Another model for fiscal devolution

At the end of last week the IPPR published a paper of mine setting out a model for enhanced financial devolution Devo More: Fiscal options for strengthening the Union (available here). It is intended first of all to offer a meaningful option for extended devolution in Scotland, where all three unionist parties have said that further devolution will be on offer if there is a vote to stay in the Union in the 2014 referendum. That is not all it does, though; it is also intended to work for Wales and Northern Ireland as well, if they wish to go down the path of further fiscal devolution. In a Welsh context, this might be the step beyond the Silk recommendations – which in Scotland are the start of a story but not its end.

An option like this is badly needed, for two reasons. First, there is clear evidence that it is what the people of Scotland want. They like devolution and want more of it; in particular, they want devolution to affect control of taxation and welfare.  That has been shown clearly in numerous opinion surveys, particularly the Scottish Social Attitudes ones, and their 2012 findings just released confirm the point. Outright devolution of those is very difficult within the Union – it would only be possible with some sort of ‘devo max’ approach, which is emphatically not what I am proposing.  Apart from anything else, it would not be viable for Wales or Northern Ireland.  Significant control of those is, however, possible, and that is what this paper (and the wider ‘Devo More’ project of which it forms the first output) is investigating.

Finding practicable ways to ensure devolved control of these functions is part of making sure that Scottish devolution (and devolution elsewhere) matches the aspirations of the Scottish people, a basic democratic goal. It also serves a more constitutionally fundamental purpose; it ensures that government in Scotland (and elsewhere) is, and should remain, legitimate. Devolution in 1998 was, after all, a response to similar problems that arose in both Wales and Scotland in the 1980s and 1990s.

Second, it relates to the 2014 independence referendum. An ‘enhanced devolution’ scheme is not on the ballot paper, of course. That is probably right; it would be hard (though not impossible) for a referendum to offer multiple choices to the voters in such a way that it would also establish a clear mandate for independence, if that were the choice of the electorate. Once the SNP committed itself to having a single referendum on independence, it effectively ruled out putting an ‘extra devolution’ option to the voters in the same poll, even though it dangled the prospect of that in front of Scottish voters after the 2011 election.

There are good practical reasons why more devolution could not have been on offer in any event.  There was no such scheme on the table, and still is not.  You could not prepare for a referendum in which one of the options was essentially undefined until the last minute. (The Welsh referendum on legislative powers in 2011 shows how badly such polls can go if an expected player doesn’t show up.) Such a scheme would need to have agreement across the unionist parties to be viable, as the Calman proposals had.  It’s fair to say that before now the unionist parties where in no mood to consider such an option. This is only a proposal for a scheme which is meant to work for all the unionist parties; we shall see whether they embrace it, and how enthusiastically they do so.  But defining such an option plays into the wider referendum debates by ensuring that the offer of ‘more powers after a referendum’ can be a credible one.  The battle-ground in the referendum campaign is voters who support that; if they do want more devolution but do not believe that promises of it will be delivered after a poll, the risk increases that a referendum will be lost.

Part of what has to define an ‘enhanced devolution’ scheme is what works in the interest of the UK as a whole. This scheme is meant to do that; it is intended to work for Wales and Northern Ireland as well, if they wish to go down the path of fiscal devolution. It is also designed to be ‘union-reinforcing’ rather than ‘union-weakening’, as ‘devo max’ would be, and as devolution of taxes like corporation tax, inheritance tax or fuel duties would be likely to be.

It also offers benefits for England, chiefly because the transfer of fiscal capacity to Scotland and other devolved governments will both enable and require them to finance spending on better services than those in England out of their own resources.  Free university tuition in Scotland has become a politically toxic symbol of supposedly generous financing of Scotland.  Some of this anger is misplaced, and is to do with choices made by devolved governments – funding, say, free prescriptions at the cost of other functions. But some of it has a point. Transferring a significant degree of fiscal capacity means that, if the Scottish Government wishes to provide an overall higher level of public services, it can do so – but Scottish taxpayers will have to pay for it, and the Scottish Government will have to make the case to its voters for that.  That is what autonomy means.

Fiscal devolution does not stop the UK Government undertaking redistribution across the UK, if it wishes.  A ‘vertical fiscal imbalance’ – a gap between the revenues a regional-level government can raise using its own tax powers, and its spending obligations – is common in federal systems. In the UK it is unavoidable. There are many taxes which are not suitable for devolution, either because the administrative costs of doing so would be disproportionate, or because of the character of the taxes themselves.

