Constitutional change and inequality in Scotland David Bell, David Comerford and David Eiser

Overview Inequality and social justice central to the independence debate This paper considers the effectiveness of different policy levers in influencing inequality Results are based on a household level model of earnings and benefits Policy levers considered include personal taxation, welfare spending, and council tax – some of which are already devolved to the Scottish Parliament ‘We will be more successful and more equal as a society’ Alex Salmond, GMS 18/09/2013

Presentation structure Economic reasons for independence, fiscal federalism, and optimal taxation Inequality: measurement and trends Approach/ model Results: – Marginal effects – Scenarios Conclusions

Reasons for independence, fiscal federalism and optimal taxation

Reasons for independence We focus on possible heterogeneous preference for egalitarianism in Scotland Or perhaps this preference is shared but government policy targets swing seats in rUK which do not share this preference

Fiscal federalism First-generation theory of fiscal federalism: Central govt should have basic responsibility for income redistribution, given mobility of economic factors But differential preferences for or costs of redistribution may provide grounds for some decentralisation of tax and spend levers Second-generation theory of fiscal federalism provides additional set of explanations for decentralisation of taxation and welfare spending: Local knowledge and participation in service design ‘Laboratory federalism’/ policy experimentation Increase accountability/ incentives for provision of market enhancing public goods “The provision of public services should be located at the lowest level of government encompassing … the relevant benefits and costs” Oates (1999)

Optimal taxation Theory suggests devolve: – Taxes on immobile factors e.g. Land Don’t devolve: – Taxes on highly mobile factors e.g. Corporation tax (c.f. need supranational agreement to deal with Amazon, Google, and Starbucks) Cross country evidence has examples consistent and inconsistent with Oates theory Consider the political economy: – Losers shout louder than winners – Problem of tax burden falling on the asset rich but income poor – Need to consider the behavioural responses to changes “In the absence of cost-savings from the centralized provision of a [local public] good and of inter-jurisdictional externalities, the level of welfare will always be at least as high (and typically higher) if Pareto-efficient levels of consumption are provided in each jurisdiction than if any single, uniform level of consumption is maintained across all jurisdictions” Oates (1972)

The constitutional options Constitutional options “on the table”: – Status quo (Scotland Act 2012) – Independence Constitutional options also discussed – DevoMore (Alan Trench, IPPR, Joseph Rowntree Trust) – DevoPlus (Jeremy Purvis, Reform Scotland) – DevoMax/Full Fiscal Autonomy (?) We present a stylised interpretation of how these options map into fiscal policy levers

The constitutional options Status quo Devo-more Devo-plus Devo-max Full independence Scottish Rate of Income Tax (flat-tax) + some smaller taxes + powers for new taxes (with Westminster consent) Full devolution of income tax, assignment of 10pp VAT, LT ambitions for devolution of alcohol and tobacco duties Full devolution of income tax, corporation tax, capital gains and inheritance tax Full devolution of all taxes (other than VAT, assigned), plus devolution of welfare spending Complete fiscal autonomy

Inequality: measurement and trends

The inequality debate ‘Scotland is currently part of a UK economic model and society which is one of the most unequal in the OECD. Inequality within the UK has increased in recent decades. Such patterns of inequality will continue to have a negative impact on growth and prosperity over the long-term.’ (Scottish Government, 2013)

Are attitudes to inequality different in Scotland? Scottish electorate often perceived to be have more socially democratic/ collectivist views, evidenced by voting patterns But specific differences are unclear: – 78% of Scots v. 74% of English voters think gap between high and low incomes is too large (ScotCen) – 43% of Scots said they supported government redistribution compared to 34% in England (ScotCen) – Bell (2012) found no statistical difference between Scots and English voters on whether the government should spend more on welfare benefits for the poor – 58% of Scots believed that publically owned services were more professional and reliable than privately run services, compared to 30% in England/ Wales (IPSOS/MORI )

Measuring income inequality Measuring income: – Private income (employment + other sources) – Net income (after taxes and benefits) – Aggregate at household level (bhc) – Adjust for housing costs (ahc) – Equivalisation to account for household size/ structure – Include indirect benefits (health and education spending) Measuring inequality – GINI coefficient – Inequality ratios: 90/10, 90/50, 50/10 – Relative poverty rates

The GINI Coefficient GINI = A/(A+B) Everyone earns same => – lowest x% of population earns x% of income – B fills triangle & GINI = 0% Very unequal => – lowest x% of population earns  0 – A fills triangle & GINI  100%

Problems with the GINI Coefficient? Single number to describe whole distribution: – Different distributions could have same GINI Implicitly takes a view of importance of changes to different parts of distribution relative to other parts – Income changes at different %tiles can have different impacts on the GINI. We address these problems using Percentile ratios and Relative Poverty Rates Other problems exist (e.g. income vs wealth, and absolute vs relative) and are not addressed

Other Measures of Inequality Ratios of household income at different percentiles: – Gives indication of where in income distribution a change is having an impact – Quote ratio of household income between 10 th and 50 th and 90 th percentiles, and between the 50 th and the 90 th. Relative Poverty Rate: – Defined as percentage of households with net income lower than 60% of median net household income – Relative measure: appropriate as social welfare indicator since psychological evidence suggests relative comparisons are important Can be misleading: transfer from top to middle worsens poverty rate by raising median income

Weekly earnings inequality: increase driven by variation in working hours

Net earnings inequality: little increase during 2000s…

…but UK inequality remains high relative to most OECD countries

Trends across the income distribution

Rise of the top 1-2%

Explanations Increasing returns to skill Technical change and globalisation leading to job polarisation Rise of flexible working and greater variation in working hours/ practices Financial services taking increased share of factor incomes: – Real social benefit through reduction in credit frictions? – Incomes from financial services have large rent-seeking or ‘private profits/socialised losses’ component?

