Devolved income tax policy has been much debated, but evidence around its effects is still emerging. There are uncertainties around the revenue raised by particular policies and their cumulative effects on the wider economy over the long term. Ahead of the Scottish Budget on Wednesday, this blog looks at where uncertainty remains.
Income tax policy has diverged between Scotland and the rest of the UK (rUK) since 2017-18, following its partial devolution in the Scotland Act 2012 and Scotland Act 2016. Broadly speaking, the Scottish Government has increased tax rates on higher earners and reduced (in real terms) the earnings threshold at which these higher rates apply.
Given how interconnected Scotland’s economy is with rUK’s, a key aspect of devolved income tax policy is its relationship to income tax policy in rUK. This matters both in terms of the substantive impacts on the economy and tax revenues, but also in shaping the political debate.
More detail can be found in SPICe’s 2024-25 budget briefing, but the overall result of income tax devolution is a more progressive income tax schedule for Scottish residents.
Table 1: Differences between Scottish and rUK income tax, 2024-25
Annual taxable income (£) | 2024-25 Scottish income tax payable (£ per year) | Difference compared with rUK (£ per year) |
20,000 | 1,463 | -23 |
30,000 | 3,497 | 11 |
40,000 | 5,597 | 111 |
50,000 | 9,028 | 1,542 |
60,000 | 13,228 | 1,796 |
70,000 | 17,428 | 1,996 |
80,000 | 21,778 | 2,346 |
90,000 | 26,278 | 2,846 |
100,000 | 30,778 | 3,346 |
150,000 | 59,681 | 5,978 |
Note: Scottish income tax policy does not apply to income generated through savings or dividends.
Devolved income tax policy raises significant additional revenue…
Starting with what we do know – the Scottish income tax system raises a significant amount of revenue for the Scottish Government. Ahead of 2024-25, the Scottish Fiscal Commission (SFC) forecast that income tax would raise £18.8 billion. This is £1.4 billion higher than the Block Grant Adjustment, which adjusts the Scottish Budget to account for the partial devolution of income tax.
This means that the revenue raised from income tax is projected to be £1.4 billion higher than if Scotland had retained the same tax policy as rUK and if Scotland’s per capita tax revenues had grown at the same rate as rUK. This £1.4 billion is added to the Scottish Budget to fund devolved spending and is referred to as ‘the income tax net position’. For context, £1.4 billion is almost as much as budgeted for the Scottish Police Authority.
A key reason for this additional revenue is ‘fiscal drag’. This occurs when earnings rise faster than the thresholds at which higher rates of tax apply. In recent years, earnings have risen relatively quickly to keep pace with high inflation. But the threshold at which the higher rate of Scottish income tax (42%) kicks in has been largely unchanged since 2017-18. In 2024-25, it stands at £43,662, whereas in rUK, 40% income tax applies to earnings over £50,270.
This has ‘dragged’ more taxpayers into the higher rate bracket, which now applies to the highest earning 22% of taxpayers (up from 12% eight years ago). Interestingly, this is sometimes described as a ‘tax on middle earners’, yet it is difficult to think of another scenario where someone in the 78th percentile is described as being in the middle.
The SFC’s December 2023 Economic and Fiscal Forecasts estimate that, “due to fiscal drag each 1 percentage point of earnings growth delivers around £25 million more revenue in Scotland than would be generated with UK tax policy.” The relatively high rate of nominal earnings growth in recent years has therefore delivered increased revenues to the Scottish Government, in part due to the structure of its income tax system.
However, this is where the uncertainty steps up. The SFC stress that the outlook for the income tax net position is highly sensitive to small changes in forecasts of earnings in Scotland and the UK. And a key determinant of income tax revenues is earnings growth across the economy. Here, Scotland has underperformed rUK since income tax devolution, resulting in what the SFC call “the economic performance gap”. In 2022-23, this was worth £624 million in income tax revenues. Early data suggests that there has since been some catchup in earnings growth, but the SFC have cast doubt on how sustainable this is.
