The Scotland Bill - Scottish Affairs Committee Contents

Examination of Witnesses (Questions 170-237)



Q170   Chair: Welcome to the meeting. We understand, Professor Keating, that you are off on Eurostar to somewhere exciting and therefore you want to be out of here by three o'clock. So thank you very much.

Professor Keating: Quarter to three.

Q171   Chair: Quarter to three. We had better make sure that you go even faster in that case. Professor Muscatelli, thanks very much for coming along.

We have been warned, by The Scotsman no less, that academics are delicate flowers who should not be asked impudent questions by "common people like what we is", so if there is anything that you think is impertinent by all means feel free to let us know. You are indicating that you are a trifle more robust than that, are you?

Professor Muscatelli: Absolutely. We are very happy to take any questions from you, Chairman.

Q172   Chair: Fine. Thank you very much. Could I start off by asking you about the general background to the Scotland Bill? At the moment, the Scottish Parliament has the power to vary income tax by up to 3p and they have not done so. Are your proposals to allow them to vary income tax by up to 10p just more of the same or significantly different?

Professor Muscatelli: When my independent expert group considered how to advise the Calman Commission on how to provide greater fiscal powers, we did think long and hard about that question, about whether the tax room proposals that are currently embedded in the Bill would do exactly that.

There are two reasons perhaps why the tax powers have not been used. One possible reason is that there is a tendency to focus on the status quo and it is politically quite difficult when it comes to making decisions on taxation to move away from that frame of reference. This is one of the reasons why we suggested the mechanism, which was defaulting to a rate below the normal standard rate at UK level because that would force Parliament to take a decision and actually debate and discuss the issue. The issue would need to be discussed. Even if the tax was kept at the same rate as the UK rate, it would need to be an issue that is discussed. The other reason why perhaps they have not used the tax powers is because they are rather limited in terms of additional revenue or less revenue. In terms of the level of accountability it is relatively small. That was the reason for providing, or suggesting, larger powers and also forcing the Parliament to have a discussion on the tax measures.

Q173   Chair: Can I clarify that? Is there not a real danger that they just simply end up at the default position, which is that they take a conscious decision to leave it at exactly the same level as it is in the UK as a whole and therefore they make no change at all so this whole thing is pretty meaningless?

Professor Muscatelli: There is a risk that no decision will be taken at first. We might perhaps go back to the adjustment mechanism for the grant because that will also drive what happens in the transition period. Once we go past the transition period and there is the definitive adjustment in the block grant, of course the revenues to the Parliament will fluctuate with tax revenues so they will no longer be as predictable as a proportion of UK expenditure in devolved areas. Therefore, I think there will need to be a discussion about this. There will need to be a recognition that the tax base matters for the Scottish economy and, in that sense, that will drive the debate towards what the right level of taxation should be to encourage the tax base to grow.

Q174   Chair: Professor Keating, you have a different view.

Professor Keating: I think it is more of the same and there are two ways in which one can look at this issue. One is that this is a minor adjustment of the existing settlement, which is based upon the assumption that we are going to have similar kinds of services and a similar role for the state in Scotland and England, in which case we should be discussing the technicalities of Calman and the Bill. It is very difficult, and it would be very difficult, to do anything other than go for a default rate because of the technical problems of changing it and because of the political problems. No Government has raised income tax since 1975. It is the most difficult tax to raise, so I think there will be a strong inclination to go for the default. The only difference would be, as Anton has said, that you would have to have an explicit decision by the Scottish Parliament to make a tax rate. That might be a small increase in accountability.

  The other way to look at the issue is as a radical shift in the basis of the devolution settlement, with real fiscal responsibility which would imply control of a much broader range of taxes. This would be appropriate if we anticipate that there will be significant policy differences between Scotland and the UK.

Q175   Chair: Could we come on to the question of what the alternatives are in a moment and just stick with the impact of what is being proposed? I read one distinguished commentator who is indicating that the mechanism was going to be much better in the good times for Scotland and in the worst times much worse. Can you clarify that position? Because the Scottish Government also seems to be saying that had the proposals that you are suggesting been in position for some considerable time in the past, Scotland would have been more in the slough of despond than it is at the moment.

Professor Muscatelli: It is certainly true that once you move to a different mechanism, Scotland's departmental expenditure limit—DEL—will depend not only on UK Government spending but also on the tax base, so the outcomes will be different under the two systems. At a time when Government spending in the UK is rising faster relative to taxation, Scotland will do better under Barnett on the current system. However, if we do not think that that situation is going to happen in the future, then clearly Scotland would do better under the new system whereby a share of UK taxation would accrue to it.

  The best calculations I have seen of what would happen under the two different systems are in a technical note which was submitted by the UK Government to the Scotland Bill Committee of the Scottish Parliament. It shows that if the grant reduction was made in 1999-2000 on the basis of the receipts over the whole decade after that, you would be better off with the new system. If, on the other hand, as the Scottish Government says, you had simply made the adjustment before the big expansion in UK public spending, then you would be worse off.

I do not think you can choose a fiscal system to be based on the experience of a five or 10-year historical period. It is for life; it is not for a short period of time. Over time, you would expect UK taxation and UK Government spending as a proportion of GDP to be broadly in line. Arguably, what we have seen in terms of public spending in the UK over the last 10 years is not sustainable.

I would think that, in future, the new system would probably work as well. The only difference, of course, is that some of the risks in terms of tax revenue fluctuations would be shared by the Scottish Parliament and it would not simply be a share of UK Government spending.

Professor Keating: I would agree with that as far as the taxes are concerned, but I do not think you can predict the outcome until you know what is going to happen to Barnett, because in the past there have been all sorts of Barnett bypasses which are very obscure and we need to know a lot more about how that is going to work. For example, there is a no-detriment clause and it is priced so that if there is a change in the UK tax allowances, there will be compensation, but that will be discretionary by the UK Government. What I would like to see in the Bill is a much clearer statement of exactly how that would work.

Chair: One of the issues that we have touched on with other witnesses was the question of transparency for a number of areas. Perhaps the one that you are indicating there might be one that we want to pick up as being an area where there requires to be a greater degree of transparency. I think it is helpful to have that drawn to our attention.

Q176   Fiona O'Donnell: Good afternoon, gentlemen. I wonder if I could ask in terms of what did not make it into the Bill that was in the Commission's report. Generally, is there anything that you are disappointed is not there? Specifically, in terms of the four taxes which were in the Commission's report, now there are only two. It may be that we will revisit that and that is amended in the future. Are you disappointed that the other two were left out? I would like to talk about tax revenue from savings and dividends after that, but can we start with the general and then the four becoming two?

Professor Muscatelli: Obviously, I am disappointed that the four taxes that we certainly suggested are not going to be devolved. I can understand the reasons for delaying the decision, but a contingent decision could have been taken on two—the higher passenger duty and aggregates levies.

  Our recommendations were originally to include savings and dividends within the devolved taxation powers, but I can understand why that was left out; it does require major amendment in terms of the administrative arrangements for tax collection in the UK, because it is difficult to attribute that without additional administrative requirements, say, on banks and building societies.

Q177   Fiona O'Donnell: There was no provision to alter the tax on savings and dividends. Is that correct? It was just half of the revenue. Where would the accountability be for the Scottish Government?

