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Background Analysis to the Framework for Economic Development in Scotland

5 The Management of Public Finances

Before discussing the detail of the Framework's strategic objectives, it is valuable to consider the wider role and impact of Scottish fiscal policy. In particular, this chapter sets out the underlying rationale for some key areas of the Executive's management of public finances.

5.1 Economic Impact of Executive Expenditure

The devolved Scottish government's expenditure programme supports the Scottish economy in several ways. Firstly, it provides public services that raise the Scottish growth potential through, for example, education and health spending. Secondly, investment expenditure on public infrastructure supports further development of the Scottish economy. Thirdly, total spending on public services and investment in turn generates demand for Scottish goods and services. Finally, the public sector provides employment and income to those it employs, which subsequently translates into private demand. The appropriate role of the public sector was considered in chapter 3.4 above.

In Scotland, the public sector has a very significant influence on the macro-economic development of the economy. In 2001-02, aggregate Scottish public expenditure totalled 39.4 billion, of which 19.6 billion was directed through the Scottish Executive.

The public sector clearly brings many important economic benefits as indicated in the paragraphs above, but its actions also may inhibit the development of the private sector. At the aggregate UK level, it would, for example, be undesirable if increasing public spending drove up interest rates through increased borrowing (or reduced the funds available to the private sector - e.g. through increased taxation) and thus crowded out private investment. Equally, if public-sector activity led to a diversion of skilled individuals away from the private sector or created markets in which private enterprises and the self-employed found it difficult to compete there would necessarily be concern.

In recent years, Scotland has been in the fortunate position that, in the UK as a whole, net borrowing has been at a low level (or even in surplus), not threatening to put pressure on the financial markets. Adherence to sound fiscal rules ( see chapter 4.2) at the UK level has ensured a sustainable level of public expenditure that has not deterred private-sector activity and investment.

This chapter highlights several elements that the Executive has put in place to ensure that public sector activity is both catalytic in its impact and subject to very rigorous analysis to ensure that it does provide the most appropriate level of support. It, therefore, covers the Executive's strategic approach to:

• integrity and transparency in expenditure;
• appraisal and effectiveness of expenditure;
• innovation and productivity in public services;
• the present extent of fiscal powers;
• the management of business taxation;
• the management of personal taxation;
• the future of local taxation;
• relocation strategy.

5.2 Integrity and Transparency of Executive Expenditure

Given the importance of public sector expenditure to the Scottish economy, it is critical to ensure that resources are spent wisely. If the benefits of public expenditure are to be maximised, spending proposals must represent good value for money. Equally, if the anticipated benefits of spending are to be realised, proposals must have effective delivery and monitoring arrangements in place.

The key framework for spending decisions is the Spending Review. For each aspect of government presented in the Spending Review, high-level aims and objectives explicitly set out the policy goals that the Executive is pursuing. Linked to this is a set of targets, which set out the desired results of the spending.

This financial and performance regime should increase the efficiency of our spending, enhance the way we report our finances and performance to the public, and ensure that our spending has maximum impact in meeting our priorities.

The Minister for Finance and Public Services has set out Five Principles for public spending which summarise best practice in creating value for money:

• pre-appraising expenditure: we must be clear before we take any decisions what the resources will buy and when;
• identifying the delivery mechanisms: we must examine how these resources will deliver the required output and the arrangements we require to have with relevant partners;
• identifying the benefits: we must clearly specify what benefits the improved service delivery will bring;
• measuring the benefits: we must measure and assess those benefits; and
• monitoring delivery: we must establish key milestones to monitor and ensure that final delivery is achieved.

The aim of these Principles is to make sure that the devolved Scottish government's resources are directed explicitly at making a real difference to what matters in the daily lives of the people of Scotland. These Principles will not only help to ensure that spending plans are effective and deliverable, they will also improve transparency and accountability.

