Scottish Government

Section 10: A Local Income Tax

Introduction

1. In section9, we concluded that only taxes on income and property merited detailed further consideration. In this section, we examine a tax on income. As discussed there, we received many expressions of support for a local income tax, particularly from those who assumed that their tax bill would fall compared with council tax.

2. Income tax is tax payable on earnings of employed and self-employed people and includes retirement and occupational pensions. Tax is also payable on unearned income, such as interest on savings and dividends on investments.

3. Three rates of tax currently apply to earned income: starting, basic and higher rates. Three rates (starting, lower and higher) also apply to interest on savings, while two rates (ordinary and higher) apply to investment dividends.

4. Income tax is deducted at source from certain types of income. Employers deduct income tax from the earnings of their employees at source under the Pay As You Earn ( PAYE) system, while banks and building societies also deduct income tax at the basic rate from interest on savings at source.

5. Where a taxpayer is liable to pay tax in respect of income received from other sources, for example from self-employment, they complete a Self-Assessment. Tax payable under Self-Assessment typically requires to be paid by 31 January following the tax year in question (tax years run from 6 April to 5 April).

6. A number of previous enquiries have considered the possibility of replacing or supplementing property-based tax with a local income tax. These have included Layfield and the Scottish Parliament's former Local Government Committee. In the past, converting the idea of a local income tax into a practical, viable and workable taxation scheme has proven to be the big challenge.

7. In this section, we examine issues about the design of a local income tax:

• How should a local income tax be assessed and collected (bearing in mind that a local income tax would not necessarily apply only to income subject to PAYE)?
• Should a local income tax have the same system of personal allowances and tax bands that currently applies to UK income tax or a different system?
• What income should be subject to local income tax?
• Should tax rates be set "locally" by each local authority for its own area (as council tax is now) or "nationally" by the Scottish Executive (as the non-domestic rate is now)?

8. These four issues are examined in turn.

9. We then assess how a local income tax might operate in practice, under the following categories:

• Local income tax rates;
• Administering a local income tax;
• Estimating the costs of a local income tax; and
• Other issues.

10. For the purposes of this report, we have assumed that a local income tax would be introduced only in Scotland. This assumption has a number of consequences, which are discussed later.

How could a local income tax be assessed and collected?

11. The administration of income tax has two key elements: assessment (or calculation) of tax liability, and collection of the tax. A local income tax could be assessed and collected either:

• In parallel with the UK income tax system; that is, by employers and HMRC in the case of income subject to the PAYE system, and by taxpayers and HMRC in the case of those taxpayers subject to Self-Assessment.
• By local authorities; or
• Through a universal system of Self-Assessment.

12. The most practical basis for collecting a local income tax would be through HMRC. For people in employment, this would result in the tax being collected by employers and remitted to HMRC through the PAYE system. Earners in self-employment would pay tax to HMRC under Self-Assessment.

13. Unlike those other countries (such as the USA) where all individuals complete a tax return, the UK income tax structure is designed to maximise the collection of tax at source and minimise the number of individuals who have to complete Self-Assessment returns.

14. Amongst the public (both participants in the focus groups conducted by GfKNOP and members of the public who responded to our consultation), there was a desire or an assumption that a local income tax should be integrated with the PAYE system, which people appear to trust. There appeared to be very much less enthusiasm for a local income tax administered either by local authorities as council tax currently is or through universal self-assessment.

15. A tax collected separately by local authorities would be more easily identifiable as a local tax than one collected by HMRC, given that local income tax payments could be less identifiable within payslips.

16. Nevertheless, we take the view that the system would be complex and expensive if responsibility for collection were to rest with local authorities. The capacity of local authorities to administer a local income tax was described well in a paper produced by CIPFA for the ODPM Balance of Funding Review. ¹⁶⁴ They remarked that, although local authorities have well developed revenue collection capabilities, these are not linked to income assessment processes (other than in administering Council Tax Benefit). There would be negative economies of scale were each council to operate their own administration operation. There would also be a need for a considerable training programme, accompanied by a recruitment drive for scarce resources experienced in tax administration.

17. We assess other issues relating to the administration of a local income tax later in this section.

Need a local income tax reflect the UK income tax structure?

18. We have considered whether a local income tax should necessarily be restricted to the tax structure that presently applies to UK income tax. For example, should a local income tax be subject to the same band thresholds and personal allowances as UK income tax?

19. With the exception of the Scottish Socialist Party ( SSP), no respondent suggested that a local income tax should depart from the UK income tax structure of allowances and tax bands. The SSP proposed a Scottish Service Tax that would have applied a distinct structure of tax bands. Their proposal was designed to achieve a redistribution of wealth within Scotland and the proponents of the Bill considered that a different tax band structure was an important means of achieving this. Beyond ensuring that a local tax applies in a way deemed to be fair to households of differing incomes and wealth, it is not part of our remit to consider the use of the local tax system as a means of achieving a redistribution of wealth.

20. There appears to be no compelling reason why different tax bands should apply across Scotland. The complexity and cost for employers and for HMRC in administering a series of local income tax arrangements, each with their own series of bands, would be immense.

21.UK income tax bands are settled, well understood and broadly accepted. Applying the same bands to both UK and local income taxes would ensure that the local income tax system was relatively easy to understand.

What income should be subject to a local income tax?

22. Given that support for a local income tax appears to be based on its perceived greater "fairness", it follows that fairness requires the tax to be levied on all income, so that people whose income comes from one source should not be at a disadvantage to those whose income comes from another source or sources. However, to include different types of income within the scope of a local income tax makes it more complex and expensive in terms of its assessment and the costs of collection.

23. A local income tax should cover all income to maximise the tax base, so that the desired overall tax yield is obtained by the lowest possible marginal tax rate.

