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How tax devolution could work

Neil Amin Smith
Newspaper article

Local government finance in England has undergone two significant changes in the past decade. The first, a move to make councils’ funding more dependent on their own choices and economic activity, has stalled since 100% business rates retention was shelved. The second, substantial reductions in funding, is set to become increasingly challenging as adult social care costs are set to grow faster than council tax and business rates revenues. One solution to both these issues that is gaining traction is the idea of local tax devolution. 

It will come of no surprise to anyone that has braved the streets of Edinburgh at Hogmanay to hear that the city has begun to wonder if there is, perhaps, such a thing as too many tourists. Although soliciting for visitors has become a key plank of almost every city’s economic plan (‘Think you know Hull? Think again!’), Edinburgh is one of a number of UK cities that have mooted the idea of imposing some form of ‘tourism tax’ on its overnight visitors. Such taxes are already commonplace in Europe – the UK is in fact one of only nine countries from the EU-28 that doesn’t allow cities to charge a tourist accommodation tax.

There are two economic arguments that can be made in favour of tourism taxes. The first is that tourism imposes a cost on a local area – a cost that tourists do not have to pay. For example, Bath, another city keen on introducing a tourism tax, has to spend much more than it otherwise would on keeping its streets clean, and its residents have to pick their way through camera-toting hoards as they go about their daily business. These spill-over effects are what economists call negative externalities – tourists aren’t facing the true cost of their visit when they pay for their hotel or entrance to a museum.

Related to this, the second economic argument in favour of tourism taxes is that whilst tourists derive some benefit from local services, local taxpayers and voters will not take this into account when deciding how much tax to pay and how local revenues should be spent. Imposing a tax on tourists could raise additional revenues for those services, and allow tourists to vote with their feet! The flipside of that, of course, is that if a tourism tax led to fewer tourists, it could reduce economic activity and, as a result, revenues from other taxes. It is also worth noting that tourism is, in truth, already taxed in a number of ways – through VAT and business rates, for example.

Soaking the tourists

The more pragmatic argument for a tourism tax is that it would allow councils to raise additional revenues (without raising taxes on their voters!). The truth is, however, that a tourism tax would bring in relatively little at a national level. If a tax of £1 per overnight stay (as proposed in Bath) was levied on visitors across England, it would raise approximately £420m, equivalent to less than 1% of councils’ core spending power. Of course, this would be much higher in some areas than others (London, for example, has more than four times as many overnight stays per resident than West Yorkshire).

Tourism tax not the only option

Because of the relatively small amount a tourism tax would raise, my colleagues and I have looked into whether other taxes could be usefully devolved to councils in England. This could also be a way of reviving the project that has faltered since 100% business rates retention was shelved – changing the system so that it gives councils greater control over their funding and provides them with stronger financial incentives to grow their economies.

We have considered a number of options, all of which are used to a greater or lesser degree by sub-national governments in other countries, and concluded that income tax would be the only sensible candidate for devolution within England.

If full devolution of income tax sounds like an absurdly outlandish idea, that’s because it is. Instead, consider allowing councils to control just part of the income tax schedule. For example, they might be allowed to levy a small surtax on the basic rate band, or a small flat-rate surtax across all bands. Either approach would significantly reduce the disparities between areas in revenues raised that full income tax devolution would imply. Furthermore, allowing councils only to levy a flat-rate surtax in this way would limit the incentive for high-earners to move between areas in order to reduce their tax liability as any gains would be relatively small.

This, in particular, is one of the advantages that partial income tax devolution has over other possible devolved taxes. Local VAT or corporation taxes, both of which have been discussed within the sector, would likely result in sales or profits being shifted to lower tax areas – consumers are happy to travel a bit to buy things more cheaply, and many larger firms have ample scope to shift their profits between locations. Even more problematically, both would be extremely difficult, and likely expensive, to apportion between areas.

Not that income tax is immune to such problems, of course. In theory, it should be easier to apportion income tax revenues between areas – most income tax payers live at a defined address. However, it turns out that there is no statutory requirement on taxpayers to tell HMRC about changes of address.

Nevertheless, if government did want to devolve further taxation powers to councils, income tax does seem to be the most attractive option – even a 3p surtax on the basic rate would raise £12bn for councils. And there would be a clear incentive for councils to increase employment and incomes among their residents.

But…there’s only one way to increase government funding

This all sounds pretty good, right? For some among you, however, talk of a ‘surtax’ may have rung alarm bells. And, really, the issue of higher levels of taxation stalks this whole discussion. Councils may well feel that they need more funding, and projections of social care costs over the next few decades suggest that council tax and business rates revenues will struggle to keep up. Many have discussed tax devolution as a way to address this, but if it simply meant transferring revenues from central to local government it would mean less funding were available for things like the NHS or schools. Ultimately there is only one way of increasing the funding available across government – higher taxes.

This article was originally published in Local Government Chronicle and is reproduced here with full permission. Neil Amin-Smith is a Research Economist at the Institute for Fiscal Studies.