Professor Muscatelli: You are right. Tax sharing of that type would not involve as much accountability as having the power to vary that taxation. In that sense, perhaps the thought behind the Scotland Bill was that it was not going to add significantly to accountability. In terms of other disappointments, that comes back to the grant reduction mechanism. My group did not make a specific recommendation on how to make the block grant reduction, nor about the mechanisms for co-ordination between UK and Scottish Governments around the issue of the shared tax base. We hoped that this would be worked out, but in fact, as Michael hinted, some of that has not been worked out yet. I think I would like to see that spelt out much more carefully because it is an important issue.

Professor Keating: It is a pity that they did not put the two taxes in, but there was a technical reason for it. It has not been excluded. The more serious issue is the tax on savings. I would have liked to have seen that included. I would also say that in other countries they also devolve the rights and it is not just assigned. So, technically, that seems to be possible.

Q178   Dr Whiteford: Welcome, gentlemen. It is good to see you here. I want to ask a bit about fiscal and economic drivers, especially to you, Professor Keating, because in your written evidence you highlighted various shortcomings in the Bill in terms of how it would deliver its aims, especially in relation to autonomy, policy innovation and accountability. What, in your view, would this Bill need in order to deliver genuine and effective powers of the sort that you envisage would deliver those aims?

Professor Keating: There are a number of issues here. One is about overall levels of expenditure. What I was hinting at earlier—I may come back to it—is about welfare spending and public services. The debate in Scotland in the last few weeks has been all about economic development. It has been, in my view, somewhat ill-informed debate in many ways. What is important from the experience of other jurisdictions is that when you devolve taxation powers, it is important exactly how you use those powers and what incentives you put in place.

For example, in the Basque country, which is a case I know quite well, the corporation tax is slightly lower than the Spanish level—very slightly. But the use of the powers, the incentives for research and development, the tax credits for cultural industries and so on are a very important instrument used by the Basque Government. It is in the detail of how you use those powers and what the priorities are that is important. Of course that does not happen automatically. That has to be a policy choice by Governments, but we need to allow them to make those policy choices.

Q179   Dr Whiteford: The other thing that you wrote about in the submissions you made to us was about a similar issue of VAT and corporation tax in Scotland. I wonder if you think it was a mistake not to recommend the devolution of corporation tax in the Calman proposals.

Professor Keating: Yes, I do. I think corporation tax could have been devolved. There are huge economic constraints on variation and it probably would not have varied very much because of the loss of competitiveness if you put it too high and the loss of revenues if you put it too low. The tax competition is a fact. This indeed would have meant, as we find in other federal countries, that there is not a huge amount of variation, but it does give the opportunity for the fine tuning I was talking about earlier on and the use of that in pursuit of specific industrial policy objectives. If Scotland had its own priorities, it could use the tax power in order to further them.

Q180   Chair: Could I follow up one point? One previous witness, when we were asking about corporation tax, made the points that you have made, but they also made the point that reducing corporation tax for Scotland could be, essentially, to cannibalise corporation tax from the rest of the United Kingdom. The rest of the United Kingdom would lose considerably as a result of transfers, but Scotland would gain. Now, if you are in the Scottish position, I can see that being sensible. If you are taking the UK position, of course it is not. I wondered if you could maybe comment on either the dangers or opportunities that cannibalisation would be the main driver of any change in corporation tax rather than growing the economy.

Professor Keating: Yes. There is evidence from Ireland of transfer pricing or declaring profits in Ireland when they were probably generated somewhere else. With something like software creation, which is big in Ireland, you never know where it is actually being done. Then there is a separate argument about the shifting of economic activity to Scotland. I am sceptical about corporation tax as a means of shifting economic activity to Scotland. There is a danger of transfer pricing, which is why, in my paper, I said that we should do like other countries do and have some kind of concordats to control this, which is what exists in Spain. It is to control those negative externalities.

Q181   Chair: Before I ask Eilidh to come back in, can I just be clear? I think what you were saying, if I understood it, was that you were doubtful about the ability of small corporation tax changes to generate additional economic activity. Obviously, a lot of the debate in Scotland seems to assume that marginal changes of corporation tax would result in an explosion of economic development. Your view and your evidence is that that is not the case. Is that correct?

Professor Keating: Yes. I do not see the international evidence for that. Indeed, the studies that have been floating around in Scotland are based upon some dubious methodology. It is the details of what you do with taxes rather than the absolute level, and what you spend the money on, that are more important. If you look at jurisdictions across the world, there is no association between tax levels and economic growth. It depends what you are spending the money on and how you are raising it.

Q182   Chair: Sorry, Professor, do you want to come in before I go back to Eilidh?

Professor Muscatelli: It is just to stress that tax competition was the main reason why our group recommended that corporation tax should not be devolved. We have seen evidence from other countries, including Switzerland, that it would be very likely, if corporation tax had been devolved and, say, the Scottish Parliament had decided to marginally lower corporation tax, that it would have put pressure on the rest of the UK to follow suit. What is happening in other countries like Switzerland is that you sometimes find that, overall, the rate of corporation tax is lowered and the burden then falls on personal income taxation because something has to pay for the taxation hole. That was the reason why we decided not to.

  As Michael said, in most countries where corporation tax is varied for economic development reasons, that needs to be as part of a concordat at national level to specify exactly what the aims are of that measure. It is not simply the Basque country saying, "We are going to create a tax haven and all businesses are going to come to us." It requires quite close co-ordination and then it is not an effective level of fiscal autonomy that you generate that way. It would be driven by economic development issues. I think it is something that should be borne in mind. I cannot envisage a situation in which you could simply have complete freedom in terms of setting different rates of corporation tax. Even the Holtham Commission, when it brought recommendations which, to avoid brass-plating, were based not around turnover but around employment, which I think was sensible, basically said, "You should think about this, but it can only be a measure of economic development and not for fiscal autonomy."

Q183   Dr Whiteford: I want to come back to decentralised fiscal models because I know, Professor Keating, that you have very wide expertise in this area from other parts of Europe and even further afield. I just wondered if you had any more general thoughts on the hallmarks of the most successful models.

Professor Keating: This is all very contextual. There are countries that have very low taxes but very weakly developed welfare states because they are transition economies. They are developing countries as well. They are not particularly relevant. I do not think Scotland wants to go down that road of just radically cutting out the welfare state. Our comparable must be developed welfare states, not emerging economies in central and eastern Europe, Asia or, indeed, the United States, where they do not have a mature welfare state. Canada, Germany, Spain and Italy are relevant and so on.

  The experience of these is very different. In Germany, they have a highly integrated system in which there is revenue sharing rather than revenue autonomy. Elsewhere, they are moving towards autonomy. Spain is moving this way. Italy has been moving rather haltingly in this direction. Even in France there are moves in that direction so that local and regional governments are dependent more on their tax base. This is connected with the notion of competitive regionalism—that we no longer have top-down regional policies managing the whole space. Regions are moulding their own development projects. That is where things are going. A degree of fiscal autonomy is important in that, but a fiscal free-for-all, for the reasons that Anton mentioned, would not necessarily be helpful.

Switzerland is the example where you do get this destructive fiscal competition. You do not get it amongst federations because there are intergovernmental arrangements in place to try to control that to make sure it does not get out of hand, as indeed there are at the European level. There is a degree of harmonisation at the European level through competition policy to make sure that this competition does not become destructive. Competition can be dynamic and can promote development, but you can also get this so-called race to the bottom and we need to make sure that that does not happen.