24. As Figure 10.1 below shows, UK income tax payments in 2006-07 are estimated to total £131 billion. Since approximately 7.3% of UK income tax is attributable to Scotland, ¹⁶⁵ we estimate that £9.58 billion of income tax payments will be attributable to Scotland in 2006-07.

Figure 10.1: Projected UK income tax payments 2006-07 ¹⁶⁶

25. Figure 10.2 shows the projected number of taxpayers in Scotland. It also subdivides them, according to the marginal tax rate at which their next £1 of earnings would be taxed. The "savers" rate category includes taxpayers whose next £1 would be taxed at either the lower rate for savings income or the ordinary rate for dividends. The higher rate category includes taxpayers whose next £1 would be taxed at higher rate, and includes all earned income, savings and dividends at that rate.

Figure 10.2: Projected number of taxpayers in Scotland 2006-07¹⁶⁷

Earned income at starting rate

26. There is no reason in principle why a local income tax should not apply to earned income at starting rate. However, in terms of yield, the effect of including earned income at starting rate would be modest: £13 is raised in UK income tax from earned income at basic rate for every £1 that is raised from earned income at starting rate.

27. If a local income tax was being considered for earned income at starting rate, careful consideration would have to be given to its overall effect on low income households. Depending on where respective rates were set, it is possible that some households could actually find their net income decline as their earnings increased, once increased UK and local income tax and national insurance contributions had been deducted and reduced benefit payments were taken into account.

Earned income at basic rate

28. Earned income at basic rate provides the core of income tax revenue (56.6% of UK income tax liabilities, and probably a higher proportion of liabilities attributable to Scotland). We have assumed that any practicable proposal for a local income tax would include earned income at basic rate.

29. A local income tax administered by employers and HMRC limited to earned income at basic rate would be the most straight-forward version to introduce.

The Scottish Variable Rate as a proxy for a local income tax

30. The Scottish Parliament already holds a limited power to vary UK income tax (the SVR). While the SVR is not itself a local income tax, we have briefly considered whether it could be used as a proxy for one.

31. The SVR only applies to earned income at basic rate; tax at this rate can be varied (up or down) by up to 3 pence in the pound. Even if raised by the full 3 pence, SVR would only raise around 40% of the taxable income currently collected through council tax (an estimated £810 million in 2004-05 ¹⁶⁸, compared with council tax income that year of £1.960 billion ¹⁶⁹). Use of the SVR in this way would deprive the Scottish Parliament of the opportunity to use it in any other way.

32. The fact that the SVR applies only to earned income at basic rate reflects the model set out both in the Scotland White Paper ¹⁷⁰ and the 1995 proposals of the Scottish Constitutional Convention. ¹⁷¹ Heald and Geaughan ¹⁷² reported contemporary criticism surrounding the absence of a tax liability at higher rate which, it was claimed, would result in higher rate taxpayers paying a lower proportion of their income under the SVR than many basic rate taxpayers. Heald and Geaughan also set out why the Scottish Constitutional Convention and then government might have decided to propose the tax-varying power in this way. They argued that it was appropriate to focus on people's total tax contributions, rather than what was paid under any one type of tax. They also pointed to a risk of potential economic disadvantage for the finance and other industries in Scotland.

33. We recognise that there are two key differences between the SVR and a local income tax. First, the SVR is a discretionary power: the Scottish Parliament can decide whether or not to use and has a practical choice to vary the level of any SVR it applies in line with policy objectives of the day, subject to the maximum variation permitted by the Scotland Act 1998 of ±3%. In contrast, local taxation is a core and long-term element of the overall basket of taxes. Second, as discussed above, even the maximum potential yield from the SVR is significantly less than the revenues that are currently collected from non-business local taxes.

Earned income at higher rate

34. Perceived fairness requires the inclusion of income taxable at the higher rate within the scope of a local income tax. Earned income at the higher rate provides around 30% of UK income tax liabilities, although it is likely its contribution towards those liabilities attributable to Scotland would be less than this.

Income on savings and investments

35. A particular issue arises in relation to income on savings and investments, which together account for 8.6% of projected UK income tax liabilities for 2006-07 (although less in Scotland ¹⁷³).

36. Different types of tax collection arrangement would need to be introduced to deduct a local income tax element from different kinds of investment income. In relation to savings interest, financial institutions currently deduct a 20% flat rate for all taxpayers, while a tax credit of 10% is currently deducted from company dividends, which eliminates any basic rate liability. In both cases, higher rate taxpayers pay additional liability via Self-Assessment returns. Collection arrangements for a local income tax on interest on savings and investment income would have to match income to individuals (which could be difficult, e.g. in relation to nominee and joint accounts). Any development which increased the need for
Self-Assessment procedures would operate counter to established Government policy, which is to provide for as much tax as possible to be deducted at source.

37. In their evidence to the ODPM Balance of Funding Review, CIPFA concluded that:

"taxing investment income raises many problems, none of which appear to be capable of being satisfactorily resolved within reasonable cost". ¹⁷⁴

38. The UK Government considered in 1997 whether the SVR should apply to this income. They concluded that "savings and dividend income should in future remain exempt from any income tax variation power, in order to ensure that such income is taxed on a consistent basis throughout the UK, thus avoiding economic distortion." ¹⁷⁵

39. We consider later in this section the possible costs of applying a local income tax. Available evidence suggests that a tax on unearned income could prove very expensive to operate, relative to the tax receipts it could produce.

40. In line with the conclusion of CIPFA and evidence that was given to the Scottish Parliament's former Local Government Committee on this point, ¹⁷⁶ the only practicable option is that a local income tax should be applied only to earned income. However, this conflicts with the principle of fairness.

Who Should Set Local Income Tax Rates?

41. A question for a local income tax concerns how tax rates should be set: whether local authorities should have discretion to set tax rates to cover their own residents, or whether the Scottish Executive should set a standard rate of tax that applied throughout the country.