Improving Programme, Policy and Project Delivery

The Executive is implementing a number of initiatives in order to improve the delivery of its programmes, policies and projects. This includes the recent formation of its Centre of Expertise for Programme, Policy and Project Delivery. This unit will promote the use of programme and project management disciplines, primarily to those who develop and implement policy. The unit will encourage and support the use of good practice and ensure that this is shared with colleagues throughout the Executive and the wider public sector in Scotland.

The Centre of Expertise is also responsible for promoting and coordinating the Executive's Gateway Review programme. This is a programme of Gateway Reviews - health-checks of projects by independent teams of practitioners at the critical stages of high-risk or mission-critical programmes and projects. Gateway Review supports programme and project delivery by reviewing and making recommendations on various areas of the programme or projects delivery - such as whether it has the appropriate skills and resources, management processes and benefits realisation plan to meet its objective.

5.3 Appraisal and Effectiveness of Expenditure

One key element of the Executive economic strategy - which follows directly from the Five Principles set out above - is to improve the degree of rigour with which resources are allocated to meet the Executive's priorities. In A Partnership for a Better Scotland, two important commitments are made:

" We will evaluate all new spending commitments for their economic and social impact and value for money."

"We will legislate to introduce strategic environmental assessment to ensure that the full environmental impacts of all new strategies, programmes and plans developed by the public sector are properly considered."

Objective assessment of the likely economic, environmental and social impacts of policies and projects is a fundamental aspect of evidence-based policy making. These commitments should help to ensure that policies and projects are well-designed, meet their objectives, and represent good value for money. In this context, "value for money" should not be seen as a narrow economic concept - it also covers wider social and environmental costs and benefits.

In the light of these commitments, the Executive is implementing a system of "Pre-Expenditure Assessments" for policies, projects, and programmes. These assessments set out:

• the Aims and Objectives of the proposal;
• the Options for addressing these objectives;
• the Evidence Base on the likely impacts and value for money of the proposal;
• the Financial Impact of the proposal, management and procurement arrangements;
• the plans for Monitoring and Evaluation.

Pre-Expenditure Assessments are based on the principles and techniques outlined in HM Treasury's Green Book on appraisal and evaluation and the Cabinet Office's Magenta Book guidance.

The Revised HM Treasury Green Book

The Treasury's "Green Book" on Appraisal and Evaluation in Central Government⁶ is widely regarded as best practice guidance for the appraisal of projects in central government. The most recent version of the guidance was published in April 2003, following a long period of consultation with UK Departments, devolved administrations, leading academics in the area, and private sector consultants.

Scottish Ministers have decided that the new guidance should also be applied in Scotland.

The new Green Book comprises a package of reforms which are designed to assess more explicitly and transparently whether spending proposals are worthy of the resources to be committed. This package includes:

• A greater emphasis on valuing and managing the benefits, as well as the costs, of spending proposals;
• An "unbundling" of the discount rate. This involves the introduction of a social time preference rate of 3.5 per cent, with other factors - particularly the tendency for over-optimism about the costs and benefits of proposals - being dealt with explicitly rather than being bundled up in the previous 6 per cent discount rate;
• More explicit consideration of the impacts of projects on different groups in society;
• An adjustment to ensure that the different tax liabilities of different options is taken into account, particularly for Public-Private Partnership proposals.

The new guidance should encourage a longer-term view of proposals, giving greater weight to future benefits than previously was the case. It should also encourage a greater focus on achieving and managing the benefits of projects.

5.4 Innovation and Productivity in Public Services

While private enterprise has to prove its viability through market success, generally there is no equivalent competitive pressure on public services. Public services providers have sought different ways of gauging and raising their performance. At the most basic level, the auditing of public expenditure aims to prevent fraud and the waste of public money in ineffective expenditure programmes.

