Scotland’s devolved tax and benefit system is more progressive – but unnecessarily complex and distortionary

Building on reforms in the 2016–21 parliament, the Scottish Government has continued to make its devolved tax and benefit system more progressive over the last five years. 

Income tax has been increased for high-income residents of Scotland through a combination of real-terms reductions in the higher- and top-rate tax thresholds, and increases in tax rates. Meanwhile, devolved benefits have been increased for low-income families with children. The combined effect of these two sets of changes is to reduce average (mean) household net income by £510 a year. But effects differ significantly across the income distribution, with low-income households gaining and high-income households seeing their net incomes reduced by more than average.

Compared with the income tax and benefit system in place in the rest of Great Britain, the second-lowest-income tenth of Scottish households are £790 a year (3.6%) better off under the devolved system, due to higher benefit entitlements. Conversely, the highest-income tenth of Scottish households are around £4,000 a year (3.8%) a year worse off.

But as well as being more progressive, Scotland’s devolved tax and benefit system is also unnecessarily complex and distortionary. 

Similar redistribution could be achieved with fewer income tax bands. Land and buildings transaction tax distorts the housing market, damages the economy, and penalises landlords and renters. Proper council tax reform has seemingly been kicked into the 2030s. And ‘cliff edges’ in many of Scotland’s benefits – most notably the Scottish child payment – create inefficiencies and unfairness. A strategy to reform Scotland’s taxes and benefits is needed – a task that is even more vital if the next Scottish Government chooses to continue increasing taxes and/or benefits. 

These are among the key findings of the third Scottish election briefing from the Institute for Fiscal Studies, funded by the Nuffield Foundation and the Robertson Trust.

The report examines the changes made by the Scottish Government to the devolved tax and benefit system over the most recent parliament. It finds that these reforms build on reforms in previous parliaments to raise revenue and increase the progressivity of the system. But they also compound some of the additional complexity and adverse consequences created by previous reforms.

Jed Michael, a Research Economist at IFS and a co-author of the report, said: 

‘The Scottish Government has made use of its powers to substantially boost the incomes of lower-income households, particularly those with children. Indeed, households with children in the second-lowest tenth of the income distribution are £2,760 a year better off than under the income tax and benefit system in place in England – equivalent to 9% of their net incomes.

‘But as the Scottish benefit system grows in size, the way support is adjusted as incomes or other circumstances change becomes increasingly important. Currently, benefits such as the Scottish child payment are withdrawn in full if earnings rise above a certain point. This creates a “cliff edge” in benefit entitlement – a small increase in wage rates or hours of work can mean losing thousands of pounds of benefits income. This is both inefficient and unfair: inefficient because it acts as a strong disincentive for some households to increase their earnings; unfair because households with very similar pre-benefits income either side of the “cliff edge” end up with post-benefits incomes that differ by thousands of pounds a year. The Scottish and UK governments should work together to allow for the more gradual tapering of Scottish benefits as income increases.’

Stuart Adam, a Senior Economist at IFS and a co-author of the report, said:

‘The current Scottish Government has used its devolved tax powers to raise revenue from higher-income taxpayers and higher-value properties. Beyond that, and despite publishing a “tax strategy” last year, it lacks a coherent strategy for the devolved tax system as a whole. 

‘Scotland’s property tax system is a case in point. Despite the SNP complaining about the unfairness of the current council tax system for 20 years and stating its commitment to reform in its 2021 manifesto, the current SNP government says meaningful reform will not be possible until after 2030. Freezes in thresholds are increasing the burden of land and buildings transaction tax, while higher rates on rental properties hurt tenants as well as landlords. And an expanding set of reliefs is further complicating Scotland’s business rates system. Scotland shares these problems with England, but with property tax an area where most of the key powers are devolved, a proper reform strategy would enable an ambitious Scottish Government to both improve fairness and benefit the economy.’

Further detail on Scottish income tax

• Based on current forecasts, 55% of Scottish income tax payers (those with a taxable income up to £33,500) will pay less income tax in 2026–27 than they would under the UK government’s income tax system – albeit saving a maximum of £40 a year. The highest-income 45% of taxpayers (those with a taxable income above £33,500) will pay more, with the amount of extra tax paid rising to around £1,500 a year more for an income of £50,000 a year and to £5,200 a year more for an income of £125,000 a year. 
• As part of a series of changes to income tax rates and bands, there have been significant real-terms reductions in the value of the Scottish higher-rate income tax threshold over the last 10 years. As a result, it is forecast that 26.3% of Scottish income tax payers will pay at least the higher rate of income tax in 2026–27, compared with 12.1% in 2016–17. This is a bigger increase than in the UK as a whole (15.3% in 2016–17 to a forecast 21.9% in 2026–27), where the real-terms value of the higher-rate threshold has not been reduced as much.
• All else equal, Scotland’s devolved income tax rates and bands would raise £1.8 billion more in revenue than if UK government rates and bands applied instead. However, the net contribution of devolved income tax revenues to the Scottish budget is just £1 billion – with some combination of behavioural responses to the tax changes, and slower underlying growth in average earnings, explaining the difference. 
• The scale of behavioural responses to changes in income tax rates – and particularly the top rate of tax – is still uncertain though. Evidence from early changes to devolved income tax rates (in 2018–19) suggests increases in the top rate of tax may reduce revenues – but given the uncertainty, more research is needed to verify this (or not), including on Scotland’s more recent income tax changes.

Further detail on other devolved taxes

• Despite the current Scottish Government’s (i.e. SNP) 2021 manifesto saying ‘We are committed to reforming the Council Tax to make it fairer’, there has been no fundamental reform, just more reviews and consultation – and ministers now say reform would require consensus and ‘would likely not be complete in this decade’. A 2021 pledge to exempt all 18- to 21-year-olds from council tax has also fallen by the wayside. Yet a ‘mansion tax’ was announced within weeks of the UK government announcing one, apparently with no need for consensus. 
• The mansion tax will mean council tax is based on up-to-date values for properties now worth £1 million or more but continues to use 1991 values for everyone else. If that proves to be a stepping stone to more comprehensive reform, it will look like a move in the right direction. But if it is the final destination, it will look like a poor substitute for much-needed fundamental reform. 
• Land and buildings transaction tax (LBTT) has been made even bigger and more damaging by freezing its thresholds and increasing the tax rates on purchases of second and rental properties. A landlord buying a £200,000 property, for example, must now pay £17,100, or 8.6%, in LBTT on top of the purchase price, compared with £1,100, or 0.6%, if bought as an owner-occupier’s main home. This encourages owner-occupation, which is already extremely tax-favoured, but makes it even more difficult and expensive for those who remain in the rental sector – tenants (who are likely to face higher rents as a result of the policy) as well as landlords. And preventing a landlord who wants to sell their property to another landlord from doing so is bad for both landlords and tenants.

Further detail on benefits changes during this parliament

• During the current parliament, the Scottish Government has increased the real-terms value of the means-tested Scottish child payment from £12.80 to £28.20 per week per child. It has also extended eligibility to families on universal credit with children aged 6 to 15 (families already received the payment for children aged 5 or under at the start of this parliament). Out-of-work families with large numbers of children and/or high housing costs have also benefited from new payments to mitigate the UK government’s benefits cap.
• Low-income families without children have not seen significant real-terms increases in devolved benefits during the current parliament, but continue to receive higher payments than they would in the rest of the UK, through reforms such as the Scottish carer supplement and mitigation of the under-occupancy charge (or ‘bedroom tax’).