Devolution of income tax
As ICAS responds to an inquiry launched by the Welsh Assembly, Donald Drysdale asks what Wales can learn from the implementation of devolved income tax in Scotland. The views expressed are his own and not necessarily those of ICAS.
Since April 2018, the Welsh Government has had responsibility for some of the taxes paid in Wales. From 6 April 2019 these have included the new Welsh rates of income tax (WRIT).
In October 2019, the Finance Committee of the National Assembly for Wales launched an inquiry to look at the impact of income tax variations in neighbouring countries or territories, and the potential impact of differences in income tax rates across the UK.
The inquiry is looking at how migration and ‘tax avoidance’ behaviours of low, medium and high-income earners may be affected by national and sub-national income tax variations – both generally in international tax systems, and specifically between England and Wales.
The Welsh Finance Committee hopes to understand what levels of divergence in income tax rates could trigger behavioural change in low, medium and high-income earners in England and Wales, and assess the potential impact on WRIT revenues.
ICAS, believing that much of the experience in Scotland and the behavioural reactions there to changes in income tax rates might be informative to the Welsh analysis, has submitted a response to the Welsh inquiry.
In relation to Scottish income tax (SIT), a distinctive direction of travel was set in 2018/19 with the introduction of five bands – providing a more progressive income tax charging structure than in the rest of the UK.
With this structure, the profile of SIT has been raised as the differentials between Scotland and the rest of the UK have grown across thresholds and rates, and from one year to another.
For Scots with above average earnings, income tax rates are progressively higher than those elsewhere in the UK, leading to concerns as to whether this might affect behaviours and, if so, at what point – not only of those in Scotland but also of those who might be attracted into Scotland.
The situation is complex. Compared with England, Scotland has fewer taxpayers paying income tax at the additional or top rate. This leaves SIT revenue flows particularly vulnerable to behavioural changes by high earners – who may react not only to cross-border rate differentials but also to other changes in UK-wide and devolved taxes.
The focus which the Welsh inquiry seems to place on 'tax avoidance' misses the point that innocent behavioural reactions by taxpayers, within the realms of what would normally be described as ‘tax planning’ or even simply ‘lifestyle choices’, could also be quite enough to affect WRIT revenues.
Like employers elsewhere in the UK, employers in Wales might decide to reconfigure remuneration packages to enable their employees to exchange salaries/wages for more tax-efficient items such as pensions or further holiday entitlement.
Likewise, individuals who are Welsh taxpayers might increase their pension contributions, reduce their working hours, or decide not to take on overtime – hence reducing their earnings subject to WRIT.
Such adjustments might comprise relatively small changes for individuals, but the cumulative effect could be significant for the Welsh Government – both in fiscal terms (reducing the tax take) and in economic terms (cutting productivity).
Where income tax thresholds and rates diverge across an unrestricted internal border, as they do between Scotland and England, there will inevitably be tensions – as each nation seeks to encourage inward migration and discourage outward migration.
The same is true to some extent at the border between England and Wales. However, Wales has power to set its own income tax rates but not its rate bands; the latter will remain in line with those for England and Northern Ireland.
In fact the rates of income tax in Wales have not yet diverged from those for England and Northern Ireland, and page iii of the Welsh draft Budget published on 16 December 2019 confirms that they will not do so through 2020/21.
With Scotland pursuing a distinctive income tax strategy which is markedly more progressive than that in the rest of the UK, it is already apparent that tensions and challenges arise from the size, shape and potential mobility of the Scottish income tax base – especially the mobility of the highest earners.
The power to set income tax rates is a two-edged sword, and the very fact that Wales has instigated the current inquiry suggests that the Welsh Assembly is aware of the risks it might face if it follows Scotland’s lead.
Across the UK, owner-managed businesses may choose to operate as sole traders or partnerships (liable to income tax) or companies (liable to corporation tax, with owners taking salary and/or dividends liable to income tax).
Interaction between the Scottish and UK tax regimes is probably already encouraging incorporation by Scottish taxpayers at an earlier stage in their business’s evolution compared with those in the rest of the UK.
This choice of trading entity and its timing determine not only the tax due but also which jurisdiction receives the tax. The UK Exchequer receives corporation tax, and income tax on dividends. Scotland directly receives only the SIT on non-savings, non-dividend income.
Note that changes from April 2020 will put the onus of whether to apply IR35 rules on each private sector organisation engaging workers. This may lead to more conservative decisions, bring more contractors within payroll and thus discourage incorporations by disguised employees.
Factors which now affect the tax planning and lifestyle choices of Scottish taxpayers might become equally relevant to Welsh taxpayers if Wales were also to opt for a divergent income tax strategy.
Classification of taxpayers
Identification of Scottish and Welsh taxpayers is crucial if public funding derived from SIT and WRIT is to be optimised in each respective devolved jurisdiction.
HMRC have not always managed this well. In early 2019, they even issued Scottish taxpayer PAYE codes to Welsh taxpayers and then blamed the error on employers.
Following lessons learned in Scotland, perhaps Wales may benefit from the mistakes which have been made to date.
The circumstances of Scotland and Wales are far from identical.
First, there are many communities straddling (or very close to) the border between England and Wales, and many people who live near that border commute across it to work on the other side. By comparison, the border between Scotland and England is relatively unpopulated.
Divergence in tax rates would likely be much more apparent and perhaps problematic within a community straddling the English/Welsh border, than in a relatively isolated village some distance from the Scottish/English border.
Second, as stated above, the fiscal powers devolved to Cardiff for WRIT differ significantly from those devolved to Edinburgh for SIT – at least for now.
Wales can learn much from the lead which Scotland has taken in implementing devolved income tax, but it should not assume that all potential difficulties have been ironed out.
Article supplied by Taxing Words Ltd