Efficient Government initiative

Scottish Ministers launched the Efficient Government initiative, which is seeking cost-effective measures to secure major improvements in service delivery, backroom and support processes and release resources for improved front-line services, focused on the needs of customers. Ministers are looking for the Efficient Government initiative to deliver around 2-3 per cent real-term savings from the Executive budget as a whole (that is, at least 500 million per year) as part of the SR2004 process. Over the next two years, Departments will need to define strategies for delivering their stated savings by the start of 2006-07.

Measuring Productivity in the Public Sector

There are inherent difficulties in measuring output and productivity in the public sector: (a) in the case of collective services such as Defence and Public Administration, it is difficult to identify the exact nature of the output, and (b) in the case of services supplied to individuals, such as Health and Education, it is hard to place a value on these services, as there is no market transaction. To derive reliable measures of productivity in the public sector we need first an accurate measure of the volume of public sector output.

Since 1998, the Office for National Statistics has increasingly produced estimates of the volume of government output for the UK. These estimates show that, while expenditure increased by 48 per cent between 1995 and 2002, output rose by only 15 per cent. However, output measures do not illustrate all relevant outcomes - such as improving quality of service - and it is often such outcomes that public policy is addressing in the first place. The results of the ongoing Atkinson Review ⁷ on the measurement of government output and productivity will advance methodologies in the context of UK National Accounts, and will help the Executive identify opportunities for improvement.

Attaining Outcomes

There are no unique policy solutions to achieve top-level outcomes such as the vision of this document or the main goals of the Partnership Agreement. In an effort to make government more accountable and progress more measurable, performance targets are being used as intermediate steps towards reaching overarching commitments.

5.5 The Present Extent of Fiscal Powers

The debate surrounding the desirability of greater devolution and increased fiscal autonomy for Scotland continues. ⁸ In the context of economic development, Scottish Ministers do not accept that the case for greater fiscal powers has yet been made.

The effective degree of fiscal powers. The external debate is often dominated by analyses that fail to recognise the many dimensions of fiscal autonomy. The effective degree of autonomy under any new approach would be a complex function of the degree of autonomy in revenue-raising, expenditure allocations and debt-raising. Looking at the prevailing fiscal structures within national economies across Europe reveals a considerable variation of practice and in the effective degree of regional autonomy.

Scotland already has considerable fiscal powers in relation to government expenditure in Scotland. The Executive, with the assent of Parliament, directs Scotland's annual allocation of resources to the nation's priorities. Addressing the priorities within FEDS is unconstrained by the current constitutional arrangements.

Resourcing public expenditure in Scotland. The finding of structural fiscal net deficits on the basis of the analysis in Government Expenditure and Revenue in Scotland, 2001-02 suggests that - at least in the near term - a continued fiscal net transfer to Scotland remains necessary to maintain the current service provision ⁹ in general, and the needs identified within FEDS. It would appear that it would require significant increases in revenues (raised and retained in Scotland) to avert the need for a transfer from the UK level.

Greater fiscal powers - whether they led to a large or a small proportion of the targeted Executive expenditure being funded directly from within Scotland - would not be a substitute for a future Needs Assessment (or an approach with a similar objective) or for a Barnett formula (or a mechanism with a similar purpose of adjusting the transfer on an annual basis). Moreover, at this time, the UK Government has stated that it sees no case to revisit the present resource allocation mechanisms and the method by which these are adjusted each year.

Accountability and the use of resources. Scottish Ministers do not believe that accountability - and the effectiveness with which the resources raised from the Scottish people are currently deployed - is inhibited by the manner in which the revenues are collected. As is made clear below, the Executive has clearly established systems for upholding the integrity and effectiveness with which resources are used - based around the Five Principles.

Moreover, the argument that economic growth may be inhibited by the fact that any additional tax revenues generated by such growth accrue to London and not to the Scottish Parliament is both inaccurate - since the Executive is a direct beneficiary of any increased tax revenues flowing to London - and ill-founded. The vision articulated in FEDS provides great clarity around the Executive's motivation for securing economic growth. In no sense does this motivation depend on the source of resources.

