In so far as this Holyrood election has been a battle at all, the battleground for it has been tax. Not only the Unionist opposition but the pro-indy left have attacked the SNP for timidity over its plans to keep income tax rates the same as the rest of the UK, with only a tweak on the threshold for the top rate.
In their defence the Nats have deployed a line that’s been widely derided as an old Tory argument derived from the so-called “Laffer curve”, but in fact is nothing of the sort. It centres around the ways wealthy people legally shield their income from tax, but there’s a very specific and very important wrinkle that applies only in the particular case of a devolved, not independent, Scotland.
It’s not at all complicated but it’s absolutely crucial, and it’s barely been discussed on even the most superficial level in any supposed analyses of the situation undertaken in the media, so as usual we suppose it’s going to be down to us to do the job.
The Scottish Government has put out a document explaining its belief that increasing the top rate to 50p in Scotland while it remains 45p in the rest of the UK would risk wealthy people avoiding it, to the point where the increase could easily LOSE money rather than gain it.
However, while it makes a pretty decent argument so far as it goes, the document barely touches on the key mechanism by which Scotland could suffer such a fate, talking instead mostly of people changing their residence in order to cut their tax bill.
That’s a genuine danger – moving from, say, Edinburgh to Newcastle to save yourself thousands of pounds in tax is a much easier proposition within the UK than it would be if Scotland was independent and such a move entailed the considerable hassle of actually emigrating – but it only applies to a proportion of higher-rate payers.
(People like headteachers, surgeons, senior police officers and council officials, who may well be on the top rate, can’t easily up sticks and do their jobs from England.)
The real risk in residence terms comes from private-sector businessmen, who can headquarter their companies and themselves pretty much anywhere they like. Should they relocate to England, the Scottish Government loses not only the extra 5p tax but the whole of their tax contribution.
“Ah”, say those on the left, “but that wouldn’t really happen, because even if they wanted to save on tax, they wouldn’t want to move because then they’d – for example – also have to pay to send their kids to university”.
And there’s a substantial element of truth in that – the financial equation has more than one variable, and the social and personal upheaval of relocating your family as well as your business isn’t a small trifle.
But there’s a very little-known aspect of the devolution of income tax to Holyrood, and that’s the fact that only the tax on income derived from SALARIES will come north. In tax jargon this is what’s called “non-savings non-dividend (NSND) income”, and it means the basic wage at the top line of your payslip.
The tax on any money earned from savings and dividends still goes to the Treasury in London, and that’s the killer. Most people have little or nothing in the way of savings and no idea what “dividends” are, or at best think they’re something to do with shares. But that’s not the case, and we need to look at what the term really means.
We have some friends in England who own a company that’s doing quite well. Despite its success they pay themselves a pretty modest wage from it – less than the UK national average of £27,531. But their real income as directors is more like twice that, because their basic wages are topped up by “dividends”.
Since we don’t want to talk in detail about people’s private financial affairs, we’ll use some completely made-up figures for illustration. Let’s say there are 10 of them, and that the company’s profits after tax are £2m a year. Out of that they pay themselves a basic salary of £20,000 each. That leaves £1.8m in the company kitty.
But any time they feel like it, our friends can also choose to pay themselves any amount of the £1.8m they want as a “dividend”, at which point the dividend becomes part of their personal income. If they choose, they can up their salaries from £20,000 a year to ten times as much, or any figure in between the two.
All of this is perfectly legal. One advantage is flexibility – they can tailor their personal incomes so as to earn as much as possible without going into the higher tax brackets in any given year. Another is that dividends, unlike salary, aren’t subject to National Insurance, saving both the company and individuals money.
But dividend income also attracts lower tax. As of this year you get the first £5000 of dividend income totally tax-free, and then pay income tax on the dividend part of your income at lower rates.
These rates are set by the UK government, not the Scottish one. And what that means is that if you’re a wealthy businessman based in Scotland and the higher rates of income tax go up significantly, you’ll suddenly have an incentive to shift some or all of your income from salary to dividends.
(Clearly that incentive already exists now, but the bigger the gap in tax rates between Scotland and England, the bigger the incentive gets. If the top rate of tax was 45% in England and 50% in Scotland, then the advantage of dividend income would go from the current 6.9% to a whopping 11.9%, almost double.)
And the key factor of switching to dividend income rather than relocating to reduce your tax bill is that for you it has no downside – you won’t have to move house, you won’t suddenly make your kids eligible for tuition fees, you won’t have to leave your nice Georgian townhouse in Edinburgh for somewhere less scenic.
But for the Scottish Government the downside will be much more serious. Even though you might not be paying very much less total tax, the tax on a huge chunk of your income – which would normally have come to Holyrood – will instead be sucked down to London, leaving a gaping hole in Scotland’s finances.
Let’s put some rough numbers on that. If our made-up directors pay themselves £200,000 each as a salary, they’d normally be paying £76,100 a year each to the new Scottish Exchequer. But if they chose to take that exact same total income as a £20,000 salary and £180,000 in dividends (because doing so meant paying top-rate tax of 38.1% on the dividend part rather than 50%), the Scottish Government would get just £1,800 in tax from each of them, with the rest going to London.
That single company would have transferred something in the region of £743,000 a year from Scotland’s coffers to Westminster’s – almost three-quarters of a million pounds of real money the Scottish Government wouldn’t have for public services, and which would show up in GERS (and endless graphs from angry dog-food salesmen) as more evidence of Scotland being too wee and too poor to run its own affairs.
In a way that’s not visible to most people (for whom tax is no more complicated than a PAYE figure that automatically comes out of their pay packet every month), the mechanics of the devolution of income tax conceal a huge and potentially lethal trap for any Scottish Government looking to put tax up – an arrangement that should come as no surprise given that it was set up by a Conservative UK government.
Anyone who’s in control of their own salary to any significant extent – which is most people running their own businesses – can choose to get their income paid in a way that saves them a useful amount of money, but which costs the Scottish Government far more than it saves the individual.
While tax rates are the same on both sides of the border there’s no reason for them to do that (if they don’t do it already). But if Scottish income tax goes up, there will be, and the result will be a potentially huge cash drain from Scotland to the Treasury.
None of this, of course, would apply in the case of an independent Scotland. In that scenario tax on dividend income would come to Holyrood just like tax on salary income. There’d still be an incentive for people to relocate themselves or their businesses if Scottish taxes were higher, but as we’ve discussed there are major downsides to that, both personal and financial.
For that reason, there’s no inconsistency whatsoever in the SNP having advocated a 50p tax rate in the UK election last year and then declining to impose one in a devolved Scotland with its new tax powers. The two situations are radically different, because in the process of devolving tax but only on NSND income, London is giving itself a back door by which it can come in and take a sneaky bite out of Scotland’s money if the powers are actually used.
We hope readers haven’t glazed over during this article. We kept it as simple as we could. But both the Unionist parties and the far-left opposition in Scotland are counting on the fact that to most people the darker intricacies of the tax system are something that simply doesn’t concern them, so they don’t have any reason to understand them.
Hiking top-rate tax in a devolved Scotland is far, far harder than it would be in an independent one, for all sorts of reasons. Dividends are just one of them. If Labour and the Lib Dems genuinely want to put up taxes to protect public services, the only way that can really work is if they start backing independence.