42. A local income tax would be more readily identifiable as a local tax if the rate was set by the local authority than if a standard rate was applied across Scotland as a whole. Both the Scottish Liberal Democrats and the Scottish National Party envisage it to be a locally-set tax. So too do the local authorities that expressed to us their support for a local income tax (the Scottish Socialist Party envisaged their proposed Scottish Service Tax would be set centrally). Overall, however, this preference for a locally-set tax appears to be predicated on the belief that it is an essential feature of local accountability.

43. As discussed in section7 above, the ability to raise taxes locally has not been a particularly important element of local accountability as perceived by local residents. We further question how visible any local income tax might be if much of it was collected via PAYE, where it might be hidden within payslips alongside other elements such as UK income tax, National Insurance and pension contributions and charitable deductions.

44. A separate issue relates to the effect on the broader economy of a local tax-raising power. Applying a higher rate of local income tax could result in certain behavioural changes among taxpayers. These are discussed in greater detail below. At this point, it is worth noting that the effect of these changes may be different, depending on whether a local income tax was applied at a single rate across Scotland or at different rates in each local authority area.

45. The other significant factor relates to the relative costs of operating a locally-set or nationally-set variant of a local income tax. A local income tax set by local authorities and potentially offering the prospect of 32 different tax rates would be significantly more complex and expensive to administer. Management systems used by HMRC and employers might need considerable development to cope with these complexities, which include problems associated with tracking residency. We consider these extensively later in this section.

Local income tax rates

46. We have assumed that any replacement tax should raise the same amount as local authorities receive in council tax, including from households in receipt of Council Tax Benefit. In their modelling work for our review, the University of Stirling calculated an approximate Scotland-average local income tax that might be payable in 2006-07 under a range of scenarios. They estimated that the tax rate would be around:

• 7.9% if applied only to earned income subject to income tax at basic rate;
• 6.5% if applied to earned income subject to income tax at basic and higher rates; and
• 5.7% if applied to all income (earned and unearned). If an amount equivalent to the Council Tax Benefit paid in Scotland were paid to local authorities as an additional grant, then the estimated rate of a local income tax which applied to all earned and unearned income would be approximately 4.5%.

47. The modelling work could not provide robust evidence on the differential effects of a local income tax according to the circumstances of particular households. The range of variables that would affect tax liability - e.g. council tax band, local authority area, whether a single person's discount applies, the number of working adults and the taxable income of each - is so great that it is extremely difficult to say definitively which households would benefit from the replacement of council tax by a local income tax. The burden could fall most heavily upon families with more than one working adult. For example, a household with two adults each earning £20,000 and currently paying an average £1,129 council tax for an average Band D home would instead pay around:

• £2,020 local income tax, if the tax applied only to earned income at basic rate (the 7.9% rate); or
• £1,670 local income tax, if the tax applied to earned income at basic and higher rates (the 6.5% rate); or
• £1,710 local income tax, if the tax applied to all income, including earned income at starting rate (the 5.7% rate).

48. As stated in section9, the demographic complexion of Scotland is changing, with the number of people of working age projected to decline by 15% - more than half a million - by 2040. Such a trend might affect the size of the tax base and, consequently, the rate that would be payable under a local income tax.

49. The potential narrowing of the tax base creates the risk of placing a further burden of funding upon existing income tax payers. The results would be resistance, including a disincentive to work or efforts to avoid payment from among those who are liable to pay income tax.

Administering a local income tax

50. Many of the respondents to our consultation who expressed support for a local income tax referred to the convenience of PAYE as a mechanism for collecting. They placed an assumed trust in the PAYE system to be able to cope smoothly with a local income tax bolted onto existing income tax arrangements.

51. In practice, how straight-forward a local income tax was to administer would to a large extent depend on the precise features of the model introduced. Nevertheless, it is apparent to us that preparing for and operating such a tax would place significant new demands upon employers and HM Revenue and Customs. For taxpayers, the introduction of a local income tax may require changes in how they pay their tax.

52. In the following paragraphs we consider issues concerning the administration of a local income tax in practice. In doing so we have drawn largely from an assessment of the practical implications of different models of local income tax, produced by a former Deputy Chairman of the Board of the Inland Revenue in 1992, ¹⁷⁷ as well as a more recent examination by CIPFA. ¹⁷⁸

53. We have not asked HMRC to provide us with a detailed evaluation of how certain models might operate in practice and the associated costs of administration. We have benefited from informal discussions with HMRC on a number of points and are grateful for the assistance they have been able to provide. However, the views in this section are the Committee's own.

54. It is worth noting a feature of how the UK income tax system deals with employment income. Many countries operate an approach to deduction of taxes during the year which relies on taxpayers completing a tax return at the end of the tax year, as a result of which they either pay any tax due or claim a refund of tax overpaid.

55. The UKPAYE system is designed to collect the right amount of tax from week to week, and month to month throughout the tax year. As a result, the individual should end the year with no tax owing and no tax repayment to claim. It is a system that seems to appeal to taxpayers, most of whom are not required to deal directly with HMRC. Around 9 million of the total 31 million taxpayers in the UK are currently required to complete Self-Assessment returns. ¹⁷⁹

56. However, the workability of PAYE arrangements depends on HMRC and employers being able to apply the right reliefs and allowances and deduct the right amount of tax at each given point of the year. It is a system that relies on a series of tax codes that reflects these reliefs and allowances.

57. In the following paragraphs we explore administrative issues in more detail, under the following categories:

• Predicting yield;
• The tax assessment and collection cycle;
• Residency issues;
• Precision of tax rate; and
• Role of employers in administering a locally-set tax.