The economic case. In essence, the economic case for increased levels of autonomy largely focuses around the view that, with greater autonomy - and an assumption that this would allow reductions in tax rates - decision-makers would respond favourably and boost investment and growth in the economy. This growth would generate increased tax revenues, thereby more than compensating for any initial reductions in tax-take.

On balance, it is questionable, however, whether increasing Scotland's devolved powers by widening its powers to raise its own tax revenue would lead to large gains in output growth. As others have pointed out, the critical question is whether behaviour of decision-makers in Scottish and overseas enterprises would in fact respond to relatively small changes in taxation as claimed, and raise investment levels. Compared with many other countries, Scotland is a relatively high-cost producer. It is therefore unlikely that any tax incentives that Scotland could offer would be a major factor for investors. Instead, it is Scotland's position within the UK and EU markets, the skills of its workforce, the quality of established industries, its public infrastructure, and the stable macro-economic environment that mainly support the decision to invest here.

Certainly, at the extreme, the Scottish Ministers rejects the view that fiscal separation will benefit Scotland. On the contrary, the loss of the significant benefits from the (existing and proven) macro-economic stability within the UK would far outweigh the (uncertain and unproven) benefits from greater economic powers that some have identified.

5.6 Business taxation

Non-domestic rates (NDR) is the only tax-raising power currently in use by the Scottish Executive. ¹⁰ While the poundage rate is set annually by the devolved Scottish government, responsibility for the day-to-day administration of NDR billing and collection in Scotland has been delegated to local authorities. NDR income is pooled across Scotland, and then redistributed to local authorities in proportion to their population. A balancing item within the local government finance settlement ensures that each council receives total central funding based on an assessment of relative need.

Scottish Ministers see NDR as a key element in the Framework, balancing the need to raise revenues for key expenditure programmes against the importance of not imposing a burden on business that inhibits investment and economic growth. The strategy in this respect focuses on four elements:

• identifying the appropriate tax burden;
• setting the appropriate level;
• complementing the other economic programmes that foster small enterprise development; and
• improving local communities.

The burden on business

In the absence of an explicit motivation to influence the behaviour of individuals or enterprises in one particular direction, the basic goal of government in raising revenues to support government expenditure programmes is to distort economic behaviour as little as possible. Moreover, there is a basic intention to treat all tax payers equitably.

When assessing the appropriateness of business tax, it is important to take account of the whole burden imposed on individual businesses by all forms of taxation. In Scotland, the levels of corporation taxes and non-domestic rates are relatively higher by comparison with other EU countries, but this burden on business is offset by lower social security contributions.

Generally, business is taxed relatively moderately in the UK and Scotland in comparison with most developed economies. In 2000, the overall tax revenue (corporation tax, employers' social security contributions and business property tax) raised from businesses in Scotland and the UK was 9.2 per cent and 9.0 per cent of GDP, respectively.

Most importantly, the Executive considers the current level of resourcing for high-quality programmes that support economic development to be broadly correct. As FEDS clearly demonstrates, while business development depends on key public sector programmes - such as supporting high quality infrastructure and the flow of skilled people - and on incentives that encourage business investment and risk-taking, the Executive regards the current resourcing available from UK transfers and from the use of the devolved tax-raising powers to be striking an appropriate balance.

Setting the appropriate level

As noted above, the Executive's strategy for the setting of non-domestic rates is underpinned by the need to strike a balance between minimising the burden of taxation on the one hand and maximising the resources available for investment in the various elements that drive economic development on the other. The Executive's strategy has been to set the maximum annual increase in the poundage rate equal to the growth in the Retail Price Index. Over the last revaluation, this means that the poundage was set to ensure that income is maintained in real terms. This is fair to business and represents an appropriate balance between these competing needs. The strategy has, moreover, preserved the real rates burden in Scotland at broadly the same level as in England.

