Is Scottish VAT too hard to assign?
By Donald Drysdale for ICAS
2 July 2019
With the practicalities of Scottish VAT assignment now being called into question at Holyrood, Donald Drysdale explains how we have reached this point.
The background - Calman
The Calman Report of June 2009 recommended giving the Scottish Parliament partial control of Scottish income tax and full responsibility for certain devolved taxes. This has of course happened.
Calman also suggested going further at a later stage – to emphasise the extent to which the Scottish Parliament is financed from Scottish tax receipts – by considering the possibility of assigning several percentage points of VAT and a share of fuel duty to the Scottish Budget.
To be fair, Calman cautioned that such assignment would carry significant risks, especially if implemented at a time of economic uncertainty, and that these risks would have to be managed carefully. This clearly pertains today, given the economic uncertainties created by Brexit.
The background - Smith
In November 2014 the Smith Commission Report recommended that receipts raised in Scotland from the first 10 percentage points of standard rate VAT should be assigned to the Scottish Budget, with a corresponding adjustment to the block grant from Westminster.
The two Governments later agreed – as set out in Scotland in the United Kingdom: An enduring settlement of January 2015 – that Westminster would go further by additionally assigning the first 2.5 percentage points of the revenue attributable to Scotland from the reduced rate of VAT.
All other aspects of VAT were to remain reserved to Westminster. Thus the Scottish Budget would be impacted (positively or negatively) by VAT assignment, while the Scottish Government would have no power to vary VAT rates or any other aspects of VAT policy.
The law
The Scotland Act 2016 legislated for the above recommendations by providing for a proportion of the VAT receipts raised in Scotland to be assigned to the Scottish Government's Budget. Interestingly, no date of implementation has been set – it is subject to agreement between the two Governments as follows.
Where HM Treasury and Scottish Ministers had agreed on a sum representing the standard rate VAT attributable to Scotland for any period, the proportion of that sum to be assigned would be calculated as (10 ÷ SR), where SR was the number of percentage points in the standard rate.
Likewise, where they had agreed on a sum representing the reduced rate VAT attributable to Scotland, the proportion of it to be assigned would be (2.5 ÷ RR), where RR was the number of percentage points in the reduced rate.
Contrary to popular belief, this doesn’t necessarily mean that half the VAT receipts raised in Scotland are to be assigned. If the UK unilaterally raises or lowers the standard rate or reduced rate of VAT, the proportion of Scottish VAT assigned to Scotland will change.
VAT raised in Scotland
An over-arching question is how to calculate VAT raised in Scotland. A possible methodology for this was discussed in a recent article by Charlotte Barbour, Director of Taxation at ICAS.
Draft proposals brought forward were based on the assumption that businesses operating across the UK would not be required to keep records of Scottish and non-Scottish VAT, since it would be unduly onerous for them to do so.
Instead, estimates of the Scottish share of VAT attributable to five distinct categories of expenditure – household, charities, central government, exempt businesses and housing – would be extrapolated from existing data, most of which is already publicly available.
By nature such estimates would be imprecise – possibly even volatile and unreliable. To illustrate this, estimates of VAT paid by all Scottish households (of which there are more than 2m) would be based on a survey of only 725 families. Hardly a very reassuring sample size.
Some of the difficulties likely to arise in assigning VAT to the Scottish Budget were discussed by the Scottish Parliament’s Finance and Constitution Committee at a meeting on 13 March, which was attended by a number of witnesses including Charlotte Barbour.
The fiscal framework
The latest version of the fiscal framework agreed between the UK and Scottish Governments stated that VAT assignment would be implemented in 2019/20. More recently it became clear that there would be a one-year transitional period from April 2019 to test the methodology.
The fiscal framework is to be reviewed periodically to ensure that it is fair, transparent and effective. The next review was to have followed the UK and Scottish Parliament elections in 2020 and 2021 respectively, informed by an independent report with recommendations presented to both Governments by the end of 2021.
Since then the UK general election of 2017 has reset the timetable for Westminster’s fixed-term Parliaments, and the next UK general election is not now due until 5 May 2022. It seems likely that the fiscal framework review will be postponed until after that date.
The latest concerns
In oral evidence presented to the Finance and Constitution Committee on 8 May, Scots Finance Secretary Derek Mackay expressed wide-ranging concerns about VAT assignment.
He spoke of a lot of issues around volatility, questions around Brexit, and margins of error. He explained that there would never be an out-turn statement on VAT, so there would be no reconciliations – they would always be comparing one set of estimates with another set of estimates.
On current estimates for 2020/21, £5.9bn of Scotland’s block grant – that is, around 15% of the total Scottish Budget – would be replaced by a broadly equivalent sum in respect of VAT revenues raised in Scotland. However, there are grave uncertainties about the Budget impact in succeeding years.
Mackay is now recommending that VAT assignment should be postponed until the fiscal framework comes up for review in 2022, to give both Governments time to assess the robustness of the VAT assignment model and to understand the impact of Brexit.
What will happen?
A press release of 14 May from the Fraser of Allander Institute provides valuable independent commentary on the Scottish Government’s dilemma. It concludes that VAT assignment as proposed would bring risk and complexity to the Scottish budget, without any upside in terms of policy flexibility.
It explains that the ‘actual’ out-turn of Scottish VAT receipts does not and never will exist. Accordingly, it argues that VAT assignment – based on using not very good data to estimate something that doesn’t actually exist – would be ineffective in enhancing the financial accountability of the Scottish Parliament.
Fraser of Allander concludes that fiscal devolution can be complicated, and that proposals for fiscal change must be resilient to challenge. It wonders whether VAT assignment will be abandoned altogether.
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