Fiscal Autonomy in Scotland: The case for change and options for reform

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3 Current framework for tax and spending in Scotland

Chapter Summary

  • Under the current devolution settlement the Scottish Parliament has a significant degree of spending autonomy but very limited tax revenue raising autonomy, no meaningful borrowing autonomy, and no responsibility over monetary policy, competition policy, company law or regulation of financial markets.
  • The current framework significantly constrains the ability of the Scottish Government to boost Scotland's long-term competitiveness through, for example, introducing a more competitive tax regime, and from taking short-term measures to stabilise the economy through, for example, tax cuts or increases in spending.
  • The consequence is that there is general consensus that the current framework requires reform.

Introduction

3.1 Before considering the options for any future fiscal framework for Scotland, it is important to have a clear picture of the current framework for tax, spending and borrowing under the existing devolution settlement and to understand how well this meets the economic challenges faced by Scotland.

3.2 This chapter describes the current arrangements based on the Scotland Act 1998 22, examines Scotland's fiscal position and identifies the constraints these arrangements place on realising Scotland's growth potential.

Scotland's Current Fiscal Framework

3.3 This section outlines the current arrangements in Scotland for tax, spending and borrowing.

3.4 Spending - Under the current devolution settlement, the Scottish Parliament and Scottish Government have a significant degree of spending autonomy both in terms of the size of its spending remit and the ability to determine policy priorities and strategies. For example, the Scottish Government has significant responsibility for the allocation of public sector expenditure in Scotland - accounting for approximately 70% of total identifiable public sector expenditure for Scotland in 2006/07 23.

3.5 The current arrangements grant the Scottish Government responsibility for a number of policy areas that affect Scotland's long-term economic performance, such as education, transport, planning and economic development. Within its expenditure remit, the Scottish Government is able to determine both the policy mix and specific policy initiatives giving a degree of real autonomy over devolved policies.

3.6 However, responsibility for several key areas of economic policy and government expenditure more generally remain largely reserved to the UK. These include science and innovation, social security, child support and pensions, foreign affairs, defence, employment law and financial regulation.

3.7 Tax Revenue - In contrast to the degree of spending autonomy, the Scottish Parliament has only limited revenue raising capacity through taxation. The instruments available are:

  • local taxation ( e.g. council tax);
  • business rates; and
  • the ability to vary the basic rate of UK income tax by up to 3 pence (the Scottish Variable Rate - ' SVR') 24.

3.8 Under the current arrangements, the majority of Scottish Government spending is financed by the Scottish Block Grant which is determined in the main by operation of the Barnett Formula. In effect, the vast majority of tax revenues raised in Scotland are set and collected at the UK level before the UK Government determines how much of this is reallocated back to Scotland via the Scottish Block Grant (see Box 3).

Box 3 - The Barnett Formula

The Barnett Formula is the method used by the UK Government to determine changes in the budgets of the Scottish Government, Welsh Assembly Government and Northern Ireland Executive. It was introduced in the 1970s and has since remained largely unchanged. Under the formula, changes in the Scottish Government's Budget are determined by increases or decreases in spending in Whitehall Departments on programmes for which responsibility in Scotland is devolved.

The formula applies to Scottish Government Departmental Expenditure Limit ( DEL) funding which accounted for approximately 85% of Scottish Government spending in 2008/09 (£28 billion out of £33.3 billion) 25. It determines changes to the Scottish Budgetary position, not the total level of the block grant.

The following factors determine the calculation made for each departmental programme in DEL which then underpins the change to the Scottish Government's Budget:

  • the quantity of the change in planned spending by UK Government (Whitehall) Departments;
  • the extent to which the relevant UK Government departmental programme is comparable with the services carried out in Scotland; and
  • Scotland's population as a proportion of England, England and Wales or Great Britain as appropriate. The population projections used reflect the latest available mid-year estimates published by the Office for National Statistics ( ONS).

It is then for the Scottish Parliament and Scottish Government to allocate spending within that budget according to their own priorities.

3.9 Borrowing - The current devolution settlement provides no authority for the Scottish Parliament to sanction meaningful borrowing by the Scottish Government. There is the opportunity for short-term borrowing sufficient to cover "a temporary excess of sums paid out of the Scottish Consolidated Fund over sums paid into the Fund" or for "providing a working balance in the Fund". Any such borrowings may only be from HM Treasury 26.

3.10 Local authorities in Scotland do have the autonomy to borrow. The Scottish Government funds the debt servicing costs of some of this borrowing, known as "supported borrowing", via the Revenue Support Grant whilst the unsupported borrowing element, arranged under the Prudential Regime, is financed through local authorities' own general resources. The Northern Ireland Executive also has limited borrowing powers.

