The tangled web

Gerald Holtham examines the complexities of devolving income tax to Wales.

The Welsh government is facing a difficult, even grueling, negotiation with Westminster and especially with the Treasury.  Discussions are afoot over a Welsh “fiscal framework” and particularly over how the block grant to Wales is to be altered to take account of taxes being devolved to Wales.  The talks will be made all the trickier because the UK and Scottish governments have just agreed a fiscal framework for Scotland and a  messy old fudge it is. No doubt this precedent will be aimed at the heads of Welsh politicians and officials.  They would do well to duck and agree something more sensible. Over the next decade or two billions of pounds will be at stake.

Up to now the Welsh government has been financed almost entirely by a block grant, determined by the infamous Barnett formula.  The U.K. Government has agreed to supplement the formula with a “floor” to stop Welsh spending falling below a certain percentage of the English average.  Currently the floor is set at a perfectly reasonable 115 per cent but that commitment lasts only for the current parliament after which we do not know what the floor will be, nor how it will be determined.

When taxes are devolved, in any event, the block grant has to be reduced because Wales then  keeps money that would have been going to the Treasury. In the first year of devolution there is nothing to argue about. You make an estimate of the revenue from the devolved tax and take that off the block grant. If the outcome is different from the estimate you subsequently adjust the block grant for the discrepancy.  The issue comes in following years. You cannot repeat that procedure because the actual revenue will depend on the policies of the Welsh government.  If it reduces tax rates, for example, revenues will fall.  If the deduction from the block grant falls too, HMG ends up financing a Welsh tax cut! Similarly it must not take away revenue resulting from a tax increase or tax devolution is defeated.

Ideally what we want to know is: what revenues would HMG have collected from those devolved taxes in a parallel universe where no devolution had occurred. That is the amount we are supposed to deduct from the Welsh block grant in this universe. Evidently those revenues, and so the deduction, will depend on the policies of the U.K. Government but not on the policies of the Welsh government, which has no power in the parallel universe. Unfortunately if there are parallel universes the laws of physics prevent us from inspecting them.  We just have to estimate the revenue foregone by the Treasury with the indicators we have.

Consider income tax. Historically while Welsh taxes revenues per head have been lower than those in the rest of the UK they have grow at much the same rate. One approach therefore is to take the initial deduction and then make it  grow at the same rate as income taxes in  the rest of the U.K. (Known as the Index deduction method).This suggestion hit a snag in Scotland.  Population there grows at a slower rate than in the rest of the U.K. so even if incomes and tax payments per head  grew at the same rate as in England the total tax would grow more slowly. The Scots therefore argued that their deduction should be indexed to (that is grow at the same rate as) tax revenues per head in the rest of the U.K., not at the rate of total revenues.(Known as the Per capita Index deduction method).

HMG and the Treasury would not agree.  The arguments were arcane and in my view specious and there is no space to rehearse them here. The Treasury came up with a different formula whose effects are a bit better than simple indexation to aggregate tax receipts but do not protect properly against relatively slow population growth. (Known as the Tax-base adjusted levels deduction).  The compromise was the Treasury imposed its formula but agreed to top up the Scottish grant for five years to give the same effect as per capita indexation. Then there will be a review and if there is no agreement the Treasury formula will continue. The Scots get their way for five years but then they are at the mercy of the Treasury and its formula.

This matters hugely for Wales.  The Office of National Statistics projects that the Welsh population will grow at an average rate of 0.21 per cent a year in the 20 years from 2018-19.  It projects that population in the UK will grow at an average 0.56 per cent a year over the same period, that is more than twice as fast as in Wales. Note that the ONS is making those projections now on the basis of existing demographic trends. There is no assumption in there about different economic policies in Wales and England affecting, for example, rates of migration.  In the economic jargon those projections are of exogenous population trends.

They mean that even if income tax receipts per head grow at the same rate in England and Wales, income tax receipts in England will grow faster, purely because of a relatively rising population.  If income tax receipts per head went up at 4 per cent in both countries, after 20 years Welsh total income tax receipts would be up by 29 per cent but receipts in the rest of UK would be up by 45 per cent.

If the adjustment to the Welsh block uses the Treasury formula instead of being indexed to per capita income tax receipts, , Wales will lose £2.6 billion pounds over those 20 years compared with the status quo.  And that is even if the Welsh economy matches that of the rest of the UK and its per capita income tax receipts move in line.

In devolving income tax, the UK must in any case impose a new risk on the Welsh government: the risk that its income tax base rises more slowly than that in the rest of the UK because the economy underperforms.  If that happens, because tax receipts are partially replacing grant money, Wales will lose relative to the current situation. If Tata closes the Port Talbot works after income tax devolution, for example, or reasons beyond Welsh government control, Wales could lose up to £150 million a year in income tax revenue.  However devolution also confers an opportunity.  To the extent that Wales can stimulate its economy its tax receipts will benefit, whereas now an acceleration in Welsh growth increases tax revenues only for the UK Treasury.  Evidently the ideal situation is one where the Welsh government takes on the responsibility and the risks over which it has some control but is not subjected to risks where it has little or no control and which are better born at the UK level.