“Scottish average earnings growth has fallen to be more in line with the rest of the UK in recent months, possibly marking the end of the recent period of catch-up.”
Source: SFC Fiscal Update, August 2024
… but how taxpayers respond to income tax policy is uncertain
Another source of uncertainty is how taxpayers are responding to changes in income tax policy, which can include changes in the number of hours worked, where to work, or how and when taxpayers receive income (eg. through dividends, rather than a salary). These behavioural responses affect the amount of tax revenue raised, and who pays what. More information can be found in another SPICe blog.
When estimating how much revenue is raised by changes in tax policy, the SFC include an estimate of the anticipated behavioural response of taxpayers. This comes with a degree of uncertainty because we can’t directly observe how taxpayers would have behaved in a hypothetical world where tax policy didn’t change.
However, there is no doubt that taxpayers do in fact change their behaviour in response to changes in tax rate – the uncertainty lies in the extent to which taxpayers change their behaviour. Importantly for Scotland (given tax increases have been concentrated on the upper end of the income scale), there is plenty of evidence that behavioural responses are greater amongst higher earners.
For example, in the 2024-25 Scottish Budget, the top rate of income tax (applied to non-savings non-dividend taxable income above £125,140) was increased from 47% to 48%. The SFC projected that the revenue raised in 2024-25 by this measure would have been £53 million with no behavioural response, but is more likely to be around £8 million once behavioural responses are factored in.
These are forecasts, but we are now starting to get evidence on the impact of Scottish income tax policy in outturn data. In April, HMRC released a study into the initial response to income tax divergence between Scotland and rUK in 2018-19 and 2019-20. It focused on the effects of Scottish income tax policy on labour market participation and intra-UK migration, and found a movement of around £60 million of revenue from Scotland to rUK in 2018-19.
For context, the SFC’s 2018-19 forecasts projected that income tax divergence would raise an additional £164 million for the Scottish Government after accounting for £51 million of behavioural responses.
However, there is a wide statistical margin of error in HMRC’s study and there was no effect found in 2019-20. This might suggest that there are other effects occurring that the study was unable to pick up.
It is also important to note that since 2019-20, Scottish income tax policy has diverged further from rUK’s. The subsequent behavioural responses may be greater, or perhaps taxpayers disproportionately adjusted their behaviour at the beginning of tax divergence. To understand the impact of the Scottish Government’s income tax policy, more evidence will be needed.
The wider economic impact of tax policy
So far, we’ve covered three sources of uncertainty around the effect of Scottish income tax policy – how taxpayers are responding to it, the outlook for earnings growth in Scotland and the UK, and the sensitivity of the income tax net position to small changes in forecasts of earnings across the economy.
All of the above uncertainty relates to the amount of tax revenue raised by the Scottish Government’s policy choices. But there is another, arguably more important source of uncertainty – the impact of Scottish income tax policy on the wider economy over the medium to long term.
Business surveys from the Fraser of Allander Institute and Institute of Directors Scotland have picked up some concern around the impact of income tax divergence on recruitment and retention, and the resulting higher wage bills reducing the competitiveness of Scotland’s firms and their ability to invest in their business.
However, these surveys tell us nothing about the magnitude of these effects, and how this compares with the flipside of the income tax trade off – all else being equal, higher tax revenues that can fund public services, infrastructure, skills development, enterprise support, employability services etc, all of which can help grow the economy and attract people to live and work in Scotland.
This matters because if the objective of the Scottish Government’s income tax policy is to increase revenues, then the only way to sustainably do this is to grow the size of the tax base (ie. earnings). This demonstrates why it is important to understand how income tax policy is affecting Scotland’s economic performance.
As time passes and more economic data becomes available, a better understanding of this should emerge. The Scottish Government could use this evidence to inform future policy choices. This evidence will be more meaningful alongside a clearly defined tax strategy that takes account of the inherent trade offs involved with tax policy. Parliament will therefore be keen to scrutinise the forthcoming tax strategy, in search of less uncertainty and more clarity.
Rob Watts,
Scottish Parliament Information Centre (SPICe), Financial Scrutiny Unit