Professor Muscatelli: To support what Michael said, I suppose this was part of our first report to the Commission. I recognise the limits of economics. I do think that this is a place where economics cannot provide definitive answers; it is about what society and politicians believe should be the right arrangements. This is an area where providing additional fiscal autonomy would effectively provide more autonomy at the expense of more risk in Scotland's block grant. It would provide more levers but, as Michael said, perhaps at the expense of greater fluctuation. It is an equity versus accountability trade-off and the Commission decided to position itself in one particular place on that. I do not think economics can tell you exactly where you should place because it is going to produce an economic miracle. As Michael said, there are different systems in Germany, the USA, Australia and Canada, for very good reasons. These systems are derived from what these countries want in terms of that trade-off.

Q184   Chair: You seem to be suggesting that full fiscal autonomy is not a magic bullet.

Professor Muscatelli: It is not a magic bullet and I do not think it exists in any other country which is a country.

Professor Keating: "Full fiscal autonomy" is just a phrase. We need to talk about what taxes you are going to have autonomy over and in what circumstances. Even independent states in the European Union do not have full fiscal autonomy. They are constrained in value added taxes and tax competition and so on.

Q185   Chair: I was not sure whether or not "autonomy" in this context was just a weasel word basically to cover separation and that people who did not want to use "separation" or "independence" as a word would use "autonomy". Is there a distinction to be made between fiscal independence and fiscal autonomy or fiscal separation and fiscal autonomy? Is there some economist-speak that means there is a difference between those terms or are we basically talking about the same thing re-badged?

Professor Keating: I am not an economist. I am a political scientist. I would say that there is a spectrum from being dependent to being completely independent and nobody is at either end of that spectrum anywhere in the world. It is about managing degrees of inter-dependency. The big question underlying this for Scotland is what kind of welfare state and what public services we want in Scotland. Would be we prepared to pay a higher level of taxes to have a higher level of public services, especially if in England they are going to reduce the role of the state? That is the big issue that is coming up there and we need to have that debate, I think.

Professor Muscatelli: I would agree with that.

Q186   Cathy Jamieson: This is linked to that and, I suppose not being an economist either, I am struggling with the kinds of questions that ordinary people have on the doorstep. What they want to know is, knowing what you know just now, is Scotland going to be better off under the Calman proposals—raising that proportion of tax directly in Scotland—or better off continuing with the block grant as it is in terms of being able to provide services? That is what I think people want to know.

Professor Muscatelli: We can certainly give a definitive answer to that, at least based on current forecasts of taxation revenues in the UK. I refer you again to the technical note produced by the Treasury essentially for the UK Government for the Scotland Bill Committee. It shows that, if, for instance, the Calman measures had been brought in in 2010-11, the grant adjustments had been made then which equate to 17.25% being taken off the block grant and then after that the Calman proposals had run, essentially by 2014-15, as public spending in the UK is not growing as fast but taxation will be growing faster in the next few years, there would be a cumulative gain to the Scottish budget of about £400 million for that period. Actually, if you did implement it now, you would be better off.

  However, as I said, there are swings and roundabouts. There are likely to be fluctuations over the period of that sort of measure. Over some period, you will see Scotland benefiting of the order of a few £100 million more or in some period it might be below that, but it will never deviate. There should not be a trend, because Government spending and Government taxation at UK level cannot trend away from each other for very long before either debt accumulates or something else happens.

Q187   Chair: Sorry, we were going to ask some other questions, but that leads directly on, if I may. Sorry, Professor Keating?

Professor Keating: Can I say something as well? The Barnett formula, in principle, is a convergence mechanism. It has never happened that way in 30 years, but had it been applied, Scottish expenditure would be a lot lower. We do not know whether it is going to be applied in the future, but given political opinion in the south, I would imagine that Barnett will be applied in future in a much tougher way, so we cannot depend on getting the slightly higher share of expenditure that we have had hitherto.

Q188   Chair: But I think Cathy asked for a yes or no and Professor Muscatelli was basically saying yes. One of the things that I was looking at was a letter which appeared in The Scotsman, the paper of record in these matters, it would appear. Professors Hughes Hallett and Scott said, "The only hole we are concerned about is that into which the Scottish economy is likely to plummet if the provisions of this Bill become law." That does not seem to have any element of, "On the one hand or on the other hand". That has the merit of clarity. What I am not quite clear about is whether or not it has the merit of accuracy. I wonder in economic terms, what is a plummet? If they are suggesting that the Scottish economy is likely to plummet, is that a phrase that implies a particular percentage reduction or anything similar?

Professor Muscatelli: I have not seen any percentage associated with that definition by Professors Hughes Hallett and Scott, but I would not agree with that assessment. As I say, over time you should not notice a huge difference between the two, but if you applied it now, on the forecast we have till 2014-15, the Calman proposals will actually generate additional income. But, as I said, I do not think that is the criterion against which you should assess the system.

Q189   Jim McGovern: Professor Muscatelli, you said that you would give a definitive answer to Cathy's question based on a forecast and it was swings and roundabouts and speculative. How can that be a definitive answer?

Professor Muscatelli: It is a yes based on the current period, but I am also telling you that over a period of 10 to 20 years you should not notice a difference because Government spending and taxation at UK level should stay broadly in line.

Q190   Jim McGovern: "Should" is not definitive, is it?

Professor Muscatelli: No, but two different systems will produce two different outcomes, otherwise what is the point of moving to a different system? In fact, one of the problems, for instance, with the transition mechanism that is embodied in the Scotland Bill is that, over the transition period, it completely insulates the Scottish Government from any fluctuation in the block grant, which basically means that over that period—I will give you a definitive forecast—there is no way that the Scottish Parliament would vary the tax rate. Why should it? Whatever the tax rate is, it will produce the same outcome as the block grant so it would not. Why should it? We would get no benefit one way or the other. That is the best you can do in terms of the forecast.

Q191   Jim McGovern: It is your opinion rather than a definitive answer.

Professor Muscatelli: It is my opinion based on my own experience.

Professor Keating: One other reason why it is so difficult to predict is that this is a matter of politics, and we do not know what politicians are going to do. They can do something under one heading and we can predict that and then they take the money out of other headings. This is how public finance works. We are talking about lots of slippery numbers here and this is why indeed we need a lot more transparency from the Treasury. It is so that we can actually find out what has been going on and what is going on.

Chair: It is not only the numbers that are slippery. It is a lot of the people that we are dealing with, is it not? Therefore, one of the things that would greatly improve the governance of Scotland would be much clearer sets of figures and so on and a much greater understanding. That is certainly something that has been said to us in a number of points and something we will certainly reflect in our report. Alan, you wanted to come in.

Q192   Mr Reid: Yes. First of all, thank you very much for coming along. It is just to explore the circumstances in which Scotland would be better off and in which it would be worse off. Am I right in saying that the two factors that you say have to be taken into account are UK public expenditure and UK taxation levels? Is that correct?

Professor Muscatelli: UK public expenditure, the UK taxation level and the balance of UK taxation between personal income taxation and other taxes. For instance, if the UK Government decided to raise VAT and lower income taxes by, say, uprating all the income tax thresholds, that would have a negative impact on the Scottish tax base. That is why you need an adjustment mechanism which takes account of that. The UK Government and the Scottish Government will share a tax base so that what the UK Government does with personal income taxation would have an impact on the Scottish Government's revenues. That is why you need a grant adjustment mechanism that takes account of it.

