The Assembly would be obliged to welcome tax powers, if Scotland’s are extended, says Professor James Foreman-Peck:

June 22nd, 2009

Devolved tax and borrowing powers for Wales inched closer last week. Gordon Brown smiled upon the Calman Commission’s proposals for Scotland to raise perhaps 16 percent of its current budget within Scotland. This must increase the chances of a similar settlement for Wales. And the Assembly would be obliged to welcome greater powers over Welsh affairs.

Peter Hain, the new Welsh Secretary, has suggested that the Assembly Government should piggyback on UK legislation for Scotland that might result from Calman’s proposals. A copycat approach for Wales would empower the Assembly to vary income tax rates by 10p in the pound in each tax band. In return the block grant (at present the Assembly’s only funding) would be cut by an equivalent amount. In addition perhaps some low yield taxes, such as those on landfill, aggregates and air passenger duty, might be devolved to Wales. Borrowing powers must accompany tax devolution, for in the present and future recessions tax revenue falls while spending requirements increase. The deficit would need to be financed.

Would tax devolution address Wales’ weak economic performance, recently discussed by Dylan Jones-Evans and the Organisation for Economic Cooperation and Development?

Measured by output per head Wales is now one of the poorer nations of Europe. The gap between Wales and the rest of the UK has widened under the independent economic development policies of the Assembly Government. Professor Jones-Evans contends the root problem is Assembly Government neglect of the private sector. He instances the concentration on public sector projects of the Objective One European Funding in Wales and claims that private sector business participation is being squeezed out by bureaucratic delay. If the Assembly Government were responsible for raising some of its income in taxes, would this focus them more closely on economic development or more effective public spending?

Not necessarily. One possibility is that, if their tax base does not grow strongly enough to support planned expenditure, the Assembly Government with tax powers will simply raise income tax rates above English levels. The only currently available example of Welsh tax independence, local authority council tax, offers supporting evidence. Council tax revenues increased by a greater percentage than all UK central government tax revenues between 2001 and 2007 (58 percent compared with 40 percent). Such an increase might be expected if local authorities just decided on their spending, without worrying about the amount of tax it was reasonable to extract.

From the viewpoint of raising revenue the council tax is nearly ideal. If one area imposes a higher tax than another, this immediately lowers property prices. Property owners in the higher tax area incur a capital loss, but they cannot avoid it. People will not be deterred from buying into the areas. House prices or rents will simply fall to cover the greater tax, while remaining comparable with prices inclusive of taxes elsewhere. It is a hard tax to escape.

Income tax differences between regions on the other hand are more avoidable. If working in Wales required that we pay a higher income tax than in England, some would demand higher before-tax wages in compensation or they would seek work across the border. Firms faced with demands for higher before-tax wages would consider whether Wales was a convenient place in which to stay.

The converse is also true, as Republic of Ireland demonstrated with its low corporation tax. A lower tax rate can draw in taxpayers and increase revenue, especially for a small country close to a much larger one.

So a tax cutting policy would be the obvious one for a development-oriented Assembly government with tax powers. But, for the moment leaving aside the domestic difficulties of deciding what spending policies to cut, Whitehall would not be enthusiastic. Not least, reservations in London would stem from the financing they provide with the Welsh block grant implicitly being used to compete with England for jobs and tax revenue. A less generous block grant would make it more difficult for a Welsh Assembly Government to cut income tax. London therefore would be obliged to consider what they have resolutely avoided for decades; whether the size of the Welsh grant was appropriate to Welsh ‘needs’.

Spending departments and ministers would probably fight tax reductions on the grounds that cuts would signal that the Welsh grant is too large for Welsh ‘needs’. Whitehall would be expected to reduce the grant if taxes were cut and so the pain of spending reductions would go unrewarded. Scotland’s behaviour is consistent with this position. Scotland has not used its 3p income tax varying powers – partly because raising it has been unnecessary. They have been able to extract more money from England than the Barnett formula indicated, starting from a high base relative to England or Wales. Cutting income tax was also impossible, for it would have undermined the justification for claiming more public money from England. Devolution of tax powers at most will affect policy makers’ thinking, but is unlikely to trigger substantially divergent income tax rates within the United Kingdom.

Would Welsh policy makers woo the private sector more vigorously with tax devolution? Doing so with Objective One funding would have required a willingness to reduce the costs to business of participation, fewer committees, less scrutiny, and perhaps greater risk of falling foul of auditors. The political appeal of such a policy must be limited whereas the payoff to public sector projects for elected representatives is immediate; they can be identified with the benefits. At first sight tax devolution offers more incentive to expand the tax base but actually the incentive was always there with the desire to generate new jobs.

Across Europe it is not clear that EU Structural Funds are an effective way of catching up. In principle the Assembly Government Business Advice Week initiative starting July 13 to provide advice to individual SMEs in 12 regional locations in Wales seems more promising. This does not depend on tax devolution. But if and when they come tax powers for the Assembly will be a fascinating experiment in devolution.

Professor James Foreman-Peck is Director of the Welsh Institute for Research in Economics and Development.

James Foreman-Peck

2 Responses to:“Welsh taxes”

  1. Wyn Hobson says:

    Concerning two of your assertions —

    (i) that if one area imposes a higher tax than another, this immediately lowers property prices, [because]:

    (ii) house prices or rents simply fall to cover the greater tax

    – are these claims based on quantified research, or on speculative extrapolations from a theoretical model of supply and demand in a closed system?

    (Report comment)

  2. James Foreman-Peck says:

    Thanks for your comment Wyn Hobson.

    If you had a choice of two equally attractive houses in two equally attractive areas but buying one
    meant you would incur a charge of, say, £1000 a year more than buying the other, at what prices
    would you be indifferent between the two?

    When the more heavily taxed house cost you £1000 a year less presumably. In the long term the
    supply of houses in the more heavily taxes area might respond to the lower prices and the
    differential narrow a little.

    To calculate the effect on sales and purchase price the annual extra tax liability must be
    capitalised. It would end up nearer £10,000 I suspect. This turns out to be a critical issue.

    In 'House Prices and Local Taxes in the UK' Fiscal Studies (1999) vol. 20, no. 1, pp. 61–76,
    Leslie Rosenthal calculated that only one third of tax liabilities were capitalised in house prices
    ( he found no capitalisation of expenditure benefits in the UK, in contrast to the US). But his
    figure depends critically on the capitalisation rate- he assumed a very low rate for the time
    (1981-1990) 3 percent. I seem to recall paying 13% on my mortgage in 1981. A 9 percent discount
    rate implies a 100% capitalisation.

    (Report comment)

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