3.11 Further afield, most other devolved governments with comparable levels of policy autonomy have the authority to borrow in order to facilitate fiscal planning and management of cash flows as well as financing long-term investments and economic strategies 27. For example, U.S. States and Canadian Provinces have powers to borrow, where bond issuances - particularly to finance infrastructure and capital spending like bridges and schools - are common 28.

Scotland's Current Fiscal Position

3.12 As highlighted above, the current economic climate has weakened fiscal positions around the world.

3.13 The recent Government Expenditure and Revenue Scotland ( GERS) report highlighted that in 2006/07, the estimated current budget balance for the public sector in Scotland was a surplus of £0.8 billion (0.7% of GDP) including an estimated geographical share of North Sea revenue. The equivalent UK current budget position, including 100% of all North Sea revenue, was a deficit of £4.3 billion (or 0.3% of GDP) 29.

3.14 Since 1976/77, the UK Government has raised approximately £155 billion in direct tax revenue from oil and gas production. Adjusted for inflation, this is equivalent to £269 billion (2008 prices); or approximately eight times the annual Scottish Government Budget. These revenues have gone directly into the UK Exchequer, with successive governments using the windfall to fund public spending and to seek to reduce taxation across the UK. Unlike other countries with substantial oil and gas reserves, the UK Government has yet to establish an oil fund where a proportion of the proceeds from the country's oil and gas production could be invested over the long-term.

3.15 Norway's oil fund, known as 'The Government Pension Fund - Global', was established in 1990 however, the first net transfer to the fund was not made until 1996 30. It is now the second largest wealth fund in the world and as at end of September 2008 it was valued at NOK 2,120 billion 31 - approximately £200 billion.

Chart 1 - Scotland's Current Budget Balance and Net Fiscal Position: 2006/07

Chart 1 - Scotland's Current Budget Balance and Net Fiscal Position: 2006/07

Source: Government Expenditure and Revenue Scotland 2006/07

3.16 In 2006/07, the estimated overall net fiscal balance in Scotland, that is the estimated current budget balance plus net capital investment, was a deficit of £2.7 billion (2.1% of GDP) when an estimated geographical share of North Sea revenue is included. This is broadly in line with the average fiscal balance in the OECD which for the years 2005 to 2007 inclusive, was a deficit of 1.8% of GDP32.

3.17 The equivalent UK position in 2006/07 including 100% of all North Sea revenue, referred to as 'net borrowing', was a deficit of £30.1 billion (or 2.3% of GDP) 33. Other large OECD countries also operate deficits: France a deficit of 2.7%, Japan a deficit of 2.4% and the USA a deficit 2.9% of GDP in 2007 34.

3.18 The GERS estimates tells us that Scotland was in a relatively stronger fiscal position in 2006/07, although it does not tell us what the fiscal position of Scotland would be under alternative fiscal structures. Under new fiscal arrangements, Scotland would have the opportunity to make choices regarding the levels of UK-wide expenditures such as welfare payments, foreign affairs and energy policy and take responsibility for ensuring that these were appropriately financed. Short of full independence, this may involve Scotland following the approach adopted in the Basque Country by raising and spending its own resources, before contributing to the UK level for certain 'national' expenditures such as defence.

Scotland's Current Monetary Policy Framework

3.19 Under the current constitutional settlement, monetary policy is fully reserved and conducted through the independent Bank of England. The Bank of England sets interest rates, conducts open market operations in the money markets and manages the UK's foreign exchange reserves. The monetary policy remit of the Bank of England is to deliver price stability, as defined by the UK Government's inflation target of 2%, measured by the Consumer Prices Index ( CPI). The UK currently operates under a flexible exchange rate regime independent of other countries. In contrast, many European countries are part of the European Monetary Union and share a common currency, the Euro.

Scotland's Current Industrial Policy and Regulatory Framework

3.20 In addition to fiscal and monetary policies, other important economic policy levers are also reserved to the UK Government, with the effect that the UK remains largely responsible for the framework for economic regulation in Scotland. Key reserved functions include:

  • energy policy, including the oil and gas sector;
  • competition policy;
  • company law;
  • economic regulation of utilities ( e.g. telecommunications, broadcasting and energy);
  • financial services and regulation of financial markets;
  • consumer protection and product and trading standards; and
  • policies affecting the labour market, including employment law and migration.

3.21 These are significant responsibilities which have a considerable bearing on the performance and the growth potential of the Scottish economy. Decisions in these areas by the UK Government and the EU can also have important consequences for fiscal policy, at both a UK level and in Scotland. For example, decisions made by UK Ministers on labour market policy, and particularly on migration, can have an important influence on demand for public services and the size of the tax base.