Q193   Mr Reid: Is this grant adjustment mechanism in the Bill?

Professor Muscatelli: No. The Bill at the moment suggests a transition period in which the Scottish Government's receipts would be totally insulated so there would be no impact. Then, after that, it suggests a once-and-for-all deduction in the grant. After that, all the risk is transferred to the Government. There is talk about no detriment, but I would much rather see a mechanism that is clear and transparent and which does not insulate the Scottish Government from its own actions, because, after all, that is what accountability is about, but insulates the Scottish Government from actions taken by the Westminster Parliament on taxation because it would be unfair to see that reflected on the Scottish devolved resources.

Q194   Mr Reid: What you are saying is that, with the Bill as it stands at the moment, if a future UK Government was to increase tax allowances above inflation and so reduce the income tax take, the Scottish Government would lose out.

Professor Muscatelli: Yes, absolutely.

Q195   Mr Reid: You are suggesting that a formula needs to go into the Bill to take that into account.

Professor Muscatelli: The formula is very straightforward because the Holtham Commission did quite a bit more research on this area; indexing the grant to the UK income tax base would achieve that result.

Q196   Mr Reid: How does that link to Barnett because Barnett is based on expenditure and not taxation? You would have a more complicated formula then.

Professor Muscatelli: No, you would not have to adjust Barnett. Barnett would stay under the current measure. The block grant adjustment would not be a once-and-for-all adjustment. It would be varied every year on the basis of what is happening to the UK income tax base. On Barnett, I should also say that my group always had at the back of its mind that if we move towards this sort of system of income tax sharing, Barnett might eventually be revisited, as Michael says, because it is not based on need. Perhaps after 15 or 20 years you need to look at the issue of how that is going to be handled. Again, the Holtham Commission raised it in the case of Wales. Convergence has already happened to a large extent in Scotland and there is quite a lot of discontent as to whether Barnett delivers what is needed in terms of public spending there.

Q197   Mr Reid: You mentioned comparable countries such as Canada, Spain, Italy and Germany. How do they address these issues?

Professor Keating: They all have a system of revenue sharing and fiscal equalisation. They sometimes assign taxes and then they have an element based upon need and an element based upon resources. The technicalities of the system are quite different, but they compensate to a greater or lesser degree for the tax base. In Germany, this equalisation is complete so it does not really matter what your tax base is; you get your money. In Canada, it is much less complete. If you are an oil-producing province—because there is oil tax as well—you get the benefit, but you lose when the oil prices collapse.

In European countries where they have regional governments, in Spain and Italy, they are gradually moving towards a similar kind of system. In Spain, they have been doing this for 20 years. I am not talking about the Basque country, which has always had it. I am talking about the other autonomous communities gradually getting a mix of taxes typically involving the sharing of value added tax on a population basis, because it is not suitable for devolution, a share of income tax and a share of business taxation, because business taxation takes different forms. There is then the devolution of taxes that are easily identifiable territorially: property tax, succession tax, vehicle licensing duties and so on.

Q198   Mr Reid: Do you have any personal recommendation for the route Britain should go down?

Professor Keating: Those are the technicalities of it. The brutal reality is that what you get is a political compromise because you do the sums and you show that Region A should lose and Region B should gain, but politically it is impossible unless you have lots of money to compensate people; so you fudge. It is always a political compromise. The difference here is that we are talking about Scotland in isolation from the rest of the UK, even from the other devolveds, which is very difficult to think about. There is no other place that I know that is in that position. Where you have a federal system it is fairly clear because you have rules that apply to everybody.

Professor Muscatelli: My own view is exactly that. In 15 to 20 years' time, within that arc of time, you would hope that the UK Government might look again at the Barnett formula, which was only designed to last for a few years. It has lasted the test of time, but, as Michael says, it is simply an administrative formula which does not take account of relative need and changing need over time.

Chair: We will deal with the Barnett formula next week, but at the moment we had better deal with the Scotland Bill.

Q199   Lindsay Roy: Good afternoon, gentlemen. In your considered judgment, do the proposals fail to provide Scotland with any significant new economic levers? Is there a genuine advance here?

Professor Muscatelli: I think there is a genuine advance. I think it will require the Scottish Parliament to have a genuine debate about resources, taxation and the source of those resources and not simply how to allocate a block grant. I think there is an advance. Is it the final step? That is another issue. What we have in front of us here today does involve a significant increase in accountability.

Professor Keating: There is a connection because the more you devolve taxation, the more you force stakeholders, Scottish business, trade unions, you name it, to get involved in political debate, which is one of my interests. To a lot of people in Scotland, it does not make that much difference to them what the Scottish budget is. If it really made a difference, then you would improve the quality of political debate. You would have a debate every year about what level of taxation we want and what the consequences of that are. I am not sure this proposal would take us much further in that direction. I think it is too timid.

Q200   Lindsay Roy: Would you agree that a key to success in delivering this is a commitment to work together; in other words, perhaps a stronger attitudinal change?

Professor Muscatelli: That is right and, as Michael said, it probably takes the UK into a more federal direction, but, over time, we have to develop those institutions to have that greater working together between the countries of the UK. It will also lead to a greater engagement between the different political parties and other stakeholders in Scotland because it will involve some substantive discussions about taxation as well as revenues.

Q201   Chair: Can I pick up on the assumption that giving additional powers over some areas results in greater debate and discussion, better policy and so on? One of the witnesses, in a previous session about the Scottish economy, from the Federation of Small Businesses was telling us about the high number of youngsters coming out of schools who were functionally illiterate and innumerate. There were even graduates coming out who were not able to deal properly with interactions and so on. Scotland has had powers for some considerable time to deal with, say, literacy and numeracy, yet not a great deal of improvement has occurred. Simply having the powers does not automatically, in the way that you seem to suggest, result in better decision making.

Professor Keating: Of course not, but there is a lot of work going on in Scotland at the moment about how to improve policy innovation and policy making. This is something that was not thought of at the time of devolution. People talked about the Parliament, the committees and so on and did not think about this. We have had 10 years of experience of how to learn how to make public policy. It has been extremely slow, but I think that is happening. Indeed, when it comes to education and health, the powers are already there. This is going to make no difference to the powers. The spending powers are already there. We should not confuse that with—

Q202   Chair: I understand that, but the point I was responding to is that we still have problems of illiteracy and numeracy amongst young Scottish people coming through the education system for which the Scottish Parliament and Government have been responsible for some 10 years. Therefore, you cannot automatically assume that additional powers in relation to the economy will result in better solutions being devised, in the way that you seem to be doing.

Professor Keating: My argument is that the existence of those powers for 10 or 12 years or so has gradually improved the quality of policy debate in Scotland and the quality of policy making, but these are very, very long-term things. These are deep-seated social problems that do not have easy answers. Indeed, extending autonomy into the fiscal area will bring more people into the policy debate, particularly the business community that has been a little bit detached from the policy debate in Scotland, because it will affect them very, very directly and they will have to get involved then.

Professor Muscatelli: I would agree with the statement that it is to do with what the money is spent on. However, it could lead to a discussion of the following type. At the moment, the UK is having cuts in public spending. If we thought that solving some of those problems in Scotland required additional expenditure over the next few years, that could be a decision that the Scottish Parliament will be able to take after 2015 with those powers. If we think that those issues are not related with choices on the level of expenditure, then you are right. It is to do with the quality of spending and it does not matter too much. What this does is to improve the accountability on the revenue side. It does not improve accountability of how well the money is spent.