58. This discussion is not designed to provide an exhaustive assessment of the types of administrative issue that would have to be resolved. There would inevitably be a substantial volume of matters of important detail. A technical consultation paper produced by the Inland Revenue in 1998 about the operation of the SVR illustrates the extent and nature of some of the issues that would have to be considered in relation to a local income tax. ¹⁸⁰

Predicting yield

59. Local taxes are used to meet the spending needs of local authorities. A local authority cannot budget for a deficit for day-to-day spending purposes. As a result, councils need to be able to predict the yield of a local tax in any given year with a degree of certainty.

60. In the case of a local income tax, the actual yield could either exceed or fall short of expectations, depending on the number of taxpayers living in a local authority area and their levels of taxable income which would be affected by local economic circumstances. This would require authorities, as part of their budgeting process, to make the best assessment they could each year of those two factors. It might be necessary to consider a role for the Scottish Executive in topping up shortfalls in yield in lean years, although this in turn might necessitate detailed involvement by the Executive in scrutinising councils' initial predictions of local income tax yield.

61. Local authorities' budgeting processes could potentially be easier if they were supplied (either directly by residents or by HMRC) with information about the likely income of their residents in the year ahead. However, we think that supplying local authorities with what at the moment is confidential information about incomes would be unacceptable to the public. In any event, many taxpayers would find it difficult to predict their future income accurately.

The tax assessment and collection cycle

62. At present, households are notified in February or March of their council tax bills for the financial year commencing on 1 April.

63. A slightly longer timetable applies to the annual updating of income tax codes under the PAYE system. HMRC determines tax codes in January or February and notifies employers of these before the start of the new financial year. These tax codes can then be adjusted as necessary to take account of the Budget in March. Employers then apply these tax codes to take effect in the pay period following mid-May.

64. If a local income tax is to be deducted from earned income through the PAYE system at the same time as UK income tax is collected, sufficient time would have to be given for local income tax rates to be confirmed and notified to employers. This would be a particular issue in the case of a locally-set tax, if local authorities had to decide upon their tax codes and then notify HMRC, which would collate a potentially large number of different tax codes for dissemination in turn to employers.

65. Overcoming this pressure would probably require one or more of the following measures to be taken:

• local authorities bringing forward their budget timetables (with implications in turn for the timing of announcements by the Executive of the local government finance settlement for the following year);
• obligations upon local authorities to produce and manage a balanced budget being relaxed;
• tax collection arrangements taking account of a potential delay in tax codes being confirmed. These adjustments might include applying provisional tax codes at the start of the year with in-year adjustment once tax codes had been confirmed, delaying commencement of collection of local income tax until these tax codes had been confirmed, and making end-year adjustments of tax liabilities.

66. Particular issues relate to the self-employed. In 2003-04, around 13% of earned income in the UK and 11% of earned income in Scotland was self-employment income, with 3.5 million UK taxpayers and 243,000 Scottish taxpayers earning income from self-employment. ¹⁸¹

67. Under Self-Assessment, tax liabilities for self-employed earners are calculated on the taxable profits arising in the current tax year. If the accounting period for the business is different from the tax year, then tax is calculated on the profit arising in the 12-month accounting period ending in the tax year. Taxpayers are required to complete a Self-Assessment return for the year in question by the following January. Two payments on account, based on tax payable in the previous tax year, are normally made prior to the submission of the Self-Assessment return. In light of this return, the taxpayer either receives a refund of any overpayment made in the payments on account or has to pay any additional tax due.

68. The impact on a local income tax is that it is not possible to collect all non- PAYE revenues in the tax year to which they relate. This raises potential cash flow issues for local authorities, especially in the first year of operation of a local income tax.

Residency issues

69. A decision would have to be taken as to whether a local income tax should be payable according to a person's place of residence or where they work. Place of residence is probably simpler to define (not least for temporary and peripatetic workers). It equates with the present local council tax system and it provides a link between a taxpayer and services provided for their household in the area where they live. Among those respondents to the consultation who referred to the issue, place of residence was also the preferred basis for assessment.

70. However, the current UK income tax system is not organised on the basis of where a taxpayer lives. The information that HMRC holds about people who pay tax only through PAYE is the information that employers are required to provide to HMRC. HMRC systems recognise Scottish postcodes for the purpose of determining whether the address is either in or outwith Scotland. Employers are not currently required to tell HMRC when their staff move home.

71. The administration of a locally-set local income tax could require the compilation, updating and enforcement of a register of taxpayers for each local authority area. In evidence to the Scottish Parliament's Local Government Committee, Stephen Smith suggested that "with a local income tax, there would be more places with different rates than if there were simply a single different income tax rate in Scotland, so there would have to be more micro-level enforcement of residence declarations". ¹⁸²

72. Employers and HMRC would have to track the movements of these residents in order to know what rate of local income tax they would be liable to pay. In the case of a nationally-set tax, the point at issue would be whether or not the taxpayer lived in Scotland. Under a locally-set local income tax, it would be necessary to identify the local authority area in which the taxpayer lived. Experience from the community charge which was attached to a potentially mobile individual rather than a fixed property indicates that a large number of people move home each year, often to a different local authority area.

73. A range of additional refinement to tax codes would be required to distinguish the council area within which each taxpayer lives. In order to associate a correct tax code to each taxpayer, HMRC would have to identify and maintain records of each taxpayer's home address. This, in turn would place a new obligation upon taxpayers and/or their employers to notify HMRC when their address changed.

74. We understand that HMRC has already been giving thought to this issue in considering how the SVR might operate. Postcode would be the identifier for assessing which taxpayers resided in Scotland and so were affected by the SVR. However, people may have various postcodes (including c/o addresses) if they have more than one residence, so a reconciliation exercise would be required to ensure that each tax record had the correct postcode allocated to it.

