Monday, 22 September 2014

The Economic Consequences of the Scottish Referendum - Prof Brigitte Granville - Professor in International Economics and Economic Policy, Queen Mary

The political result of the Scottish referendum – the preservation of the Union combined with a commitment by the UK political class to devolve further powers to Scotland – has naturally led to most instant commentary being focused on the political and, more specifically, constitutional consequences.  By contrast, the economic results will have difficulty competing for the attention they deserve – especially what looks likely to be the most tangible economic result: higher taxes in Scotland. This change holds out the interesting prospect of increased competition within the UK as regards the balance between the tax burden and the quality of public services.

The likelihood of higher taxes in Scotland is clear from a straightforward analysis of the referendum campaign and result. The ‘Yes’ platform was overtly redistributionist. It depicted union with England as binding Scotland into fiscal restraints that reflected the preferences of the UK political class (especially as represented by the Conservative Party that is the dominant partner in the present UK coalition government) rather than the choices and needs of the Scottish people. The electorate clearly got that message. An analysis of voting patterns in the referendum shows that the ‘Yes’ vote was higher in areas where there were proportionally more voters with the greatest dependency on the welfare state – such as the unemployed and recipients of disability benefits.  Against this background, and on the safe assumption that the promised further instalment of devolution will focus on tax raising powers, it follows that future elections to the Scottish parliament are likely to be won on platforms of higher marginal taxation to finance increased public spending.

At least, that must be the outlook for two or three political cycles, after which it will become clear whether there is any backlash among Scottish voters against higher personal taxation or, if Scottish governments have had both the power and the wish to hike payroll taxation, against the higher unemployment that so often results from any such increases in the tax burden on labour. The outcome will hinge on the public tolerance for higher taxes and on the effectiveness of the Scottish government in delivering commensurate improvements in public services.

Countries and societies differ quite widely as regards their internal consensus on the optimal balance between taxation and public services – or, put another way, between the maintenance of individual incentives that lie at the heart of wealth creation and distributive justice (the collective sharing of wealth for the sake of fairness and a cohesive national community). Scandinavian countries are the best known example of societies that support high progressive taxation in return for enhanced collective provision of public goods. This model results in more equal living standards across the society than in countries like the US whose culture is less favourable to wealth distribution and collective welfare provision relative to support for individual striving and aspiration.

It seems likely that Scottish national culture leans more closely towards the Scandinavian model than England. But the more important point is that regardless of whether public tolerance for higher taxation is greater in Scotland than in England, no such tolerance will be limitless; and once the limit is breached, the negative effects of increased taxes – distorted incentives, tax evasion, a brain and wealth drain – will start to make themselves felt.  The classic economic measurement of this limit is the Laffer curve, which plots the relationship between the burden and the proceeds of taxation. Once a country reaches the top of that curve, higher taxes fail to raise more revenues and only manage to impede growth.

Successful Scandinavian-style models avoid reaching the top of the curve because the higher quality public services financed by higher taxation – such as improved outcomes in public health and education and skills – generate productivity gains hence incremental economic growth that allows such good public services to be financed sustainably without further increases in tax rates. In short, an equilibrium is reached at high tax levels matched by enhanced provision of public goods and services.

An interesting attempt to compare where Western countries stand on the Laffer curve was made in research on the behaviour of US and European firms and households by Mathias Trabandt and Harald Uhlig "How far are we from the slippery slope? The Laffer curve revisited." published in the National Bureau of economic Research Working Paper Series in 2009. They calculated tax rates from 1995 to 2007 assuming fixed productivity growth and no labour mobility between the US and the EU and found that the US could increase tax revenues by 30 percent by raising labour taxes and 6 percent by raising taxes on income and capital, while the equivalent scope for hiking tax rates without losing revenue in the fourteen EU countries studied were 8 per cent and 1 per cent respectively. As regards the EU, considerable variations were observed between countries. For instance, the UK could raise labour taxes by 17 percent while France only by 5 per cent, Italy by 4 per cent and Belgium by 3 per cent. The results for taxes on income and capital were that only 1 additional percent could be raised in the group of EU countries as a whole, and 0 percent in France, Italy and Belgium.

Interestingly and logically – given for instance the persistence of high unemployment in France since the 1970s – the model found that for the US 32 per cent of a labour tax cut and 51 per cent of a capital tax cut would be self-financing while the equivalent figures for the EU countries were 54 per cent and 79 per cent respectively, rising in the case of France to 62 per cent and 88 per cent.

Note that for the purposes of this study, the authors had to assume constant labour mobility. In practice, however, where mobility is easy not only in the legal sense but also – as between England and Scotland – in geographical, linguistic and cultural terms, the top of the Laffer curve will be reached more quickly. Put another way, once the limit of tolerance for higher taxation is reached, people will leave. Even within the preserved union, therefore, future redistributionist Scottish governments will have to deliver tangible improvements in public sector efficiency in return for levying higher taxes or risk large-scale migration of Scottish residents south of the border.

If future Scottish governments fail to meet this challenge, English tax revenues would get a demographic boost and the tax base in Scotland would be eroded. And, since more such internal UK migrants from Scotland to England would tend to be in employment rather than welfare recipients, the result would be to allow higher funding for public services and welfare in England without increasing taxation.

Conversely, if public goods in Scotland became demonstrably superior – as seen, for example, in educational attainments and survival rates from cancer and degenerative diseases – this successful “Scandinavian” model would attract internal UK immigrants from England.

In short, the Scottish referendum has teed up an interesting competition of governance within the UK that will play out in the next couple of decades.

Brigitte Granville is Director of the Centre forGlobalisation Research (CGR) and Professor of International Economics and Economic Policy at the School of Business and Management, Queen Mary, University of London, and the author of Remembering Inflation.

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