Take fuel duties as an example. These are a useful source of revenue (they account for about 5 per cent of total UK tax revenues, proportionally more in Wales and Northern Ireland). However, devolving something so obviously and necessarily mobile would trigger widespread avoidance, tax competition or both, and even then would incur considerable compliance costs.  The same applies to a good many other taxes, which are best left in UK Government hands. Scottish, Welsh and Northern Ireland taxpayers will continue to contribute to the UK as a whole, through a wide range of non-devolved taxes, and it is for the UK Government to decide how to use those.

The recipe I have come up with involves handing over four sets of revenues to devolved governments:

1. All personal income tax, including decisions about rates, thresholds, exemptions and relief.  There will need to be some practical restrictions on this, if HM Revenue & Customs are to continue to collect income tax across the UK (and there are good reasons why they should), but those should be as minimal as possible for administrative reasons.
2. All land taxes.  This should be uncontroversial; to a large degree, it has already been accomplished for Scotland through the Scotland Act 2012, and is recommended for Wales by the Silk Commission (and supported by the Welsh Government).  Land taxes are not a major source of revenue, but they are a secure and easily devolvable tax base, and are an important instrument of policy as well.
3. ‘Sin taxes’, meaning duties on alcohol and tobacco.  This faces serious legal problems, but there is such a close relationship between the harm these products can do and other devolved functions, notably public health, that devolved governments should have control over tax levers as well as regulatory mechanisms when dealing with them.  They are also quite useful as sources of revenue.
4. Assign a large proportion – 10 points, of the 20 currently levied – of Value Added Tax.  EU law prevents devolution of VAT, although sales taxes are commonly levied by state or regional-level governments in federal systems.  Assigning it – passing the revenues directly to a devolved government, which does not have control of the rate of tax or what the tax is levied on – was considered and dismissed by the Calman Commission for Scotland, and the Holtham and Silk Commissions for Wales.  But, if we are looking at going meaningfully beyond that model of fiscal devolution, we have to think again.  VAT is a major source of revenue, and in the hunt for ‘devolvable’ taxes the choice of good taxes to devolve is a very limited one.  A major consumption tax is an attractive proposition for regional-level governments, and assigning it is the best one can do.

This is not so much the end of my work on devolution finance as establishing a clear starting point. It is impossible to work out a scheme for devolution finance without working out what it is you are financing. I have used the current division of functions between the devolved governments and London for this work, and if there were further devolution of expensive functions (notably welfare benefits, but also policing and criminal justice in Wales) it would be necessary to look at this again.

In later work in IPPR’s ‘Devo More’ project, we shall be considering those issues; that will mean returning to financial issues afterward as well. But using 2010-11 figures, this model would have put £21.7 billion directly into the hands of the Scottish Government, £9.7 billion into those of the Welsh Government, and £6.1 billion into those of the Northern Ireland Executive. That equates to 60.6 per cent of Scottish devolved spending, 62.2 per cent of Welsh devolved spending and 55.6 per cent of devolved non-social security spending in Northern Ireland.  Of that, large proportions would come from wholly devolved taxes: 42.1 per cent of Scottish spending, 44.2 of that in Wales, and 34.3 per cent of that in Northern Ireland. That contrasts with the measures in the Scotland Act 2012, which would devolve taxes revenues accounting for around 30 per cent of devolved spending in Scotland, and the Silk Commission’s proposals, which would account for about 25 per cent in Wales.

Whatever form fiscal devolution takes, it is important to think about it as a package. Devolving one or two taxes on their own increases the risk of government revenues being exposed to serious shocks. That is especially the case with volatile taxes like corporation tax. Some devolved services are simply inflationary in character (notably health). Others are counter-cyclical, with demand increasing somewhat when times are bad (notably education). None of them get cheaper to provide in hard times. As there’s no such thing as a counter-cyclical major tax, stable revenues are needed to pay for them, and if the UK Government is to cease to manage the risk of fluctuations in revenue (which it does at present, through the block grant and formula system), devolved governments need tax revenues that are relatively stable, and if possible that balance the fluctuations among them.

In particular, the combination of devolved income tax and assigned VAT does that. Assigning VAT might not give devolved governments any control over policy levers, but the revenues are relatively stable, act as a counterweight to income tax ones (they shrink and grow on a different cycle), and over time it is a growth tax.

This model is an attempt to make a devolved UK work better; to enable it to be both more devolved, but also more unified. Quite a lot of work remains to be done, but it is hard to see that any sort of durable and workable solution would not draw heavily on it.