Devolved taxes, the Welsh budget and a no-deal Brexit

Over the past two years, responsibility over three taxes have been devolved to the Welsh Government: Land Transaction Tax (replacing Stamp Duty), Landfill Disposals Tax and 10 pence on each rate of Income Tax paid on non-savings, non-dividend (NS-ND) earnings.

In Spring, the Wales Fiscal Analysis team published a briefing paper suggesting that tax devolution could have a relatively modest, but positive net effect on the Welsh budget over the next five years.

However, these projections were underpinned by forecasts published by the Office for Budget Responsibility (OBR). The OBR had assumed that the UK would leave the European Union with a deal at the end of March 2019.

Despite the UK parliament’s attempts to legislate against a no-deal exit, there remains a real possibility that the UK could leave the European Union without securing a deal.

A no-deal Brexit would affect the Welsh budget in various ways, likely reducing future growth in spending and creating extra pressures on the spending side of the budget. In this blog post, we explore another channel through which the Welsh budget may be affected by a no-deal Brexit – through the effect on devolved tax revenues

Devolved taxes and a no-deal Brexit

As a result of the Fiscal Framework (2016) agreement reached by the Welsh and UK governments, the relative performance of Welsh revenues from the three newly-devolved taxes compared to England and Northern Ireland has a direct effect on the size of the Welsh budget.

If, as expected, a no-deal Brexit reduces devolved Income Tax revenues and revenues from property taxes in Wales, the Welsh budget may not necessarily be worse-off.

The extent to which the Welsh budget is exposed to risks associated with tax devolution in a no-deal scenario depends on whether the shock to tax revenues is asymmetrically felt across the UK.

If devolved Welsh tax revenues are relatively more adversely affected as a result of a no-deal Brexit compared to equivalent revenues in England and Northern Ireland, tax devolution could have a negative net effect on the Welsh budget.

On the other hand, if devolved Welsh tax revenues are relatively less adversely affected as a result of a no-deal Brexit compared to equivalent revenues in England and Northern Ireland, tax devolution could have a positive net effect on the Welsh budget.

Let’s explore what this means in relation to two of the devolved taxes:

Welsh Rates of Income Tax (WRIT)

Using data from the OBR’s Fiscal Risks Report, we have modelled the net effect of tax devolution (i.e. whether it will have a positive or negative impact on the Welsh budget) under three no-deal scenarios:

For the central projection (green line), we assume that Wales is as equally adversely affected as England and Northern Ireland by the shock to average earnings and the employment rate caused by a no-deal Brexit.

In this case, the net effect of Income Tax devolution on the Welsh budget is positive and grows over the forecast period. This positive effect amounts to £5 million in 2020-21 and £14 million in 2021-22 (broadly in line with the figures we reported in March, which assumed an orderly withdrawal from the European Union.)

Put another way, if non-savings, non-dividend Income Tax revenues fall uniformly across the UK as a result of a no-deal Brexit, this will not materially alter the net effect of Income Tax devolution on the Welsh budget.

The other two scenarios show the potential net effect of Income Tax devolution on the Welsh budget if Wales is relatively more affected or relatively less affected by any shock to average earnings and the employment rate compared to England and Northern Ireland. Specifically, we have modelled scenarios where a no-deal shock hits Wales 50% harder than England and Northern Ireland and a scenario where the shock hits Wales only half as hard. Therefore, if average earnings across the UK are forecast to be 1.2% lower in 2020-21 in the event of a no-deal Brexit, our scenarios assume that Welsh average earnings would be 1.8% and 0.6% lower respectively.

If Wales is relatively less affected by a No-Deal Brexit, the positive net effect of Income Tax devolution is expected to be even greater, coming in at over £30 million in 2020-21 and higher in later years.

However, if Wales is hit relatively harder than England and Northern Ireland, this could place a dent in the Welsh Government’s budget each year over the forecast period, amounting to £30 million in 2021-22.

Whether the Welsh tax base is likely to be hit harder than the rest of the UK may depend, in part, on which industries would be most adversely affected in the event of a no-deal Brexit.

Of course, the precise impact of a no-deal Brexit on different sectors of the economy is uncertain, but a key determinant of Wales’ relative economic performance will be differences in the industry-mix of the Welsh Income Tax base.

The Welsh tax base’s greater reliance on employment from the manufacturing industry could be a source of risk for the Welsh budget in the event of a no-deal Brexit. Moreover, since Wales’s manufacturing industry is smaller in absolute terms compared to England and Northern Ireland, Welsh tax revenues would be relatively more affected by the closure of one large manufacturing plant.

On the other hand, lower revenues from the financial services sector would likely generate a relatively larger dent in the English and Northern Irish tax base.

Land Transaction Tax (LTT)

Stamp Duty Land Tax was one of the revenue streams most adversely affected during the 2008 financial crisis in proportionate terms. Between 2007 and 2009, total revenues fell by 53% in Wales and 51% across the UK.

In their no-deal Brexit stress test, the OBR projects that this tax and its devolved equivalents will have the largest proportionate hit on revenues, because of the expected reduction in the volume and value of property transactions.

Again, we have modelled three scenarios exploring what the net effect on the Welsh budget might be:

In our central projection, LTT revenues to Wales are hit by an equally proportionate amount as the average shock across England and Northern Ireland. In this case, there would be a small but negative impact on the Welsh budget over the forecast period, broadly reflecting our findings from March 2019.

However, the net effect in the other two scenarios are quite striking. If LTT revenues are hit twice as hard in proportionate terms compared to England and Northern Ireland, this could have a significant negative effect on the Welsh budget, amounting to nearly £50 million a year from 2021-22 onwards.

Although LTT brings in only a tenth of the revenue brought in by Welsh Rates of Income Tax, this tax could play just as great a role in determining whether the Welsh budget is better or worse-off as a result of tax devolution.

In a further quirk of the tax devolution settlement, trends in a relatively small number of high value property transactions in London could determine whether the net effect on the Welsh budget is positive or negative in a no-deal Brexit scenario.

The impact of a no-deal Brexit on the Welsh budget

Of course, even if the net effect of tax devolution on the Welsh budget is positive, this does not necessarily imply that the overall impact of a no-deal Brexit on the Welsh budget is positive. If the UK government responded to weaker economic forecasts by imposing tighter restraints on spending growth on devolved areas in England, this would limit the size of the Welsh block grant in future years.

However, this month’s spending round announcement and the fact that many public services have yet to recover from previous rounds of austerity suggests that further spending restraints are unlikely, at least in the short term. The UK government would seem more likely to increase borrowing.

If so, the most significant short-term impact of a no-deal Brexit on the Welsh budget could be through its impact on devolved taxes and the block grant adjustments.