Risks in tax devolution talks if Welsh concerns pushed aside

After many years of preparation, in 20 months’ time the UK-wide Stamp Duty Land Tax and the Landfill Tax will be “switched off” in Wales. The Welsh Government will introduce two devolved taxes to replace them, the Land Transactions Tax and the Landfill Disposals Tax. Although perhaps not traditionally the most eye-catching among a government’s suite of taxes, these will be the first home-grown Welsh taxes in 800 years, and their devolution will set an important precedent for the next stage of tax devolution: the £1.9 billion Welsh rates of income tax.

Crucially for Wales, whatever the policy plans the Welsh Government intends from these taxes, their budget impact will largely be determined by how the Welsh Block Grant is adjusted after their devolution, and this method will be decided during negotiations between the Welsh Government and HM Treasury this autumn.  

In principle, the adjustment to the Welsh Block should reflect the ongoing opportunity cost of devolution for the Treasury, i.e. the amount of revenue the UK Government would have collected in Wales had tax devolution not occurred. However, in years following tax devolution, it will be impossible to know exactly what this would have been, because devolved tax policy may change the amount of revenue collected or influence the underlying tax base. This means that the opportunity cost of devolution for the Treasury will need to be estimated. Given the variety of methods under consideration to do this, the upcoming intergovernmental negotiations over tax devolution will be critical.

One approach would be to somehow link annual changes in Wales’ Block Grant to changes in comparable revenues in the rest of the UK. For example, under the ‘Indexed Deduction’ method (also known as the Holtham method after the namesake Commission report), if revenues in the rest of the UK grew by 10%, then the Block Grant Adjustment, or the amount taken off the Welsh Block each year, would also grow by 10%. Growth in Welsh revenues would therefore need to grow by 10% if the shortfall were to be made up. With an amendment to account for Scotland’s lower population growth, this is how the adjustments to Scotland’s Block Grant will be calculated in coming years.

In the Welsh context however, there is an acute problem with a method that is integrally linked to substantial variations in housing market conditions across the UK. Stamp Duty revenues in Wales have grown and are projected to grow much more slowly than comparable revenues elsewhere. Over time, we would therefore expect the amount taken off the Welsh block (linked to revenue growth in the rest of the UK) to grow much faster than the devolved revenues available to the Welsh Government. Over a relatively short time period, we would expect the Welsh Government to face significant cuts in its budget compared with full block grant funding, regardless of the success or failure of its own policies on Stamp Duty or economic growth.

In our paper, we explore the four indexation methods that featured in the recent Scottish tax devolution negotiations, and take a hypothetical look at what their impact would have been had they been devolved at some point in the past. We find that all four methods would have led to cuts in Welsh funding had tax devolution occurred from 2010 onwards. The starkest of these is the ‘Levels Deduction’ method, understood to have been the Treasury’s preferred method in the Scottish negotiations, under which the Welsh Budget would be around £460 million a year smaller after a decade of tax devolution, an amount far exceeding total forecast Stamp Duty receipts. In fact, if Levels Deduction were to be used when Stamp Duty is devolved in 2018, Welsh revenues would need to grow 330% more quickly than revenues in the rest of the UK just in order to maintain the same level of funding as under the block grant system. The three other methods would not have had as deleterious an effect, although the budget would still have reduced compared with full block grant funding.

Put simply, given the UK’s highly uneven property market, growth in Stamp Duty revenues in the rest of the UK are not necessarily a good predictor of Welsh revenues, and this basic mismatch would likely lead to Block Grant Adjustments far above the opportunity cost of devolution to the Treasury. Driving much of this difference is the property market of London and South East England, which accounts for around 59% of all UK Stamp Duty revenue. The Parliamentary constituency of Kensington alone raises twice as much in Stamp Duty revenue per year as the whole of Wales; the Cities of London and Westminster constituency generates five times as much!

To mitigate some (but not all) of these effects, our paper simply suggests removing revenue from London and South East England from the calculations. This would still provide the Welsh Government with an incentive to grow the tax base, but with a much more realistic and achievable goal. By excluding these revenues, we get a much closer predictor of the amount of revenue that would have been raised in Wales without devolution. This adjustment would protect the Welsh budget from the effects of London property bubbles which are often driven by international financial flows far beyond the control of Welsh politicians.

The chart below illustrates the effect of Stamp Duty had devolution been in place from 2005 onwards, using the ‘Indexed Deduction’ method as an example, and shows the better protection afforded to the Welsh budget had revenues from London and South East England been excluded.

Figure 1- Effect on Welsh Government budget of Stamp Duty Devolution with Indexed Deduction method applied, 2005-06 to 2014-15

The deal reached at the conclusion of the long Scottish fiscal negotiations treated all taxes in a consistent, ‘one size fits all’ way. Although straightforward, such an approach neglects the fact that each devolved tax bears different levels of likely growth, risks and volatility: A method that works for one tax may not work for another and some taxes will need to be treated differently to mitigate detrimental losses to the Welsh budget. This basic position will hopefully be reflected in the fiscal agreement eventually reached for Wales.