Equally important, in view of the emphasis placed here on the capacity of Scottish enterprises to compete effectively in global markets, this approach preserves the aggregate burden of the taxation system upon Scottish businesses - as the Box above demonstrated - at a level that is similar to or below that prevailing in most of the advanced economies with which Scotland competes.

In implementing the strategy, as set out in the 2003 Partnership Agreement, the poundage rate for 2003/4 was frozen at its 2002/3 level of 47.8p and increased by less than the rate of inflation in 2004/5 to 48.8p. Scottish Ministers are also committed to limiting the rates increase in 2005/6 to no more than inflation.

In addition, as part of the strategy, the Executive has recently looked to introduce a degree of flexibility with the creation of a discount for the smallest enterprises (see below) and a marginal surcharge for the largest enterprises to finance this policy.

Fostering Small Enterprise Development

There is evidence that rates represent a larger proportion of turnover for small businesses than for larger enterprises. This has been a concern for the Executive in the light of its major efforts to promote the development of the small business sector - both through the stimulation of new enterprises and the encouragement of small ones to grow into medium sized enterprises.

In order to address this imbalance and to further support the enterprise development programme, the Executive launched the Small Business Rates Relief Scheme from 1 ^st April 2003. Under this scheme, all non-domestic subjects in Scotland with a rateable value of 10,000 or less are eligible for a discount of between 5 per cent and 50 per cent on the rate poundage. This provides rates relief for some 70 per cent of non-domestic ratepayers in Scotland. The net additional cost of this scheme, beyond previous schemes, is met by a surcharge of 0.3p on the poundage for properties with a rateable value of over 25,000 in 2004/05. The Executive will, where appropriate, take the opportunity to provide further incentives for growth.

Improving Local Communities

As part of its programme to raise the standard of locally provided services and to revitalise local areas, the Executive is consulting with local authorities, the business community and other interested partners on how Business Improvement Districts (BID) might best be implemented in Scotland. BIDs are an arrangement through which local authorities and the local business community agree to take forward schemes of benefit to the local business community. Introducing BIDs in Scotland is a commitment in the Partnership Agreement for a Better Scotland.

Where the basis for such a BID is agreed between the partners, the funding of any BID would, at least in part, be raised from businesses through an agreed levy on non-domestic rates. Exactly what additional services would be secured would vary according to local need, be it improvements in the local environment, facilities, security or transport infrastructure. The benefit secured by local businesses could include higher turnover, increased property values, improved staff recruitment and retention, or improved security and subsequent lower insurance payments.

5.7 Personal Taxation - the Scottish Variable Rate

As set out in the Scotland Act (1998), the devolved Scottish government has the power to vary the basic rate of income tax up or down by 3 percentage points. ¹¹ Since devolution, Scottish Minsters have, however, not made use of this power and have indicated in the 2003 Partnership Agreement for a Better Scotland that they " will not use the income tax varying powers of the Scottish Parliament."

The Executive's decision is founded on a range of factors that currently make the use of the power undesirable. These include:

• work incentives: lowering income tax might, in principle, stimulate the Scottish economy if it raised the incentive to work, especially for those that are currently not participating in the labour market. Comparing labour markets across Europe suggests, however, that the hours worked per employee are already significantly above the EU average. Consequently, there seems to be little need to provide further work incentives.

  Moreover, varying income tax does not appear to be the appropriate instrument for integrating the economically inactive into the labour market. Economic inactivity and underemployment are primarily linked to a lack of skills and attitudes to do productive work. Futureskills Scotland found that 'soft' skills such as customer handling, oral communication, team working, and problem solving, were cited most frequently by employers as the type of skills applicants lacked. Generally, skills are a middle-ranking challenge for Scotland's employers, but they are the highest-ranking challenge over which the public sector could act. Changing the rate of income tax would do nothing to address the skills problem and, thereby, Scotland's growth potential;

