Representation without taxation?

The question of how democratic governments should raise revenues from their citizens is central to the business of constitution-building.  An entire academic field known as Fiscal Federalism has grown around the question of how to best distribute revenues to different tiers of a country’s government.

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Despite recent moves to devolve some revenues to Scotland, Wales and Northern Ireland, the UK retains one of the most centralised revenue structures on the planet and is pipped only by New Zealand in the percentage of a country’s tax revenues that are collected centrally.

CENTRAL GOVERNMENT REVENUES AS A PERCENTAGE OF ALL REVENUES IN 31 OECD COUNTRIES (2009, OECD)

 

Source: OECD

As part of one of the world’s most centralised states in terms of revenues collected, all major taxes paid by Welsh taxpayers and businesses (except Council Tax) are currently collected and pooled centrally at Westminster.  These funds are then distributed back to the devolved administrations in Edinburgh, Cardiff and Belfast by way of an annual block grant, the size of which is calculated by the (in)famous Barnett Formula. This grant gives flexibility to devolved governments to reallocate funds between different policy priorities such as education and health, but the Welsh Government can neither set the overall size of the budget nor change tax rates for people living in Wales.

What’s more, the Barnett Formula is not based on factors that might take account of Wales’ higher needs, including its older population, higher levels of income poverty and prevalence of ill health. In 2009, a Welsh Government Commission chaired by Gerald Holtham used the UK government’s own needs-based formulas used to distribute funds to English regions and found that Wales was £300 million underfunded relative to the regions of England.

In addition to this funding gap, the Holtham Commission and its successor, the Silk Commission, identified the central democratic problems underlying Wales’ current funding system. First, because all of Wales’ taxes are pooled at Westminster and distributed back to Wales via the Barnett Formula, the Welsh Government has no direct budgetary incentives to develop innovative, growth-oriented policies. Second, because the Welsh Government and Assembly are not required to levy taxes to pay for at least some Welsh public services, the political parties cannot offer choices to Welsh voters over overall spending and taxation levels, a decision that one of the most fundamental at any election of importance. As it stands, the National Assembly is highly unusual internationally in having legislative and spending powers but not taxation powers.

As a replacement for the current system, both the Holtham and Silk Commissions laid out a menu of funding options, ranging from the status quo (the block grant), to the partial or full devolution of specific taxes such as stamp duty and income tax, right through to a scenario in which Wales would pay for Welsh public services entirely from its own tax base.

So, what UK taxes could be devolved to the Welsh Government? In theory, the UK could devolve all taxes and Wales’ public spending would be paid for by these taxes (termed full fiscal autonomy). However, because of Wales’ poorer-performing economy compared with the rest of the UK, at least in the short term this would require large public spending cuts or tax increases to make up for the shortfall in Wales’ budget.

Pragmatically, and assuming Wales’s current constitutional status within the UK and EU, a viable solution for devolved Welsh taxes would fall somewhere between the two extremes of the block grant and full fiscal autonomy. The Wales Act 2014, passed in December, devolved two minor taxes to Wales that align with Welsh Government functions, stamp duty and landfill tax. But total receipts for these taxes amount to less than £200 million, just one percent of the Welsh Government’s current budget.

If Welsh taxes are to play an important accountability role on Welsh elections, other weightier candidates for tax devolution will need to be found. Perhaps the likeliest candidates for devolution are:

• Income Tax – As the largest of all UK-wide taxes collected in Wales, devolving income taxes might establish a clear link between the performance of the Welsh economy and the amount of money available to spend on public services, thereby encouraging Welsh-made policies that boost economic growth and therefore Welsh income tax receipts. Almost all income tax receipts and decisions over rates will be devolved to Scottish Parliament as a result of the cross-party Smith Commission set up after the independence referendum.
• VAT – The Welsh Government would not be able to deviate from the UK rate under EU rules, but assignment of VAT receipts collected in Wales might link to the effectiveness of Welsh Government policy to grow the tax base to the size of the budget it has to spend on public services. 50% of VAT receipts will be devolved to Scotland as a result of the Smith agreement.
• Corporation Tax – Reducing corporation tax might offer one way of jumpstarting inward investment in Wales.  On the other hand, cutting Welsh corporation tax rates might risk “cannibalising” tax receipts from across the UK if England and Scotland lower their own rates to match those in Wales. Corporation Tax will be devolved to Northern Ireland in 2015 to help compete with much lower rates levied by its southern neighbour.
• Air Passenger Duty – Devolving APD would help Cardiff Airport attract new airlines, routes and passengers, but might give it an advantage over near neighbours in England that attract Welsh customers. The Smith Commission also intends to devolve both long- and short-haul Air Passenger Duty to the Scottish Parliament, and long-haul APD was devolved to Northern Ireland in 2012.

Income tax is perhaps the primary candidate for devolution to Wales. The Wales Act 2014 devolved responsibility for 10p of each band of income tax to Wales, but this provision is subject to a referendum being called by a two-thirds vote of the National Assembly. The current situation is therefore quite anomalous in that a government can choose whether it wants to be accountable to the public for the money it spends.

All the parties have stressed the importance of rectifying the funding shortfall first identified at £300 million by the Holtham Commission in 2009. But as Gerald Holtham has argued, it is very likely that this gap has reduced since then, so there is a lingering question of how “fair funding” should be defined.  If a fair funding settlement is achieved, perhaps through a funding floor to prevent a shortfall from opening up again, there is certainly a debate over whether an income tax referendum is needed.  Northern Ireland has recently been granted a major economic lever in a devolved corporation tax, and major new responsibilities were recently devolved to new elected mayor for Greater Manchester despite that city voting “No” to a mayor in 2012 (albeit on different boundaries).

“No taxation without representation” was the call of the original Tea Party of the American Revolution. But at least in the short term, Wales may continue to be that internationally anomalous position of “representation without taxation”.