Chair: Eilidh, do you want to pick up the issue about income tax or do you feel that has already been asked?

Q203   Dr Whiteford: Yes, I am very happy to ask about income tax. I guess that one of the concerns there has been around this is about the differential rates of tax in terms of higher rate taxpayers. This is maybe a bit of a geeky economic question for which I apologise, but would you expect, in times of economic growth, total tax yield to grow faster than income tax yield? Within that, would you expect more yield to come from higher rates of income tax—within the higher bands?

Professor Muscatelli: It is certainly true that with economic growth, you would expect the tax base to grow. The sort of estimates we would see—I think this was part of the evidence given to the Scotland Bill Committee by one of the people who gave evidence—is that the elasticity is around 1.2%, which suggests that, for every 1% of growth in the economy, you should get 1.2% of growth in the tax base.

  Presumably, behind your question is the issue of the fact that the current powers only allow you to vary all the rates at once and not to change the shape of the tax curve. I think you are right; that is an issue. The reason why we suggested that it should simply be a 10p variation across all the bands is because there was an issue of administrative simplicity. Introducing this other level of complexity would lead to the need for greater co-ordination and greater administrative complexity in terms of applying PAYE. I think that was an issue. You are right that it then raises some issues because, if, say, the Scottish Parliament were to put up the rate by 3p, that might have more impact on the decision of higher taxpayers than standard rate taxpayers.

Q204   Dr Whiteford: I think this is very helpful and I welcome the clarification that simplicity was the guiding motivation. My concern is that that does introduce a deflationary bias in the system. If the Scottish economy is actually growing, which presumably we are all keen to see, a greater proportion of the tax receipts that accrue are then going to go to London, with a smaller share coming to Scotland. So there is an inherent kind of flaw in the mechanism that perhaps we should be looking at a more sophisticated way of ironing out.

Professor Muscatelli: I would put a slightly different gloss on it. I do not think it is a deflationary bias and I would not see any problem, for instance, if some of the benefits would accrue to the UK after all. The tax base is being shared and that means that in a downswing, Scotland also shares some of the benefits, and some of the risks accrue to the UK tax take. I see it more as an issue of flexibility on the part of the Scottish Government. For instance, higher rate taxpayers are the ones who are most mobile. If the Scottish Parliament, say, was to put up the rate by 10p, that is quite a significant increase in the higher rate tax and might lead to a large number of higher rate taxpayers saying, "I will make my main residence across the border", which might cause a reduction in the tax take. Those spillovers would be more problematic, which should cause us to think about whether, in due course, we should have some flexibility. I am less worried about who benefits, because both the benefits and the risks are shared in the system.

Q205   Dr Whiteford: Professor Keating, do you have any thoughts on that in terms of the differential tax bands and the income tax? How adequate do you think the income tax proposals are?

Professor Keating: I defer to Anton on the economic technicalities of it, but I would favour for political reasons or constitutional reasons—I do not mean party reasons but for reasons of good governance—the devolution of the rates because I think it is a legitimate decision whether we decide to have a higher or lower marginal rate. This applies in other federal countries as well. They change not just the basic rate but also the allowances and the marginal rates.

Q206   Dr Whiteford: Presumably they get over the technical difficulties of doing so.

Professor Keating: Yes.

Professor Muscatelli: I can tell you what the technical difficulties are. It is interesting because in the case of Canada—Mike will correct me—they started by giving the provinces the right to charge a tax on a tax. They started with a surtax, and over time they have given them more rights to change thresholds and tax rates. In part, it is to do with sophistication of decision making.

  In terms of the UK tax system—you will be able to ask this question of HMRC, who will know the complexities more—essentially, we have a PAYE system which means that most UK taxpayers do not fill in a tax form. In most other countries which have more complex tax systems and devolve more of the taxation powers at local level, everybody would need to file a tax return because you would need to do that to properly allocate taxes between devolved Governments and central Governments. I suspect that the only way to start applying different tax rates in Scotland in different thresholds is that you would need HMRC to start issuing tax returns to everyone and then you would need some sort of mechanism to ensure that there is not evasion by people switching residence from one part of the UK to the other. Those are the issues.

Professor Keating: I lived in Canada for a long time, and in Ontario the two tax systems are linked so you fill in your federal tax form and your provincial tax form. It takes about 30 minutes if you have the right software. It is very sophisticated. The province can put into that whatever kind of deductions it wants and it just comes out the other end. In Quebec, you have to fill in two separate systems, but the outcome is the same.

Q207   Chair: Professor Keating, can I just clarify this? Your point about the merits of devolving powers over additional tax rates is based on the politics of it. There is not, again, any economic evidence that automatically devolving the higher tax rates would result in better growth or better decisions. It comes back again, does it not, to this question that it depends on the use that is made of it?

Professor Keating: Yes, exactly.

Q208   Chair: There is no automatic gain as a result of doing one thing or the other.

Professor Keating: No, you cannot. It is impossible to say that a given change in the system automatically produces a policy outcome. It depends on what you do with the powers. This is true, whichever power we are talking about.

Q209   Chair: It slightly confused me because there does seem to be some coverage in some of the press from some authors that would suggest that if you do certain things, then some other things will happen automatically. That is what we are struggling with a little as just mere common people.

Professor Keating: There are various papers. There are many of them and the inferences depend on large-n studies. You generalise from a large number of cases. They are methodologically very problematic, because I cannot quite see what the mechanism is supposed to be. Is it increasing taxes or reducing taxes? The sample of cases is problematic. The application, even if you produced a general result that in general lower taxes produce growth, says nothing whatever about Scotland because Scotland is a particular case and you cannot generalise from a statistical analysis to a particular case. My argument is that the question is not meaningful, not that the answer is wrong. It is just not a meaningful question. It is just not something that social science can do.

Professor Muscatelli: Just to clarify, it is impossible for any statistical study to prove it in my view. Suppose you have two countries. One of them has more fiscal autonomy and the other one has less. Suppose the one that has greater fiscal autonomy just has greater innovation and greater resources and happens to grow faster for that reason. You might find over time that that is what is driving the result. It is some other variable that you have not picked up, yet the inadvertent economist might say, "This country has got a greater fiscal autonomy and has grown faster than this other country." It is nothing to do with the tax mechanisms. It is to do with good fortune in the case of natural resources, perhaps good governance in the case of good policies, or some other factor like innovation and entrepreneurship. I would not even start looking at the data. I am surprised that people find this sort of question interesting and apply statistical techniques to it. I just do not think it is particularly interesting.

Chair: I did not say I found it interesting. I just thought I had better ask you about it; that is all.

Q210   Fiona O'Donnell: Moving on from income tax because we have a very long session with HMRC after this, could I ask about the fact that the Bill proposes that any new taxes set by the Scottish Government would have to be approved by Westminster? What are your views on that? Is that about safeguarding Scotland against any risk? Can you understand, though, that that probably will be seen by a lot of people as centralising power, or do you approve of that?

Professor Muscatelli: My view is that I think it is necessary for there to be some sort of co-ordination. I can see why it is couched in those terms, because of issues of tax competition. Suppose the Scottish Parliament were to introduce some sort of payroll tax that impinged on national insurance contributions. This would have an impact on UK taxation so you would need some sort of co-ordination plan. I see it as that. I am not a constitutional lawyer so I cannot say whether the way it is drawn up at the moment is too restrictive, but I think you would need some sort of co-ordination in those cases. You cannot just have a free-for-all.

