Scottish Budget 2023-24 Income Tax Performance

28th January 2023

This chapter looks at what we know about why Scotland's tax base has grown more slowly so far since devolution.

Since the partial devolution of income tax to Scotland, revenues have disappointed. For example, whereas increases in tax rates and changes to tax bands are - before accounting for behavioural responses - estimated to have generated over £600 million in 2020-21, revenues were only £96 million more than the amount subtracted from the Scottish Government's block grant funding (the block grant adjustment, or BGA) to account for devolution. This is because the underlying tax base grew less quickly in Scotland than in the rest of the UK (rUK), offsetting most of the revenue generated by the Scottish Government's tax changes.

Forecasts suggest that this trend has continued into the current year. In particular, the Scottish Fiscal Commission (SFC) has forecast that the Scottish Government's tax changes will raise the equivalent of £850 million this year (again before accounting for behavioural responses), yet revenues will be around £100 million lower than the BGA. In other words, slower tax base growth is expected to more than offset Scotland's higher tax rates.

In both December 2021 and May 2022, the SFC was forecasting the trend to continue in the medium term. However, the forecasts published last month are for a significant reversal of this trend, with revenues set to exceed the BGA by £1.1 billion by 2026-27, and £1.3 billion by 2027-28. This is an important change, providing a notable boost to the Scottish Budget (see Chapter 2).

This chapter of the report therefore looks at what we know about why Scotland's tax base has grown more slowly so far since devolution, and discusses the SFC’s explanation for the partial catch-up expected over the next few years.

Key findings
1. Scottish Government policy measures – which include reducing the higher rate threshold, moving to a five-band system of income tax, and increasing the higher and top rates of tax – have raised significant amounts of revenue relative to if it had followed UK government tax policy that applies in rUK. The SFC estimates that, before accounting for any behavioural responses, these changes boosted revenues by £385 million in 2018–19 and will boost revenues by £852 million in the current financial year, 2022–23.

2. However, slow growth in Scotland’s underlying tax base compared with rUK has exerted downwards pressure on Scottish income tax revenues, despite these reforms to Scottish income tax policy. In 2018–19, revenues from income tax were only £127 million higher than the BGA subtracted from Scotland’s block grant funding to account for tax devolution (which is updated each year in line with growth in revenues in rUK), and in the current financial year, 2022–23, revenues are forecast to be £107 million lower than the BGA. In other words, slow growth in the underlying tax base is forecast to more than offset the additional revenues from Scotland’s higher tax rates this year.

3. Relatively slow employment growth in Scotland, compared with rUK, has been one factor behind this poor net tax position. Scotland’s population is ageing more rapidly than the population of rUK, and there have been falls in economic participation rates within age groups. For adults aged 35–49, the labour force participation rate in 2014–15 was comparable in Scotland to that in the UK as a whole (86.8% versus 86.9%), but by 2021–22, a 3.5 percentage point gap had emerged (84.5% versus 88.0%), with participation falling in Scotland and rising in rUK. This depresses tax revenues per person in Scotland relative to rUK, worsening Scotland’s net position.

4. Scottish earnings growth has also been weak compared with earnings growth in rUK over the period in which income tax has been devolved. Scottish Government analysis suggests that this primarily reflects two factors. The first is strong growth in earnings in London and its surrounding regions, related to growth in the finance and insurance sector in particular. In the period between 2016–17 and 2021–22, changes in London, the South East and the East of England can account for more than half of the shortfall in growth in average earnings in Scotland relative to rUK. The second factor is the weak performance of the oil and gas sectors and associated industries, particularly affecting earnings – and so income tax revenues – in North Eastern Scotland.

5. As recently as May 2022, the SFC was expecting this slow growth in the Scottish tax base to continue in 2023–24 onwards, with negative impacts on forecast net income tax revenue in Scotland. This was largely as a result of its forecast for continued slower employment growth in Scotland compared with rUK.

6. In its latest forecasts, however, the net income tax position for 2023–24 onwards is much stronger. Forecasts for Scottish revenues were revised upwards from their May levels in each year between 2023–24 and 2026–27, while the BGA forecasts by the Office for Budget Responsibility (OBR) were revised downwards (apart from a slight upwards revision in 2024–25). Only a small part of this net improvement is as a result of income tax policy changes announced in the December 2022 Scottish Budget, which include increasing the higher rate of tax (from 41% to 42%) and the top rate (from 46% to 47%).

7. The most important factor causing the improvement in the forecast net position from 2023–24 between May and December 2022 is the change in underlying economic forecasts. Employment forecasts have been revised downwards by the OBR in the UK for 2023–24 and 2024–25, but the SFC has not done the same. The OBR also forecasts that earnings will grow much more slowly (at an average of 2% per year between 2024–25 and 2027–28) in the UK than is forecast for Scotland by the SFC (2.6% on average).

8. To some extent, these differences are likely to reflect Scotland-specific factors: much elevated energy prices are likely to boost employment and earnings in the oil and gas sectors in North Eastern Scotland, and a recession and rising interest rates may slow earnings growth in the large financial sector in rUK. But part of the differences are also likely to reflect different judgements about the economic outlook for the UK as a whole. If the SFC’s more ‘optimistic’ position is borne out, the OBR’s revenue forecasts will be too low, and the BGAs will be revised upwards. If the OBR’s forecasts are more accurate, Scottish revenues will be lower than is forecast. In both cases, Scotland’s net income tax position would be weaker than currently forecast. Risks to Scotland’s net income tax position are therefore likely to be weighted to the downside.

9. Despite the improved outlook for the income tax net position from 2023–24, forecasts are still lower than would be expected as a result of income tax policy alone. In 2026–27, for example, the latest forecast for the net position is £1,068 million, but the effect of tax policy alone, according to SFC analysis, would be a net position of £1,528 million. This reflects the fact that the stronger forecast growth in the tax base over the next few years is only expected partly to undo the slower growth in the tax base during the first few years of income tax devolution.

End notes
Strictly speaking, the comparator has switched to England and Northern Ireland, following the devolution of tax powers to Wales in 2018–19 (Stamp Duty Land Tax and landfill tax) and 2020–21 (income tax). We use the term rUK throughout for ease of reference.

Note
To read the full report go HERE
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