• the effectiveness of using current revenues: the devolved Scottish government's present approach is to maximize the value and effectiveness with which existing revenues are spent, rather than seek new sources of revenue. As the Five Principles, set out above, demonstrated, the key challenge is to improve the decision-making processes on the basis of better evidence and knowledge and, thereby, direct our limited resources towards their optimal uses in order to deliver the key Executive objectives;
• a one-off increase: there is a misapprehension in much of the debate that raising the basic rate will yield ever-increasing revenues. In fact, raising the rate would represent a one-off step increase in revenues in that year. In subsequent years, the level of revenues would not change for this reason. Consequently, using the power could not counter any long-term adverse trend that some commentators perceive but only provide a temporary relief. In fact, the budget impact of varying the basic rate would be relatively small when compared to the overall size of the Scottish Budget (25 billion by
  2005-06) ¹²;
• accountability: some have argued that increasing the tax revenues raised by the Executive would enhance the accountability of the devolved Scottish government to the Scottish people. As the Five Principles again make clear, that accountability is already well acknowledged by Scottish Ministers and the use of public resources is already conducted to the highest possible standards.

In view of these considerations, ¹³ the Executive strategy with regard to the use of the tax-varying power is clearly established for the present.

The future of local taxation. In June 2004 the Executive launched the Independent Review of Local Government Finance. Its remit is to review the different forms of local taxation, including reform of the Council Tax, to identify the problems and opportunities of implementing any changes to the local taxation system in Scotland, including the practicalities and the implications for the rest of the local government finance system and any wider economic impact, and to make recommendations based on this assessment.

5.8 Relocation Policy

Since 1999, the Executive has had a strategy of dispersing public sector jobs away from Edinburgh to areas throughout Scotland. In the first four years around 1,300 posts have been or are planned to be located outwith Edinburgh. This is an ongoing process and around a further 1,800 posts are being considered for relocation before the end of the year.

The strategy is driven from an economic perspective by two key objectives:

• the promotion of an efficient and effective operation of the departments and agencies of the Scottish Executive;
• the wish to distribute economic prosperity more evenly across Scotland.

These two objectives need not be in conflict with each other, and nor are they inconsistent with the national priority of accelerating economic growth. In the right circumstances, relocations can lead to both national and local economic benefits.

The Executive strategy is motivated by a range of factors including:

(i) Direct cost savings. Relocating jobs from overheated property and labour markets can lead to direct cost savings, e.g. reduced rents and lower recruitment costs.

(ii) Organisational benefit. When assessing the impact on organisational effectiveness, both short and long-term impacts are taken into account. Whilst a degree of short-term disruption is inevitable when an organisation is relocated, it is equally important to assess potential longer-term benefits such as reduced staff turnover. In addition, rapid improvements in communications technology have made it increasingly feasible to locate public sector functions in more remote areas throughout Scotland;

(iii) National and regional economic prosperity. Relocating jobs away from overheated areas, such as Edinburgh, to more fragile and rural areas can also potentially lead to wider economic and social benefits, including;

• local demand: a beneficial 'demand-side' boost to the local economy through improved employment opportunities and increased local spending. Even if all of the existing staff decide to commute to the new location rather than move to the area, they will spend some money on local goods and services. In the medium term, unemployed residents of the area might start to take up the jobs in place of the existing staff, and some of the existing staff may relocate to the area and start spending a higher proportion of their income locally. All of this will help to boost local demand and reduce local unemployment;
• fragile communities: improving local job opportunities and reducing unemployment should help to strengthen fragile communities. Countering the slow depopulation of regions of Scotland can help avoid the potential for a vicious circle of falling job opportunities and further out-migration. It can also help to ensure that local infrastructure (e.g. roads, schools, and hospitals) is used efficiently;
• national employment: a limited boost to overall Scottish employment can result, as those who choose not to relocate should be better-able to find alternative employment than residents of an economically depressed area;
• land-use pressures: overall land-use pressures can fall, with consequential social and economic benefits. The impacts on housing, transport and the environment are potentially important factors in determining the overall impact of a relocation.

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