Professor Keating: Yes, there is a danger of tax exporting as well—tax activity that was not actually in Scotland—and the UK Government would have a legitimate interest in stopping that. Most constitutions I have looked at have a clause that says you can tax something that does not duplicate an existing tax. They have this in Spain and Italy, which is pretty restricting. It has the same effect, I think, as saying that it has to get Westminster approval. I would rather put it in the way that I have just put it. It seems to give more autonomy to the Scottish Government and then ultimately it would be up to the courts to decide whether this was overlapping with an existing tax. It would be two ways of addressing this problem that Scotland should not be doing things that have a negative impact on the UK or vice versa.

Q211   Jim McGovern: Could I just ask, Professor Muscatelli, about the last contribution you made prior to Fiona's question? How could one country have greater fiscal autonomy than another country?

Professor Muscatelli: In the example I gave, if one country had devolved more of its taxes to its local regional state level than another one. For instance, Canada, at the moment, has more fiscal autonomy than the UK in the sense that the provinces in Canada have to raise more of their taxation locally than the UK countries do. It is in that sense I meant it.

Q212   Jim McGovern: It is not so much countrywide; it is regional-wide.

Professor Muscatelli: Yes, sorry.

Q213   Jim McGovern: There is no such thing as a country having more fiscal autonomy than another country.

Professor Muscatelli: No, you are quite right. I was imprecise. Within the country, the regions, states or provinces have greater powers in the example I gave.

Professor Keating: Yes. There has been quite a lot of confusion in the papers on that point. You might be saying that countries that are decentralised have a greater countrywide rate of growth or that the regions that are devolved have a greater growth than the regions that are not devolved. These are two quite different questions.

Professor Muscatelli: Indeed, in the example cited by Hughes Hallett and Scott, where they got the figure from had to do with devolution to local government. It had nothing to do with devolution to state or regional government. This was why we answered through an article in The Scotsman. We felt that it was an inappropriate translation of the data because the study on which it had been applied had nothing to do with devolution to regional or state government.

Jim McGovern: Could I just say to you, at the risk of being even more pedantic, that when they debated the Scotland Bill a couple of weeks ago, it was confirmed that, at the moment, there is no such entity as a Scottish Government? It is a Scottish Executive, for the record.

Chair: You are not really doing very well on a whole number of things, are you? You must pay more attention, I think.

Q214   Mr Reid: In calculating the new block grant, one should take the tax base into account. That will obviously have to be carried out by some organisation. Would you think that the Office for Budget Responsibility is the right body to do that?

Professor Muscatelli: I personally would be comfortable with the Office for Budget Responsibility doing that. I know that some other commentators have said that basically it does still sit within the Treasury and therefore it might be seen as not an independent party. To create yet another body would be administrative overkill, but if the OBR had that responsibility, and if the whole system had oversight from the National Audit Office, I would have thought that would be sufficient.

Chair: Jim, do you want to pick up the questions in question 9?

Jim McGovern: Yes. I am quite intrigued as it mentions the Scottish Government, which we have already said does not exist.

Chair: Write out 500 times, "I must pay more attention."

Q215   Jim McGovern: He has got to go and stand in a corner obviously. I think we have probably done it to death actually, but what would the risks to the Scottish economy be of effectively putting all the eggs in one basket when it comes to taxes?

Professor Muscatelli: Our reason for suggesting that personal income taxation should be the shared tax basis is that it is less volatile than the obvious other candidates, which were corporation tax and VAT. In the case of VAT, there are other issues around European competition. If you look at the data over the last 10 years, corporation tax is much more volatile than personal income taxation. Regarding the argument as to whether devolving these other taxes, perhaps through tax sharing, would reduce the volatility, I do not think it necessarily would because you are adding two other taxes which are more volatile than personal income tax and they are quite well correlated over the business cycle. I do not think it would help offset the risks from devolving personal income taxation.

Professor Keating: That maybe gets us on to the other problem that has been raised about this, which is what happens to tax volatility and the fact that the Scottish Parliament, because it is the Parliament technically, does not have the power to borrow. The Bill gives it very limited powers to borrow and maybe there should be a greater capacity to borrow to overcome that kind of volatility, again subject to various constraints and overall thresholds.

Professor Muscatelli: Can I come in on that because I would certainly agree with that point? When I was asked by the Scotland Bill Committee in the Scottish Parliament what changes I would make, one of them was on the grant adjustment mechanisms but the other issue is on the borrowing powers. The £500 million overall limit does not cover the potential fluctuations. If you look at the difference in personal income taxation and receipts accruing to Scotland—this is the total as opposed to the bit that would be devolved under Calman—between 2007-08 and 2008-09 there was a fall of about £500 million in income tax receipts which were attributable to Scotland. This is from the Government Expenditure and Revenue Scotland survey—the GERS report. Over time, if you wanted to protect Scotland from fluctuations in tax receipts or allow them to smooth the total resources available, you might want to look at whether £500 million is sufficient.

Q216   Mr Reid: Do you have any particular figure that you would want to put as the limit?

Professor Muscatelli: Any figure is going to be dependent on experience in the last few years, and the last two years have been particular because of the depth of the recession, but I would have thought that doubling that limit would not be exaggerated in terms of prudence and in terms of giving the Scottish Parliament a bit more room for manoeuvre.

Q217   Mr Reid: What about restrictions to make sure that it is being used wisely? For example, a Scottish Government, coming to the end of its term of office, could decide, "Let's borrow a lot of money and spend a lot of money to make ourselves popular and either ourselves or the next Government can worry about it after the election." Do you have a fear that that might happen and, if so, what sort of restrictions would you put on to stop, say, irresponsible borrowing?

Professor Muscatelli: There are two reactions to that. One is why should that not be part of the political process because it is up to electors then to punish the Government which has behaved in that way? In terms of keeping actual and forecast income taxes in line, one of the things other commentators and I suggested to the Scotland Bill Committee in the Scottish Parliament is that, rather than applying a forecast over four years, we might perhaps update these forecasts more frequently so that you could not have a Government doing this and then saying, "The forecasts were wrong." By having a rolling forecast and keeping actual and forecast tax receipts closer together, that would become part of the political process. I think that is fair game. That is what politics is about. It is about making promises and sticking by them, or being punished.

Chair: Or not, as the case may be.

Q218   Mr Reid: How about, say, a Scottish Office for Budget Responsibility so that the electorate would be aware of perhaps what independent opinion was of what the Government was doing?

Professor Muscatelli: It is possible, but you could also ask the OBR to play that role. Again, it is a question as to whether you want to create another body given that we are talking here about a fraction of the total resources of the Scottish budget. It is whether you want to create another body—another quango—to do that.

Professor Keating: The mechanism must ultimately be political. The Parliament should answer to its electors, but there are things that you can do. There have been a lot of experiences in Canada in fact with irresponsible Governments racking up deficits in the 1980s and the 1990s and there have been some constitutional changes, some of which provide for a balanced budget, which is a nonsense and never really happens. The more serious ones set a total limit on the amount of Government debt, whether it is for accrued deficits, for revenue expenditure or whether it is capital expenditure, which is what exists in Europe through the Maastricht Treaty. It is not very well applied at the moment as it broke down, but something like that could be done to ensure that the borrowing did not get completely out of hand. Indeed, something like that exists in Spain because the borrowing of the regional governments counts towards the overall Spanish debt for European purposes. The national Government has negotiated with the regions that there will be a limit on the total amount of debt that they are allowed to hold at any given point in time.

