise 17% of UK taxpayers. The proportion of total income tax payable by higher rate and additional rate taxpayers in Scotland is likely to be slightly less than the 68% for the UK as a whole, since this group only accounts for 15.4% of Scottish taxpayers and because average incomes within this group are somewhat lower in Scotland than in rUK.
Figure 1: Number of Higher and Additional Rate Taxpayers in Scotland 1999-00 to 2015-16
Source: HMRC. Note that the 2008-09 figure is interpolated.
There is a further complication: the UK Government is committed to aligning National Insurance (NI) and income tax contributions. In recent years it has set the higher rate threshold equal to the upper earnings limit (UEL) for NI. For 2017-18 this practice will continue to be followed. This matching of thresholds has been adopted to avoid NI and income tax interacting to produce excessively high marginal tax rates (the tax paid on the last pound earned) on income.
But the devolution of income tax opens the door to new opportunities for such anomalies to arise in Scotland. In particular, if the higher rate threshold is not increased in Scotland, NI at 12 per cent will be payable on income up to £45,000 even though the higher rate starts in Scotland at £43,387. This means that Scottish taxpayers will pay 52p tax on each extra pound they earn between £43,387 and £45,000. The difference in marginal rates of tax on earned income between Scottish and rUK taxpayers is shown in Figure 2. It clearly indicates how Scots earnings above £43,387 will experience a significant increase, from 32% to 52%, in the tax rate they pay on earned income between £43,387 and £45,000.
Figure 2: Marginal Tax Rates on Earned Income for Scottish and rUK Taxpayers
This anomaly will pose a particular problem for those with earnings between £43,387 and £45,000. An offer of a pay rise of £1,613 to someone earning £43,387, which will increase their gross earnings to £45,000, will only increase their net income by £774. This may make them unwilling, for example, to accept promotion if the increased wage offer lies in this range. The effect of the non-indexation will be greater for those whose incomes are close to the higher rate thresholds, not only because they will be exposed to higher marginal rates of tax, but also because the impact of not indexing the threshold will have a larger proportion of effect on their net take-home pay than it will for those whose incomes substantially exceed the higher rate threshold.
The intention of the Chancellor is to raise the higher rate threshold to £50,000 by the end of the Parliament (which we take to be 2020-21). This would imply continuing above inflation increases of around £1666 each year from 2017-18 to 2020-21. The SNP has further proposed to only increase the higher rate threshold by inflation during this period. This would mean a continuation of the higher rate/national insurance anomaly just described. However, if this alternative strategy is followed, the SNP claims that “around £1.2 billion can be raised in the period up to 2021-22”. Could this be realised?
In Table 1 below we estimate the extra funds that might be raised in Scotland between 2017-18 and 2020-21 if it chose to index the higher rate threshold to inflation rather than following the UK Government proposal to increase it to £50,000 over this period. The first column shows how the UK Government might increase the threshold in equal stages to £50,000 by 2020-21. The second column shows the Scottish higher rate threshold, which increases each year according to the OBR forecast of inflation, as measured by the CPI. The third column shows the difference between these columns 1 and 2. It therefore gives the size of the income band on which Scottish taxpayers will pay the higher rate, while those in rUK will pay the standard rate. The next column shows how much extra income tax will be paid by Scots taxpayers who earn more than the UK higher rate threshold, assuming that the basic rate stays at 20p and the higher rate stays at 40p. The final column aggregates these payments, assuming that there are 389,000 Scottish higher-rate and additional rate taxpayers and that this number does not change between 2017-18 and 2020-21.
Table 1: Revenue consequences of not following rUK increases in the higher rate threshold
|Value of Higher Rate Threshold||Difference||Cost to Higher Rate Taxpayers in Scotland||Aggregate Cost|
Source: own calculations
Between 2017-18 and 2020-21, the extra cost to individual Scottish higher rate taxpayers would grow from £323 per year to £801 per year as the gap between the Scottish and rUK higher rate tax thresholds widens. By 2020-21, the additional revenue available to the Scottish Government through its decision not to raise the higher rate threshold to £50,000 would be £887m.
If the SNP claim of realising £1.2bn by 2021-22 from this source is to be met, a further £313m would have to be raised during 2021-22. This would require each Scottish higher and additional rate taxpayer to pay a further £800 more income tax than their rUK counterparts. This would require a continuation of the gap between the Scottish and rUK higher rate tax thresholds in 2021-2022.
The larger the size and duration of the gap between Scottish and rUK higher rate tax thresholds, the higher the probability of behavioural response, with individuals seeking to reduce their income tax liabilities in Scotland. These responses might include reducing work effort by cutting hours worked, taking income in a different form e.g. profits or dividends, or by finding a job outside Scotland. Key to any decisions about changing work patterns, tax affairs or relocation will be whether individuals believe that tax differentials between Scotland and rUK will persist. At present, it is not known how far this gap can be increased before the disparities between the Scottish and rUK tax systems have an adverse effect on Scotland’s economy and therefore on its ability to generate income tax, implying that the estimates presented in Table 1 might not be realised.