75. This reconciliation task would be significantly more complex for HMRC in the case of a locally-set local income tax. SVR requires taxpayers to be distinguished between those who are resident in Scotland and those who are not. This locally-set local income tax model would oblige HMRC to do this and also correctly identify which of the 32 local authority areas each taxpayer resides within.

76. This alternative scenario would place a substantial obligation upon employers to assess local income tax liabilities for their employees, by requiring them to apply a series of tax tables varied according to the particular tax rate applied by each local authority in which their staff reside.

77. Other complicating factors arise. One is how to treat taxpayers who move home during a financial year, either in or out of Scotland or (in the case of a locally-set tax) between two council areas in Scotland. The choice lies between basing residence for the whole year on the basis of where a person lived on a particular date ( e.g. 31 March each year), or apportioning liability more precisely according to the amount of time in which the taxpayer lived at each residence during the year. AJG Isaac noted that most countries apply the former option. ¹⁸³ The choice is one of simplicity or precision. So that the correct tax code was applied to any particular year, it might be necessary for residence on a particular date to relate to a date
in the preceding financial year. Equally, if liability was apportioned in accordance with where the person lived during a particular year, an end-year adjustment of tax liability might be required to make any necessary corrections.

78. Another factor relates to the treatment of those taxpayers who do not have a fixed address and also those who have more than one home. Arrangements and working assumptions would have to be set in place to deal with both types of situation.

Precision of tax rate

79. Local authorities set council tax rates each year at a level that will meet an anticipated funding need quite precisely. Income tax operates on a different scale. As AJG Isaac said: "Income tax yields big money". ¹⁸⁴

80. This creates a potential tension as to how precisely local authorities should be permitted to set a local income tax under a locally-set system. Simply increasing a local income tax rate from 6.5% to 6.6% would be akin to raising council tax by 1.5%. Permitting local authorities to vary the income tax rate by smaller fractions might enable them to target the rate more precisely to the desired yield (subject to the fact that the unpredictable nature of income tax at a local authority level and especially in the case of authorities with a small population would make it harder to forecast yield accurately than under a council tax). However, it would also make the tax regime more complex and require employers and HMRC to handle a potentially large number of different tax rates.

Role of employers in administering a locally-set tax

81. The Institute of Chartered Accountants of Scotland ( ICAS) expressed concern about the administrative costs, including on business, and cross-border difficulties for UK-wide companies, if a locally-set tax were introduced. ICAS had fewer concerns about a nationally-set tax. In their oral evidence, the Confederation of British Industry in Scotland ( CBI Scotland) expressed concern about the possible effects on business of a local income tax. They too were concerned particularly about a locally-set tax.

82.CIPFA explained that there would be potential difficulties for employers in administering a local income tax, in light of consultation with the CBI and the Institute of Payroll and Pensions Management ( IPPM). ¹⁸⁵ The extent of this additional burden would depend on the number of tax rates involved and the nature of the employer. For example, a higher burden might apply to employers with staff living in all council areas, in cities to where staff might congregate from a number of authority areas, those with high staff turnover or a large proportion of casual, short-term or seasonal workers, and smaller firms running manual payrolls.

83.CIPFA reported that the capacity of current IT system to deal with a number of different local income tax rates would be a major issue. They referred to CBI as being of the view that current IT capacity may only be able to deal with 3 or 4 rates.

Estimating the costs of a local income tax

84. We have assessed the possible costs of introducing a local income tax. The estimates assume that:

• a local income tax replaces council tax;
• tax liability would be based on place of residence rather than place of work; and
• a local income tax would not be applied to earned income subject to the starting UK tax rate. No account has been taken of any additional costs of applying a local income tax to that income.

85. Costs of setting up and running a local income tax system would vary depending both on what taxable income was subjected to local income tax and on whether the tax rate was set nationally or locally.

86. As a general rule, we anticipate that the Scottish Executive would be expected to compensate HMRC and the Department of Work and Pensions ( DWP) for any costs they incur in setting up and operating a local income tax scheme that applied to Scotland only. Businesses would be expected to bear any costs they incurred themselves without compensation from the Executive.

87. We consider cost issues in turn under the following headings:

• savings from the abolition of the council tax;
• costs of a local income tax which applied only to earned income subject to the basicUK tax rate and which was nationally set;
• costs of a local income tax which applied only to earned income subject to the basicUK tax rate and which was locally set;
• costs of a local income tax which applied to earned income subject to both the basic and higherUK tax rates and which was (a) nationally set or (b) locally set; and
• additional costs of applying a local income tax to income from savings and dividends as well as earned income.

Savings from abolition of the council tax

88. The abolition of the council tax would produce savings for both Assessors, who would no longer have to maintain the Council Tax Valuation List, and local authorities, who would no longer have to collect the tax. However, local authorities would still have to collect non-domestic rates and administer the Housing Benefit Scheme.

89. The Scottish Assessors' Association told us that, if Assessors were no longer required to maintain the Council Tax Valuation List, the reduction in their workload might produce savings of around £6.5 million per annum to their current annual budget of £37 million. Even if council tax were abolished, Assessors would remain responsible for maintaining the Valuation Roll of non-domestic properties and, except in one council area, electoral registration.

90. In addition, there would be a savings of around £35.6 million per annum as a result of local authorities no longer having to collect the council tax. So in aggregate, the abolition of the council tax could produce savings of around £42 million per annum.

Costs of a local income tax which applied only to earned income subject to the basicUK tax rate and which was nationally set

91. This option mirrors the SVR, the set-up and running costs of which were estimated in the 1997 Devolution White Paper. Updating the figures, we estimate that the costs of this option would be as follows.

92. Set-up costs. These would be around £12 million for HMRC, £7 million for DWP (both of which might require to be compensated for by the Scottish Executive) and £55-60 million for employers (although these costs could be phased). HMRC have already taken steps to prepare for the possibility that the Scottish Parliament might want to use the SVR power. As a result, the additional costs which HMRC would incur in implementing this local income tax option should be modest, as the basis for calculating the tax should already be built into the systems of HMRC. Employers would have to incur the above noted additional costs.