Labour-market polarisation in Scotland

Summary: inequality trends Slower increase in earnings inequality during late 90s and 2000s compared to 80s Little change in net inequality since 1997… …but continued pulling away of highest earners Inequality in UK remains high, but other countries are ‘catching up’ Inequality in Scotland very similar to rGB/rUK excluding London Outlook: further increase due to welfare reform and technical change?

The model

Based on DWP’s Family Resources Survey 2010/11 Weighted sample of >4000 Scottish households Individuals within survey report earnings, benefit eligibility, council tax band etc. Model calculates tax liabilities and benefit income Model can be used to examine the effects of tax/ benefit changes on aggregate government fiscal position, and on household income distribution No behavioural effects

Reconciling the model: aggregate level DataModelDifference Income Tax 10,668 10,49998% NI 7,978 8,104102% VAT 8,343 6,56379% Excise Duties 4,512 4,661103% Council Tax 1,968 1,92798% Modelled Revenues 33,469 31,75495% Out of Model 18,861 36% State Pension 5,965 5,92499% Child Benefit % Low Pay Benefits: Tax Credits 2,177 2,304106% Low/Zero Inc Benefits: JSA, IS & HB 2,840 1,87266% Disability Benefits 2,431 1,89678% Modelled Expenditure 14,354 12,91490% Out of Model 49,676 78% G-T modelled- 19, ,84099% G-T out of model 30,815 Overall G-T 11,700

Reconciling the model: distribution Scottish Government report GINI point estimate of 30.4; within confidence band between and 31.7 Model GINI = 29.4

Overview of analysis Marginal analysis: – The effect on inequality of £1m fiscal tightening – Allows comparison of individual levers in absence of behavioural effects Scenario analysis: – The effect on inequality of eight specific, hypothetical policy scenarios – Three scenarios are available to the Scottish Government through its powers under the Scotland Act; Two might be available under enhanced devolution; and Three would require full fiscal autonomy/ independence The income measure is weekly net equivalised household income after housing costs

Results

Impact on GINI of £1m fiscal tightening

Marginal impacts by decile: income tax

Marginal impacts by decile: council tax

Marginal impacts by decile: benefits

Marginal impacts: scale issues

Policy scenarios: Status Quo ‘Status quo’ options Status quo A Council tax abolition funded by SRIT rise (of 4.25%) Rationale: CT regressive, SRIT is progressive; Proxy for LIT Status quo B Revenue-raising revaluation of council tax, combined with SRIT reduction (of 0.85%) Rationale: CT revaluation progressive; increasing tax on land & fixed property and reducing tax on mobile labour likely has supply side benefits Status quo C Revenue-losing revaluation of council tax, combined with SRIT increase (of 1%) Rationale: CT revaluation progressive; SRIT progressive

Policy scenarios: Enhanced Devolution ‘Enhanced Devolution’ options Devo- More/Plus A Raising tax free allowance (from £6,475 to £10,000) & reducing upper rate threshold (from £43,875 to £34,000) Rationale: Both progressive measures Devo- More/Plus B Reinstate the 10p tax band on earnings between £4,000 and £7,800p.a. Lower upper rate threshold to £36,500 and abolish Additional Rate Rationale: Possibly progressive with exception of abolishing additional rate – this included due to model limitations!

Policy scenarios: Devo-Max / Independence Independence B Universal basic income (£150 per week) funded by flat rate tax of 56%. Abolish NI & other benefits. CT revaluation Rationale: Take universal benefits agenda to one extreme & avoid adverse incentives of generous means-tested bens. ‘Independence’ options Independence A Revenue –raising Council tax revaluation, increase rates of JSA/IS (25%), increase tax credits and state pension (10%), paid for by raising upper rate tax rate (to 46%) & reducing upper rate tax threshold (to £37,000) Rationale: Pull all levers as indicated by marginal impacts Independence C Tax simplification: amalgamate NI & income tax systems Rationale: NI maybe a needless complication and distributionally it is similar to income tax.

Scenarios: Impacts on inequality measures SQ ASQ BSQ CDev ADev BInd AInd BInd C GINI-1.090%-0.259%-0.454%-1.130%-0.035%-2.804%-5.059%0.003% 90/10 ratio /50 ratio /10 ratio Relative Poverty Rate 0.05%0.37%0.13%0.96%0.33%-1.61%-1.56%-0.35%

Scenarios: absolute impact by quintile

Status quo scenarios

Enhanced devolution scenarios

Independence scenarios

Scenarios: relative impact by quintile

Conclusions

Contribution: We have shown – which levers are most powerful in reducing inequality – revenue neutral combinations of different levers More work required to incorporate behavioural responses Clearly more power = more levers. Tautological. Some of the powerful levers will reside at Holyrood under Status Quo But many of the most powerful levers will remain reserved to Westminster under the Status Quo

Conclusions Levers that have most impact are those which have effects at specific parts of the income distribution: – Council tax rate and SRIT are relatively weak levers from inequality perspective as not very sensitive to different parts of the income distribution – Being able to differentially vary upper or additional tax rates would be much more powerful than the SRIT in influencing inequality – Out-of-work and very low income benefits have stronger effects than state pension and tax credits

Conclusions For Scotland to have inequality level similar to e.g. Sweden/ Finland, implies fall in GINI of 0.5-1% This could be achieved through existing powers, although levers are relatively blunt and may not be politically viable Independence/ full fiscal autonomy gives greater flexibility to achieve inequality reductions by targeting specific parts of the income distribution, and potentially to do this in a less distortionary way But inequality overall will continue to be influenced by global forces of tech change, trade and returns to skill – even with full fiscal autonomy, a small open country is likely to face constraints in how it can exercise these levers