Q219   Mr Reid: Do you think there needs to be a legal constraint, or simply transparency such as the OBR saying to the public, "We believe this Government is acting irresponsibly"?

Professor Muscatelli: I would argue that there should be some constraint partly because there is an issue of moral hazard. The thing about regional governments or, in this case, the Scottish Parliament is that there is an issue as to what would happen if, say, very irresponsible decisions were taken because there is a central Parliament that can always bail it out. There is a moral hazard issue which would not arise elsewhere. I would go for a limit but I would not have that limit of £500 million.

Q220   Chair: Professor Keating, at the present moment, at half-past two, they will be stoking the boiler of the Eurostar. You have to leave in 15 minutes. In particular, Professor Keating, is there anything that you think the Calman Commission has missed? Is there a better way? Is there something in particular where you would say, "Look, from my experience, they really should have considered X or Y"? I appreciate that a lot of these things are political judgments, but based on what has happened elsewhere, is there something where there is some evidence that devolving powers over a particular area would result in beneficial conclusions?

Professor Keating: It is difficult, as I think we have agreed, to say that any given measure of devolution produces an outcome that is better. It provides the opportunities for politicians to make better decisions. My view about Calman is that it was too cautious. The evidence it received from Government Departments was extremely cautious. The powers had to be prised out of them—not just the Treasury but other Departments as well. I would have liked to see something altogether bolder, including on the fiscal side.

  As I said before, it depends on what we are thinking of this and the framework that we are using for this. Are we saying, "We are assuming that devolution is going to continue at present, whereby the Scottish Parliament makes decisions that are marginally different from England?", or are we thinking about the possibility of political opinion diverging in quite a radical way in the future? If we are, then we will certainly have to revisit this question of fiscal autonomy in a few years and I think we will.

Q221   Chair: That is right, but there does not seem to be anything wrong with the idea of our revisiting the devolution settlement after 10 years. In a few years' time, depending on whether or not Professor Muscatelli and his expert group got it totally wrong or accurately right, we will no doubt want to review it again. All of these things are political judgments, are they not? In a sense, you are now moving on to the question of your own political judgment and opinion rather than anything that is particularly firmly based on evidence, are you not? What I am looking to identify is whether or not you would be able to say, given your experience, that over most similar regimes, as it were, such and such has tended to be an enormous success.

Professor Keating: On a comparative basis, we can say certain things. The Basque case has been evoked in many places in this debate, sometimes in a rather ill-informed way. In fact, in that case, fiscal powers enabled them to make a much more effective response to de-industrialisation in the 1990s than we had in Scotland, with a much more effective package of proposals and a fine-tuned industrial policy, and they have come out of the present recession much better.

  That was not automatically the result of fiscal autonomy because they have had fiscal autonomy for a long time. It was the use of those powers that really mattered. Also, as a political scientist, I can say—it does not matter about my political preference—that where you have the devolution of a lot of spending powers without the corresponding taxation powers, there is a problem about accountability. I think the Scottish Parliament should be raising the money that it spends because then you can get a better quality of democratic debate and accountability.

Q222   Chair: You quoted the example that the Basques were able to respond to de-industrialisation quite effectively. Can you just give me an indication of what powers they had that Scotland will not have?

Professor Keating: They have powers to make tax deductions and tax credits in industrial areas which are focused on particular sectors, particularly hi-tech sectors. They use tax powers not to cut taxes in a blanket way but to focus on key sectors. They are able to bring together various powers, including fiscal powers, in a package without constantly having to co-ordinate everything with Madrid. This gave them flexibility in response that we very often do not have because we have to negotiate responses to industrial crisis in a very complex system. They are also able to engage the actors in the Basque country, whether it is the business community, the trade unions, the social activists and so on, in a very direct way because they are paying taxes and they know that the decisions they make have a very immediate impact upon them. It was that combination, but the fiscal powers enabled that to happen. It did not cause it; it enabled that to be done.

Q223   Chair: We have just completed a report on the video games and interactive technology industries. In there, we are looking at ways in which we can fine tune some elements of financial support, whether or not it is tax breaks, R and D expenditure or innovative expenditure of other sorts. The thing that struck me about that was that, even though we examined it in the context of Scotland in the Scottish Affairs Committee, many of the issues about tax breaks and the like were actually UK-wide and video games industries elsewhere in the UK would equally benefit from this targeting.

I was not clear whether or not you are saying that, in a sense, there is a Scottish response to these things, or whether or not it can be done centrally. There requires a lighter touch and a more delicate touch than the Treasury is perhaps used to. Were they willing to do something like that for the video games industry, which, in the UK, does not depend only on Scotland, it would be reinforced in Scotland by what happened elsewhere in the UK; what is required is a degree of fine tuning and delicacy of touch from a UK Exchequer basis. The objectives you identify could be met in some cases by another mechanism than just simply devolution.

Professor Keating: Yes, but what is happening generally across Europe is that these kinds of industrial policy decisions and regional development decisions are being devolved to the local level where you can link up with labour markets, education policies, infrastructure and so on. That is the place where these come together and where we see the most successful examples of innovation. It can no longer be done at the state level.

Professor Muscatelli: Can I—

Q224   Chair: Can I just continue with Professor Keating because he has to go and you don't—we've got you for a little bit longer.

In terms of the advantages of decentralisation, which I understand, can I ask you to what extent that also applies to decentralisation within Scotland, say, to the local authorities? One of the things that has concerned a number of us, I know, is the extent to which power, where devolved to the Scottish Parliament, has then, in Scotland, been sucked into Edinburgh and away from local authorities, from individual economic initiatives and the like. Is that something that from your experience you have noticed happening in Scotland to a greater or lesser extent than elsewhere? Is it something that has been reversed in other circumstances? Is it something that you would recommend we look at?

Professor Keating: Yes, because the local level is critically important as well. Devolution came to Scotland, not because Scotland is some kind of natural economic unit; but because it is an historic nation. Yet it is of the scale that is more appropriate than the United Kingdom for many of these kinds of interventions. Then, of course, within Scotland there is a very important local dimension and this is something that Governments have been struggling with for 30 years, through the SDA, Scottish Enterprise and the enterprise network, to get an appropriate local level response to this. Again, we are still not there. We still have a very untidy institutional landscape when it comes to economic development. It needs an awful lot of work done on it.

Chair: Thank you. Are there any other points that we want to ask Professor Keating before we throw him out?

Q225   Jim McGovern: I want to try and determine something that you mentioned earlier about the raising of tax powers or additional tax powers for Scotland. You said that it would promote debate with trade unions and various other organisations. Are you of the opinion that it would never actually be applied, but it would be something that would be good for an argument?

Professor Keating: Out of that debate, I assume there will be a result and we will be faced with the necessity to decide whether we want high taxes and high welfare or low taxes, because you cannot have both. At the moment, we have been pretending, or if you read a lot of the debate there is a belief, that you can have low taxes and high standards of public services, but you cannot.

Q226   Jim McGovern: The tax powers that the Scottish Parliament have currently have never been applied. Is there any point in varying them in order to promote a debate?