93. Running costs.HMRC, DWP and employers would incur running costs. We estimate that these costs might be similar to those estimated for the use of the SVR itself. When the Scotland Bill was introduced to Parliament in December 1997, these costs were estimated at £8 million per annum for what is now HMRC, £1 million per annum for DWP and around £6-15 million per annum for employers. ¹⁸⁶ At today's values, these costs would be slightly higher. We estimate a total of £10 million for HMRC and DWP, and £7-18 million
for employers.

Costs of a local income tax which applied only to earned income subject to the basicUK tax rate and which was locally set

94. The system requirements for HMRC and employers would be significantly more complex under this option given that they would be faced with up to 32 different local income tax rates. As a consequence, both set-up and running costs would be significantly higher than those for the previous option.

Costs of a local income tax which applied to earned income subject to both the basic and higherUK tax rates and which was (a) nationally set or (b) locally set

95. Under both of those options there would be additional set-up and running costs for HMRC, DWP and employers as extending local income tax to earned income subject to the higher UK tax rate would require the development of new systems beyond those which HMRC have already put in place for the SVR. For the ODPM Balance of Funding Review, ¹⁸⁷CIPFA calculated the annual collection costs to HMRC for a UK local income tax would be £120 million to £260 million. We assume that the Scotland-only cost would be about 10% of this range ( i.e. £12 million to £26 million).

96. We have estimated the annual additional costs to employers to be £17-28 million. This is the £7-18 million estimate already referred to, with an additional £10 million which represents 10% of the additional £100 million cost to employers estimated by CIPFA for a UK-wide variable local income tax. There are two partly compensating factors to consider for the purposes of this estimate. One is that the figure might under-estimate the actual cost of this tax to employers, as many businesses based elsewhere in the UK either would or could have employees living in Scotland. The other is that this figure might over-estimate the actual cost to business, if the component parts included an element of double-counting.

Figure 10.3: Estimated net annual costs or savings of assessing and collecting a local income tax (applying to earned income; assessed and collected by HMRC)

97. These cost estimates should be treated with caution. In practice, the figures are likely to under-estimate the cost for HMRC in administering a local income tax, given that HMRC would need to administer a variable local income tax for Scotland for UK-wide employers who may have Scottish resident employees.

Additional costs of applying a local income tax to income from savings and dividends as well as to earned income

98. A universal self-assessment approach could be adopted to bring investment income within the scope of local income tax. It would add substantially to the cost of tax collection: CIPFA quoted to the ODPM Balance of Funding Review a broad estimate of an additional £1.3 billion per annum to current income tax collection costs at a UK level - possibly even exceeding the expected yield from this source. ¹⁸⁸

Other Issues

Economic and behavioural effects of a local income tax

99. We have considered the possible effect of a local income tax on people's behaviour and on the broader economy. Quantifying the effect is extremely difficult. Many studies have produced conflicting findings. Moreover, it is difficult to draw lessons about effects of a local income tax for Scotland from experiences in other countries, where different circumstances and different tax rates apply.

100. A local income tax may have possible effects on the following:

• Propensity to work;
• Fiscal flight;
• Incorporation by the self-employed;
• Growth and GDP;
• Entrepreneurship; and
• Overall tax receipts.

101. Propensity to work. A local income tax system will raise marginal income tax rates for the majority of people. Unless compensated for by increases in wages, this will have an effect on reducing net earnings and might in turn reduce work incentives. Conversely, abolition of council tax might improve work incentives for some lower-income workers and unemployed people, as the marginal tax payable under income tax would be less steep than the 20% marginal tax rate that applies to Council Tax Benefit above the income threshold for 100% benefit.

102. Fiscal flight. If a highly progressive tax system was introduced in Scotland alone, then this might create an incentive for higher income earners to migrate to a lower-taxed region. If such "fiscal flight" occurred, it would have implications for the availability of skilled and enterprising people in high-tax areas. Employers may face pressure to increase wages for higher earning staff to offset this effect.

103. A similar effect might occur if the level of taxation varied substantially between two local authority areas.

104. There appears to be little empirical evidence on fiscal flight. Kay and King have suggested that there is no strong evidence of fiscal flight between countries, suggesting that "for most people, the ties of family, home, culture and language outweigh fiscal incentives to work in other countries". ¹⁸⁹ However, fiscal flight within countries may be more prevalent, given proximity, common language and similar culture. For instance, Bakija and Slemrod found evidence of income-rich and wealthy people moving from higher-taxing to lower-taxing states in the United States (this report found an association for inheritance and property taxes, as well as income tax). ¹⁹⁰

105. In the case of a local income tax for Scotland, a 6.5% local income tax on basic and higher rate earned income might cost around £6,000 for a person earning £100,000 per year. It is difficult to assess how significant an incentive that level of additional tax would be for fiscal flight. Even if movers were modest in number, the effect on overall tax receipts could be significant since a high proportion of income tax receipts come from a small proportion of the highest income earners.

106. Incorporation by the self-employed. Self-employed people can incorporate their business as a limited company or operate it as an unincorporated business. In taxation terms, a key difference is that profits by unincorporated businesses are payable through personal income tax, while profits by limited companies are payable through corporation tax.

107. Changes to the relative tax rates for income tax and corporation tax can make incorporation either more or less attractive to the self-employed. At present, no corporation tax is payable on the first £10,000 of company profits; the next £300,000 of profits is then taxed at 19%.

108. Depending on the rate at which it was set, the introduction of a local income tax could create an incentive for many self-employed people to incorporate where doing so would reduce the overall tax liability of their business. Incorporation would take the profits concerned outwith the scope of local income tax and consequently reduce overall local income tax yield.