Some people oppose income tax devolution on any terms because they argue that the Welsh government does not have the power to affect relative economic growth rates.  But that is to accept Wales’ role as a pensioner with no ability even in principle to improve its public finances by improving economic performance.  Polls have shown the Welsh people are prepared to shoulder more responsibility. Yet if Wales is to bet on its own ability to improve its condition, the bet should surely be on fair terms.  If it is to be penalised for demographic trends over which it has no control, the bet is not fair and only a mug punter would take it on.

While population is the main stumbling block, the recent report by the Wales Governance Centre at Cardiff University points to another.  Welsh income tax revenues have grown more slowly than those of the rest of the U.K. since 2010-11. That is at least partly owing to the UK government steeply raising the personal allowance.  Because more Welsh taxpayers are at the lower end of the income distribution, those increases in the allowance took a higher proportion of Welsh taxpayers out of tax than the proportion in England.  If that was repeated in future after tax devolution, per capita indexation would reflect the reduction in English tax payers but that would not fully compensate the Welsh government for the loss of Welsh tax revenues – which were occurring as the result of a UK policy decision.

More to the point, think of the parallel universe. The rise in the allowance would have cost the Treasury what it will now cost the Welsh government, not the lower figure coming from indexation to England. So even per capita indexation would fail to identify the true opportunity cost to HMG.  It would understate the drop in revenue and so would overstate the opportunity cost of ceding that revenue to Wales.

Of course in future, increases in personal allowance are not likely to rise as steeply as in the recent past. The recent past is not typical of the longer run history and is unlikely to be typical of the future. If we want to avoid that risk, however, we have to make things a little more complicated, which the Treasury may resist.

It is easy enough to set up a simple model of the Welsh income-tax-paying population and to simulate the first-round effect of a given policy change. HMRC can do it; the Institute of Fiscal Studies can do it and the Welsh government had better acquire or buy the capacity to do it. Those calculations are what enable the papers to report at Budget time that such and such a measure will raise or cost x billion. If the model is agreed the effect of a UK policy change can be simulated and the result for revenues used to adjust the block grant.  To avoid marginal fiddling this procedure would be restricted to changes above a certain size. That would be in accord with the principle of “no detriment” from devolution, to which HMG is committed.

The Welsh Government should therefore insist on full per capita indexation to allow for relative population movements, and should insist that an agreed model be selected to simulate the effect of UK policy decisions on revenues from Wales.  In this negotiation Wales is, for once, in a stronger position than Scotland.  The SNP government really wanted tax devolution and could not be seen to refuse it. The Welsh Labour government has mixed feelings about income tax devolution anyway and many Ministers would be quite happy to knock it back if the deal is no good.  It would be hard for the UK to impose tax devolution on a reluctant Wales when it has waived the necessity of a referendum so if income tax devolution is to happen HMG has to agree to something reasonable for block-grant adjustments.

By the way, Treasury proposals for the block-grant adjustment for Stamp Duty devolution are far worse than what they propose for income tax. They move from the realm of the stingy to the country of the outrageous. The only suitable reply is John McEnroe’s: “you cannot be serious”. But that’s the story for another day.

*Correction: This article first stated that the Barnett Floor was set at 116 per cent. This was corrected to 115 per cent on the 26th February*

Gerald Holtham is an IWA Trustee and Managing Partner of Cadwyn Capital LLP

7 thoughts on “The tangled web

  1. Gerald thank you for attempting and to a degree succeeding to explain this Tangled Web. Are we meant to assume from the title that there is an attempt at deception? Although my sympathies are with a deal that benefits Wales I find it difficult to concur with a position that does not adjust relative expenditure with relative population levels. Am I misunderstanding this point?

  2. A good and a concise outline of Welsh financial reality and only one disagreement with Gerald and that is his inference of a Welsh Parallel Universe being impotent.

    The Welsh parallel universe is in control of the hard-nosed Welsh nationalist politicians demanding the never-ending concessions and powers to build the ‘Welsh nation’ on their terms.

    Perhaps time for Gerald and other economists to bring some reality into the equation and recognize that Wales as a separate entity is simply unviable – Consider Taxation Powers in isolation that alone would need creation of a Welsh Treasury with all the trappings that go with it including the Welsh Revenue Department, Tax collectors you name it.

    We already have an army of public employees and the Welsh public sector is by far the largest ‘Industry in Wales’ – Swansea has some 30,000 of these but in the post devo period eclipsed by Cardiff who now has some 50,000 public servants and most of them derived from North West Wales who just happen to be capable of meeting the Welsh Government’s key qualification ‘Fluent Welsh Language Speakers’ (Competence Irrelevant)!

    Then consider the implication of getting devolved Judiciary and Policing powers – Where the essential Welsh speakers are going to come from – Perhaps Patagonia?

    Time to recognize that the Welsh devolution is not working and that more powers demands are driven by the establishment including the Welsh media, whist the long suffering people of Wales are kept in the dark and irrelevant to the privileged elite!