Professor Keating: To take up the point that Anton made, under this present proposal, the Parliament would have to make an explicit decision. That may be just symbolic, but the more the tax powers and the wider the tax powers, the more people are going to get interested because the more people are going to be affected. The evidence internationally, because there are many other things going on, is that this does engage stakeholders in a really serious way. Their pockets are going to be affected so they get involved. We have to face up to the tough decision that we have been avoiding in Scotland for the last 10 years because there has been so much money going around, but the money is going to stop and it is about time we decided now what the priorities are. They may be high taxes or they may be low taxes—that is a democratic decision—but we cannot any longer evade that question.

Chair: Alan, you wanted to come in?

Q227   Mr Reid: Are there any taxes other than the ones that Calman recommended that you think could be devolved to Scotland—the power to vary other taxes?

Professor Keating: I do not see why you could not change the excise taxes, vehicle licence duty, alcohol and petrol tax. Of course, there would be limits because otherwise people would go and buy their petrol elsewhere, but nobody is going to drive all the way from Inverness to Carlisle to fill up their petrol tank. That defines what the limits are. Similarly, with alcohol taxation, there would be a fairly modest variation. The vehicle licence duty is devolved to regions in most countries in Europe. That seems to be an obvious one. You know where people register their car.

Q228   Mr Reid: Is it practical, particularly with alcohol duties? We already have cross-Channel smuggling so would we not just have cross-border smuggling? When I say "smuggling", I mean legally of course.

Professor Keating: Obviously that imposes constraints. If the tax difference is so high that it pays you to drive a truck down, get the thing and illegally retail it to your friend, then maybe you will do it. If the difference is marginal, then the incentives will not be there. That is true of the world. That is true between the south of England and France, but that is no reason for not devolving the taxes. It is just to say that there are limits on the scope for variation. The more different taxes you have with small margins of variation means that when you put them all together, you get a fairly large amount of discretion.

Q229   Mr Reid: Professor Keating, in your written evidence, at paragraph 8, you say, "If the UK government should commit itself to a radical shrinking of the public sector and the Scottish Parliament choose to maintain the existing welfare state, then more radical devolution of taxation will be necessary." From what you have said on excise taxes, there would only be small variations, so what taxes would it be?

Q230   Professor Keating: Adding up all these small taxes, you get small amounts of variation. That generates a certain amount of revenue. Income tax is another one and possibly corporation tax, but of course that is subject to competitive constraints. This is true of independent states. This is true of France versus Germany. You cannot get too far out of line, but nevertheless we do see in Europe significant differences. We see countries that have maintained relatively high taxation levels and also extremely high levels of economic performance because they have spent the taxes on things that enhance economic performance.

Q231   Mr Reid: When you say the existing welfare state, do you mean welfare benefits?

Professor Keating: No. I mean education, health, public expenditure. This is a debate that is being engaged in the UK since the last election: what should the size of the state be? If the decision in Scotland and Wales should be different from England, clearly that has implications for the revenue base. It would imply that they need to raise more taxes in Scotland.

Q232   Mr Reid: How much do you think the Scottish Government could vary income tax without people moving south of the border to escape it? Is there a figure you could put on it?

Professor Keating: Maybe Anton has a figure on that, but I could not. I would just say that the scope for substantially higher taxation is limited by precisely that. But if you look, for example, at Canada—I know Canada is a big country but most people live within 100 kilometres of the border so actually it is a fairly densely populated country—there are all sorts of other things that determine where people will live, mainly where you can get a job and where your family is. This does give scope for a certain amount of variation in taxation without provoking mass migration.

Q233   Chair: We will let you go, Professor Keating. Thank you very much for coming to see us. We hope we have not been too hard on you.

Professor Keating: No, I was expecting a lot worse.

Q234   Chair: I was going to say that if you want to complain, write to the Speaker. I can tell you what he will say. If you feel happy, tell all your friends that it is not too bad coming along here. Thank you very much.

Professor Muscatelli, we have been saving all the hard ones for you. You wanted to come in earlier on a point that was being made to Professor Keating.

Professor Muscatelli: I was just coming in to say that I agree with your statement, Chairman. If these issues around R and D taxes or a tax break for particular sectors are economic development issues, then we have to ask the question, is Scotland a special case or are these UK industries that need to be encouraged? Is the economic development issue an issue for Scotland alone or is it also for Northern Ireland, parts of Wales and parts of the north-west or whatever? If that is the case, we should be looking at tax breaks around corporation tax at local level, perhaps within a UK economic development context. The reason why we resisted the devolution of corporation tax, or suggested to the Commission that they should not go there, is because we felt that it would lead to tax competition to vary the headline rate for all firms. If corporation taxation is going to be used for economic development issues, we have to ask whether Scotland, like the Basque country, is definitely a special case in terms of de-industrialisation.

I think your point about locality within Scotland is also relevant because why should you stop the devolution there? What about issues of Glasgow versus Edinburgh, for instance? These are important issues.

Q235   Fiona O'Donnell: The Scottish Government, in terms of freezing council tax with local authorities, has set the situation up so that if local authorities choose to raise the council tax they will be penalised in terms of their allocation. Is Scotland at risk with this Bill of similar treatment from the UK Government?

Professor Muscatelli: This is why we have to pin down how the grant deduction formula is going to work so that it does not become a political issue of conflict between the two countries. I think that is important. As Michael pointed out earlier, we have that situation anyway in terms of formula bypass. Political issues arise anyway around what is Barnettable and what is not—whether the Olympic expenditure is or is not Barnettable. It is not as if these issues do not exist at the moment, but that is why it is important that the grant formula should be embedded in such a way that it is understood by all parties.

Q236   Chair: This is the same sort of point that we made to Professor Keating. Upon reflection, given all that has happened and the exchanges that have taken place since you reported, with hindsight, are there any changes that you would make, or issues that we now ought to take into account when considering our report, that you did not consider at the time?

Professor Muscatelli: I would say there are three issues, Chairman, and they are largely areas on which we were silent but with hindsight we can fill in the gaps, if you like. One is on the formula allocation adjustment where, in retrospect, I would recommend a formula adjustment which indexed the grant adjustment to the UK income tax base. Secondly, we were not precise on the issue of borrowing limits. We simply said that they had to be prudential, etc, etc, but both in terms of the borrowing for revenue and capital purposes we could have perhaps spelt out a bit more precisely what those limits were. For instance, around capital borrowing, it is not clear to me that the £2 billion limit is the right limit. Again, in exchanges with the Scotland Bill Committee, probably one way to fix that would be in terms of what is prudential serviceability out of the income tax share of the total departmental expenditure limit for Scotland. Those are the two main areas. The third is possibly issues around thresholds and different tax bands and whether this is a staging post towards a more complex discussion around those issues.

As you pointed out, the Scotland Bill may simply be a staging post. It may be that in 10 years' time we will see this as one move in the direction of greater fiscal accountability and then we have to revisit it. On the third issue, perhaps, we might have been more precise about the nature of tax devolution, but simplicity was a factor as well.

Q237   Chair: Thank you. I very much got the impression from what you were saying earlier that we should not confuse ourselves about all the furore that has been kicked up by writers about various other models and statistics and all the rest of it, as there is very little substance in that. The politics of the situation is as described in the Calman report, with minor variations. Is that a fair way of looking at it all?

Professor Muscatelli: Absolutely. I would agree with that, yes. That is our position.

Chair: Does anyone else have any final questions? Thank you very much for coming along. As before, if you have any complaints, send them to the Speaker. Tell your friends that it was not nearly as hard as you expected. Thank you very much.

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