Britain needs tax devolution, but beware of fiscal war

Britain is an outlier when it comes to centralising taxes, but devolution of taxing powers could lead to unforeseen consequences, warns Tim Sarson, a tax policy specialist. Last week, government front benchers and regional leaders from across England gathered at Number 10 North to discuss a new Visitor Levy, a tourism tax. This marked a significant milestone, as it's the first time in decades that local regions have received new taxing authority.

The prospect of more devolution in the political and fiscal landscape is exciting for those in the field. Currently, Westminster continues to collect taxes, while mayors of devolved cities and regions will have more influence over how the central pot is spent. There is hope that this trend will continue and more control will be given to the regions.

Britain is one of the most centralized states in the developed world when it comes to tax collection. In 2023, only 4.8% of the national tax revenue was collected at the local or regional level, according to the OECD. The remaining 95.2% is sent to the central Treasury, which then redistributes it across the country. This low percentage is a significant departure from other developed nations, where tax decentralisation is more common. Germany collects 32.6% of revenues at the city and lander level, while Switzerland manages 46.7%.

There are two main arguments for devolving taxation to the sub-national level. The first is that regional governments are closer to the needs and priorities of their voters and can therefore better direct fiscal policy. The second is that devolution allows for experimentation and competition among regions. The first argument holds political weight, but its economic viability is questionable.

On the other hand, tax decentralisation has been shown to create inter-regional competition in the US, UK, and Switzerland. For example, Nevada enacted tax reforms in 2014 to attract Tesla's $5 billion gigafactory, which was successful.

However, tax decentralisation is not always a silver bullet. Rich regions might end up with higher tax receipts if their wealth is based on immovable natural resources or they already have a significant competitive advantage. In Canada, Alberta, the second richest province, benefits from high oil and gas royalties, allowing it to maintain high levels of public spending.

There's also the risk of fiscal war between states, as seen in Brazil's experience with devolution. The country saw decades of "fiscal war" between states trying to outcompete each other, leading to inequality and weakened public services in financially weaker states. Brazil is now moving towards more centralized tax collection.

While Britain is not as extreme as Brazil, there is still room for improvement. The current tax decentralisation in Britain is relatively low, at 4.8%. Allowing mayors to spend central government money on local priorities is a step in the right direction, but for true regional competition, there needs to be a more symmetrical relationship between the regions and Westminster, involving control over revenue as well.

If Britain is serious about returning power to its cities and regions, it should aim to increase the tax decentralisation to a more competitive level.