Constraints on Scotland within the Current Framework

3.22 The current devolution settlement should in theory provide a stable revenue stream for the Scottish Government as the majority of funding is typically allocated for a three-year period. In practice however, this is not always the case, as unilateral changes at the UK level can significantly impact upon anticipated future funding streams. For example, decisions taken by the UK Government at the 2008 PBR will serve to reduce the Budget of the Scottish Government between 2010 and 2012 from that originally planned. While exact details of the final financial impact are as yet unknown, the total effect may be as large as £1 billion over the entire period.

3.23 Moreover, we believe that there are a significant number of more general limitations to the current framework which constrain the autonomy of the Scottish Parliament and the ability of the Scottish Government to generate a step-change in sustainable economic growth:

  • While the Scottish Government has significant levers to shape spending programmes, for example, on education and skills, it lacks the ability to shape the regulatory and tax environment, levers that are seen as vital to boosting Scotland's long-term competitiveness. For example, under the current arrangements, the Scottish Government does not have the authority to put in place a more competitive corporation tax structure - a policy that is viewed by many, including the Confederation of British Industry ( CBI) (2008) and respected academics such as MacDonald and Hallwood (2006) and Greenaway et al. (2006) - as pivotal to economic growth 35. In addition, commitments to invest in long-term infrastructure are constrained by fiscal rules which are determined and revised by the UK Government and not by what is in the best interests of the Scottish economy.
  • More generally, the Scottish Government's Budget is determined principally by changes in spending on equivalent programmes in England set by the UK Government and is not directly linked to the preferences of the Scottish population or their willingness to pay for the provision of services. Not only does this lead to inefficiencies in the decision-making process from a theoretical point of view, it also fails to give Scottish citizens the ability to choose to vary the level of public spending in any meaningful way beyond that determined by Westminster.
  • The current fiscal settlement limits the short-term flexibility of the Scottish Government to respond to changes in the economic climate. The Barnett Formula is not linked to economic conditions and borrowing powers are severely limited. Taken together, this means that during economic downturns, the Scottish Government has limited levers to stabilise the Scottish economy through cutting tax or increasing expenditure (for example, expanding investment in infrastructure). In the main, Scotland has to rely principally on action undertaken at the UK level, and this uniform stabilisation policy may not be best suited to Scotland. For example, the Scottish Government believes that the £12 billion cost of reducing VAT to 15% announced by the Chancellor at the 2008 PBR, would have been better spent on increasing net investment as analysis has shown that the net effect in terms of jobs would have been greater. However, Scottish Ministers were not able to make this choice.
  • The current framework leaves the Scottish Parliament without responsibility for North Sea revenues preventing the creation of a Scottish oil fund. In addition, many of the key levers to tackle environmental issues are reserved, including support for innovation in areas such as carbon capture and storage, environmental regulation and global environmental agreements.
  • In recent years, the application of the Barnett Formula appears to be partial with some funding subject to 'formula bypass' and with Scotland not always treated in a fair and reasonable manner. An example is the allocation of development and regeneration expenditure tied to the London Olympics and expenditure on prisons in England, from which Scotland did not receive appropriate consequential funding.
  • Finally, greater fiscal autonomy could improve political accountability and transparency by providing a more visible link between expenditure and tax choices. In 2006/07, the Scottish Government was responsible for £29.9 billion of identifiable public expenditure in Scotland but with local authorities only collected approximately £3.6 billion of total revenues through council tax and non-domestic rates 36. Fiscal autonomy, by linking expenditure with revenue (and/or borrowing), can encourage maximum rigour in the overall budget process of the public sector in Scotland through consideration of both the marginal costs and/or benefits of changes in public spending and taxation. In effect, by forcing Scottish politicians to focus on both sides of the balance sheet - revenues as well as expenditures - it emphasises the need for keeping higher sustainable economic growth at the heart of public policy debates.

Conclusion

3.24 The Scottish Parliament and Scottish Government have spending autonomy over devolved policies; however, this is in stark contrast to the level of revenue and borrowing autonomy, which is severely constrained. In this regard, Scotland stands as a clear outlier in comparison to other countries. Importantly, the Scottish Government has no role in monetary policy and key elements of broader economic policy.

3.25 We believe that the current tax, spending and borrowing arrangements seriously constrain the ability of the Scottish Government to deliver increasing sustainable economic growth. The aim of greater autonomy is to improve resource allocation and incentivise growth; to generate greater public revenues, meaning Scotland could support higher levels of public spending and/or lower taxes in the long-term.

3.26 In light of this, Chapter 4 reviews the options for reform of tax and spending responsibilities in Scotland. These are:

  • current framework;
  • assigned revenues;
  • enhanced devolution;
  • devolution max; and
  • independence.