  3. The recent ICM/BBC St David’s day poll now shows a narrow majority in favour of Income Tax devolution. I doubt very much whether those people who are willing to see tax devolution have thought about the matter in quite the depth that Gerry Holtham has, but, when it comes down to it, he has one vote.

    That is always the worry in Wales. Not long ago more than half of people polled didn’t realise that our very own National Assembly was responsible for the NHS in Wales. The latest poll shows that now only 29% of people in Wales still believe that Westminster is responsible and 6% didn’t know (care?).

    Ironically the “education” of Wales’s voting public is probably due to one phrase “Offa’s Dyke is the line between life and death.” A phrase that got the attention of the right wing press and therefore the attention of many in Wales. We now have an Assembly election where Daily Mail readers are aware of the Assembly’s importance for the two matters that they care most about; the NHS and Taxation and we know that the right-leaning elderly are the most likely to visit the polling booth. In a recent “Voodoo poll” for the a large majority of over 50s also wanted to leave the EU. Those people too will be more inclined to vote in May.

    I am inclined to think that the Assembly elections will see an increase in voter turnout and a move towards UKIP and Tory voting. The 6% of people who still want independence for Wales was somewhat dwarfed by the 13% who want the abolition of the Assembly and there is still only a minority wanting further devolution; 43%. No wonder Plaid is no longer shouting “freedom!” from the rooftops, and there is no indication that Wales will be voting Plaid anywhere but the Welsh speaking areas in May.

  4. I still want the promise of a referendum before taxation powers to be case,

    As a single issue it will force all parties to be open and honest about why they want it and how they would use it ie which taxes up which ones down and where tax income will be spent.

    I also would like clarification on how any monies raised affect Barnett. I thought at one time it was said it will be reduced by same amount as raised by taxation, in which case why bother.

  5. What is even more worrying to me with devolving some tax raising powers is that what Gerry describes is just one part of the tangled web. The argument for devolving tax powers is to place an income line into the Welsh Government’s budget and make it more accountable. However with only partial control of the taxes raised in Wales we are at the mercy of the Chancellor who can alter fundamentals about the tax we are raising or other taxes and in doing so he can completely change the expected outcome for Wales.
    Gerry talks about the Chancellor changing the bandings and the personal allowances affecting the relative tax takes in England and Wales. Think how hard it will be for the Welsh Government to calculate the effect of making a change to the rate of tax when they cannot second guess what the Chancellor might do to these fundamentals in his budgets. The level of tax raised or given away through any change could be significantly different from that which is assumed when the change is made.
    Add to this the fact that Wales will have no control over the other major taxes. If he chooses to target lower income tax and compensate through capital gains tax, for instance, Wales will have no say and major taxpayers can tax plan to avoid income tax by paying a different tax or visa versa. So many unknowns exist outside of the control of Welsh Government the so called “power” is close to illusionary.
    If you relate collecting tax to a car. The Chancellor is giving Wales total control of the accelerator (some income tax rates) but he has control of the gears (the thresholds), the clutch and the break (base rates of all taxes) and the steering wheel (tax policy). Who do you think is in control?

  6. First, a thanks for the comments and then a mea culpa. There is a mistake in the piece that fortunately does not change the argument. The quoted numbers in the 8th paragraph of 29 per cent and 45 per cent have got an ugly little one missing – that should be 129 and 145 per cent!
    JOJ, I don’t think you misunderstand anything. The present Treasury proposal would make a deduction from the block grant that did not take account of the effect of population differences on income tax receipts.
    Mr Protic, there is no proposal for Wales to do its own tax collection; that would continue to be done by HMRC. Your remarks also reveal a misapprehension. Most senior civil servants in Cardiff are not Welsh speaking; in fact many are not Welsh at all. I believe there are more English and Scots at higher levels than Welsh-speakers, not that it is relevant to tax devolution anyway.
    nospin: the whole point of all this is for tax devolution to reduce the money coming via the Barnett formula but not to offset the effects of any policy changes a Welsh government makes. If Wales doesn’t alter tax rates the idea is that the resources Wales has will be much the same as now. But if they put taxes up or down that will affect their revenues. Such changes would not be cancelled by an offsetting change in the block grant. Otherwise, as you say, why bother.
    Martin Warren, I am not here to exaggerate the policy autonomy this relatively small devolution of some income tax would bring. Some people think it is too much already, especially without a referendum (see comments above); you point to the evident limitations. How much devolution we have is a matter of political choice. But let’s make sure that whatever the degree it is fairly and reasonably organised.

  7. Mr Holtham, Do take on board your comments about the Welsh Civil Servants and their linguistic skills, but most of these people were in their jobs before the New Welsh Order and the Welsh Speak Essential for public jobs came into the being (I’m informed many under pressure to leave). New appointments favour Welsh speakers and some 7,000 moved to Cardiff from NWW alone over the last few years. Most of them got well-paid jobs in Civil Service, other public bodies including the third sector then the BBC Cymru Wales and many teaching appointments – Key Qualification: Fluent Welsh Language Skills’ !!

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