109. Growth and GDP. Most studies ¹⁹¹ have concluded that GDP levels and/or GDP growth is negatively affected by high marginal tax rates.

110. Entrepreneurship. There is limited evidence ¹⁹² that high marginal tax rates discourage entrepreneurship.

111. Overall tax receipts. The concept known as the "Laffer Curve" provides a theoretical association between marginal tax rates and tax yield. On a simply arithmetic basis, increasing the tax rate ought to produce additional tax receipts. However, as the tax rate increases, so the incentive to work, save or invest will fall or people will become more likely to take action to avoid or mitigate tax liability. Even if the principle of the Laffer Curve is accepted, however, it is difficult to judge the effect in Scotland at any given income tax rate.

Powers to operate and enforce

112. An issue arises as to whether HMRC could administer a local income tax in Scotland, if asked to do so by the Scottish Parliament, without the need for separate Westminster legislation. Legal advice we have received indicates that Scottish Ministers and Commissioners of HMRC can enter into voluntary arrangements over the handling of their respective functions. While the collection of local taxes is not a function of Scottish Ministers but of local authorities, legal advice is that this difficulty could be addressed through legislation in the Scottish Parliament.

113. To manage the collection of an important source of revenue through the continued co-operation of HMRC in a voluntary arrangement is not a robust basis for doing so (in practical, if not legal, terms).

114. The legal advice we have received states that there would be nothing in law to prevent the Scottish Parliament from conferring functions and duties upon HMRC. However, it is likely that HMRC does not currently have the power to undertake any such functions and duties that the Scottish Parliament might impose upon it (since HMRC does not at present collect any local tax). This power could be conferred by an Order in Council.

115. Nevertheless, while the Scottish Parliament may be able to confer powers and functions upon HMRC (with or without an Order in Council), our legal advisers find it difficult to envisage how either the Scottish Parliament or Scottish local authorities could force HMRC and other UK authorities to carry out these functions.

116. A related issue concerns whether HMRC could compel employers outwith Scotland to co-operate in the administration of a local income tax that applied only to Scottish residents. Legal advice we have received indicates that regulations approved by the Westminster parliament might be necessary to give HMRC the necessary enforcement powers.

Preparatory arrangements

117.CIPFA suggested that, realistically, a minimum timescale of 4 years might be necessary before a local income tax for the UK could become operational. ¹⁹³ We consider this to be an ambitious target, especially in relation to a local income tax for Scotland alone.

118. Preparation for a local income tax for Scotland would have three principal elements:

• preparation and passing of legislation at Holyrood;
• preparation and passing of supporting legislation at Westminster; and
• systems development, training and other preparatory work by HMRC and employers.

119. We anticipate that a period of at least 2-3 years would be required for the first stage. This would involve the development of policy proposals, followed by the drafting of legislation. A process of consultation would be required, preferably in relation to both the policy proposals and the draft bill, but at least for one or other of these. Once a bill is introduced to Holyrood, the process for Parliament to scrutinise, amend and ultimately pass it (with Royal Assent following) will typically take 6-12 months.

120. The timing of supporting legislation by the UK Government at Westminster would be subject to the will of the Government and Parliamentary authorities there. The fact that the necessary measures could be introduced by regulation, without the need for primary legislation, potentially both eases the hurdle of securing willingness and space to introduce the draft measure to the parliament there and reduces the time required to complete the Parliamentary process.

121. For the final stage, CIPFA estimates that HMRC and employers might require one year for systems preparation and, in parallel, two years for consultation (in the case of HMRC) and testing. A local income tax for Scotland only, or in different form for Scotland, would be more complex, as it would require HMRC and employers to operate two different systems for residents in different parts of the UK. Realistically, this stage might require 3 years to complete. It would not be practicable for this work to commence until the necessary legislative steps at Holyrood and Westminster had been completed, and the precise features of the tax envisaged were clear.

122. Overall, we anticipate a reasonable timescale to be likely to be at least 6 years before a local income tax for Scottish residents could be operational. Given the likely complexity of such a local income tax scheme, careful consideration would have to be given to the trade-off between the timing of implementation on the one hand and, on the other hand, producing a programme which is long enough both to optimise the prospects of successful implementation and to prepare taxpayers for change.

123. As part of the preparatory work, consideration would have to be given to protecting the cashflow position of local authorities in the initial period of a local income tax, given likely delays in obtaining income from self-employed earners and in confirming the tax liability of people in employment.

Equalisation

124. An important part of the methodology for the distribution of Aggregate External Finance to local authorities is the equalisation of each authority's tax base. Because of the unpredictability of tax yield at a local authority level, equalisation of the tax base could be difficult with a local income tax. This is discussed in detail in section19.

Treatment of second homes

125. In the case of the taxpayer with more than one home, a separate policy decision would have to be taken as to whether they should be liable to a secondary charge on top of their local income tax liability payable to the local authority area of their main residence. The Scottish Liberal Democrats told us in their oral evidence that they propose the retention of a property tax to cover second homes, either using the existing council tax as a proxy for the property or by aligning such properties with the non-domestic rates system. The latter proposal could treat second homes as if they were commercially rented properties.

Local income tax as a supplementary tax

126. Feedback we have received from members of the public who participated in the deliberative focus groups organised by GfKNOP, and who responded to our earlier consultation, reveals greater support for local income tax as a replacement for council tax than as a supplementary tax. The focus groups revealed some perceived association between the number of types of tax in operation and the total amount collected in tax, believing that a system with more than one type of local tax would increase the total tax yield.

127. As a matter of principle, it is our view that the local tax system should be kept as simple as possible. Local government receives most of its funding through UK taxes and it is impracticable to replicate the UK basket of taxes in a local tax system. Applying two or more types of local tax complicates the local tax system and increases the operational costs. We recognise there may be presentational advantages to considering a supplementary local income tax alongside a property tax, to provide a demonstrable link between local tax and income. However, the problems associated with a supplementary local income tax outweigh its benefits.

128. We asked the University of Stirling to model for the effects of a hybrid tax which would raise the same amount as council tax presently does by combining a local income tax set at 3% of earned income at basic rate with a property tax. Not surprisingly, the results of this modelling were that the hybrid tax was more progressive than a pure property tax but less so than income tax.

129. We state elsewhere that achieving a particular balance of funding should be a low priority. If it were felt important to introduce an income-related element to local taxation, it is our view that only the property element should be locally-variable. Based on the figures above, the cost of introducing and running a locally-set income tax would be substantial and - especially in the case of a supplement to another local tax - out of proportion to its likely yield.

130. We estimate the costs of a supplementary income tax to be similar to the cost of introducing and operating a local income tax which replaced council tax, but without the savings associated with abolishing council tax. Consequently, using figures from Figure 10.3 above, we estimate the annual operational costs to be in the region of £17-24 million per year in the case of a nationally-set tax and £29-54 million per year in the case of a locally-set tax.

Future of Council Tax Benefit

131. A total of £345 million was paid in Scotland as Council Tax Benefit in 2004-05. ¹⁹⁴

132. Funding and policy responsibility for Council Tax Benefit rests with the Department of Work and Pensions for Great Britain as a whole. Council Tax Benefit shares eligibility rules and administrative arrangements with Housing Benefit, for which DWP is also responsible. However, it does mean that, while the Scottish Parliament has powers over local taxation in Scotland, powers over local tax benefit policy are reserved to the Westminster Parliament.

133. If in Scotland the council tax were replaced by a local income tax, Council Tax Benefit would cease. We were requested by the Scottish National Party to make a recommendation that the funding presently received as Council Tax Benefit should continue to flow to Scotland. However, we have not considered this in any depth, because it is a political issue which the Scottish Executive would have to pursue with HM Treasury and the Department of Work and Pensions.

Conclusions

134. Local income tax has been considered at length by previous inquiries, such as Layfield in 1976 and the Scottish Parliament's Local Government Committee in 2002. It is the preference of the Scottish National Party, Scottish Liberal Democrats and many of our respondents. In particular, income tax is a tax that is well understood by the public and generally trusted as being fair.

135. In this section, we have considered various forms of local income tax. We concluded that any local income tax system, for practical reasons, would need to operate in parallel with the UK income tax system. As a result, a local income tax should use the same allowances and tax bands as apply to UK income tax. A local income tax should be assessed and collected using arrangements already in place for UK income tax, including the PAYE and Self-Assessment processes.

136. As a tax that would contribute towards the cost of local authority services, it seems that liability to a local income tax should be based on a person's place of residence, rather than their place of employment. However, HMRC does not compile, update or validate address records for most taxpayers at present. To introduce such a requirement would significantly increase the complexity and cost of a local income tax system.

137. To be "fair", a local income tax should apply to all taxable income. However, while excluding income on dividends and savings would detract from the fairness of a local income tax, the cost and complexity of including them would be substantial. It is arguable that a local income tax applied, like the SVR, only to earned income at basic rate would be less "fair".

138. A nationally-set local income tax would be less complex and cheaper to apply than a locally-set tax (an estimated annual cost of £17-28 million for operating a nationally-set tax and £29-55 million for operating a locally-set tax, both offset by an annual saving of approximately £42 million from the abolition of council tax). The set-up costs for a locally-set tax would be substantially more than the estimated costs of £19 million for HMRC and DWP and the further £55-60 million for employers associated with preparing for the implementation of a nationally-set tax. A nationally-set tax would mean that 100% of local authority funding was provided by the Scottish Executive.

139. Our modelling suggests that a local income tax levied only on earned income at basic and higher rates would have to be set at a rate of 6.5% in order to replace the current council tax yield.

140. A local income tax by definition cannot raise tax from second homes or non-resident owners.

141. A local income tax would require some years to implement, including the time needed for any necessary legislation by the Scottish Parliament and any supporting legislation by the UK Parliament at Westminster.

142. Overall, we have concluded that it would not be appropriate to introduce a local income tax. There are five reasons for this.

143. First, we have already stated our view that a tax on property as a proxy for wealth should feature as part of the overall basket of taxes in the UK.

144. The second reason is that income tax already provides a substantial proportion of UK tax receipts. HMRC estimates that income tax generated 32.8% of its tax receipts in 2005-06. ¹⁹⁵ On the assumption that public expenditure is funded in proportion to the yield from the various UK taxes, UK income tax already makes a significant contribution to the Scottish Budget and, in turn, the Scottish Executive's financial support for local government.

145. Third, the yield of a local income tax would be unpredictable, because of uncertainty and fluidity in both the number of taxpayers in any local authority area and the level of their taxable income. This would have implications for local authority budgeting processes and for the equalisation of councils' tax bases. The difficulties of unpredictable yield would be more acute for those local authorities with small populations and consequently small tax base.

146. Fourth, a local income tax could increase the overall tax burden upon households who are already paying income tax. The burden could fall most heavily upon families with more than one working adult.

147. An increase in income tax on earned income would be a disincentive to work. This disincentive may increase as the population of working age shrinks.

148. Finally, we doubt the feasibility of introducing a local income tax and, in particular, we are concerned about the additional administrative burdens it might place on taxpayers, employers, local and central government. The practical problems of applying a local income tax to all categories of income are immense in the context of a UK tax system designed to maximise tax deduction at source and to minimise the need for year-end adjustments and universal tax returns.

Recommendation 2: We recommend that a local income tax should not be introduced, either as a replacement for council tax or as a supplementary tax.